Placing the ball

Indecision is a batsman’s worst enemy. The batsman who cannot decide whether to play off the front or back foot will soon walk back to the pavilion. What, then, should be a batsman’s approach to scoring runs?

Bradman cautions that “it is unwise for a batsman specifically to make up his mind before the ball is bowled where he will hit it”. He advises that “batsmen should always have prominently in their minds the thought that they will take advantage in the field if opportunity occurs.”

A batsman must have a mental picture of the field before the ball is bowled and be prepared to act. As Bradman explains “this is very different from deciding on the shot before you know where the ball will be pitched.”

Similarly, an investor forms a mental picture of the potential returns offered and the risks run in targeting them. But having an estimate of fair value is quite different to investing with a fixed strategy. It is the same as a batsman with a premeditated stroke in mind – he will only score runs if the bowler delivers a ball that suits his plans. Otherwise, at best he fails to score and at worst he loses his wicket.

In contrast, a skilled batsman plays each ball on its merit. This is exactly what a skilled investor does when evaluating opportunities, executing and adapting his actions when circumstances change.

Bradman writes that a batsman “should not waste time playing the unprofitable stroke.”

Building an innings

A great innings is built one ball at a time. A batsman combines aggression and defense, knowing when to take the quick single, hit a drive for four and bludgeon a bad ball for six. More importantly, he also recognises when the bowler has his measure, patiently defending the wicket until there’s an opportunity to score.

In his book Capital Ideas, Peter Bernstein relates the story of how financial theories such as meanvariance optimisation, the capital asset pricing model and the efficient market hypothesis moved from the world of academia and into mainstream funds management. While many of these innovations were known in academic circles since Harry Markowitz’s seminal article on portfolio selection in June 1952, it wasn’t until the stock market crash of the mid 1970s that the funds management industry started to pay attention. Faced with the worst stock market crash since the Great Depression, funds managers and institutional investors responded by looking for better ways of managing money and – importantly – of controlling risk.

At this point they began to use quantitative measures of risk and diversification such as volatility and correlation. Aided by ever-increasing computing power, investment and risk management progressively became less of an art based on experience and more of a quantitative science. Risk could be easily quantified: it therefore appeared to be controllable. Once again, it has taken a financial crisis to create pressure for change throughout the world of investment. TRealising that risk isn’t just a number, investors have been asking themselves whether they could have done more to protect their portfolios. A result of all this soul searching is a renewed interest in asset allocation. To many people the idea of shifting a portfolio’s asset allocation in response to or in anticipation of market conditions makes intuitive sense. In his book, The Most Important Thing, Howard Marks describes the simple logic behind asset allocation: “There are few fields in which decisions as to strategies and tactics aren’t influenced by what we see in the environment.

Our pressure on the gas pedal varies depending on whether the road is empty or crowded. The golfer’s choice of club depends on the wind. Our decision regarding outerwear certainly varies with the weather. Shouldn’t our investment actions be equally affected by the investment climate?” With more and more investors recognising the need for asset allocation, the logical question is: how do you do it? why but not when As previously noted, classic portfolio theory reduces risk to a single number: volatility for absolute returns and tracking error for relative returns. As the last few years have shown, this methodology can be deceptive. Arguably a more appropriate measure of investment risk is loss of invested capital and the biggest contributor to a loss of capital is paying too much for an investment. Paying too much effectively locks in an insufficient reward or risk premium as compensation for investment risk. In contrast, investing at a discount to fair value or looking for a margin of safety helps to ensure that you are taking investment risks that are more likely to be rewarded. For this reason, valuation is central to most asset allocation strategies.