4 Ways to Beat Complexity and Uncertainty in Your Portfolio
Jun 19th 2012 11:34AM
Updated Jun 19th 2012 11:38AM
Being a great surgeon may have a lot in common with being a great investor.
Atul Gawande -- surgeon and author of The Checklist Manifesto -- recently delivered a commencement speech at Williams College (hat tip to Farnam Street blog). Gawande related how, as a young buck, he was impressed with the intricate skills of surgeons and that drove him to become a surgeon himself.
However, once he was in his surgical residency, he learned that those fine motor skills weren't the key to being a top-notch surgeon. "Instead," he said, "the critical skills of the best surgeons I saw involved the ability to handle complexity and uncertainty."
If there are two things that investors eternally grapple with, it's those twin demons of complexity and uncertainty. The speech got me thinking: How do I deal with complexity and uncertainty in my investing? Here are four strategies that I use.
1. Look for signposts
It'd be nice to claim a full, nuanced grasp of all the moving parts of one of my favorite investments, Berkshire Hathaway (NYS: BRK.A) (NYS: BRK.B) . Berkshire is a company with huge, complex insurance operations that span everything from plain-vanilla individual auto insurance to massive specialty catastrophe coverage. Fully understanding that alone would be an impressive feat. But Berkshire is also the owner of one of the U.S.' largest rail systems, a multibillion-dollar stock portfolio, a regulated power company, and a wide array of individual businesses including Fruit of the Loom, Dairy Queen, and Benjamin Moore.
There's some serious complexity for you.
A complete understanding of all of the complexities of a company like Berkshire may be out of the question, but what we can do is look for signposts of a successful company. For financial companies like Berkshire, for instance, book value is a key measure. For the decade ending in 2011, Berkshire grew its book value at an average annual rate of 11% per year, an attractive rate for a company that size. For other companies you may look at metrics like return on equity, revenue growth, profit margins, or balance sheet strength.
Investors have heard over and over again, "Past performance does not guarantee future results," but by looking for signals of a successful company -- even if they don't guarantee future success -- investors can gravitate toward the best companies even in the face of considerable complexity.
2. Invest in businesses you understand
No. 1 above isn't enough by itself. For proof of that, just ask pre-recession bank investors. Bank of America (NYS: BAC) , for instance, appeared to be a solid-performing, high-quality bank based on its 2006 return on equity of 18%. But then... well, we all know how that played out.
Many investors may have understood the risks that they were running by investing in a huge bank with a highly opaque balance sheet. However, some may have been caught completely by surprise as they assumed that the outward performance measures told the entire story.
So while you may not be able to fully unpack the complexity of a given company, it's imperative that you have enough of an understanding to know what you don't know and appreciate the risks you're taking.
3. Accept uncertainty
The first step to combating a problem is admitting that you have one, right? Well, if you're going to be an investor, you better get comfortable with the fact that there's always uncertainty. Always.
Uncertainty means that unexpected, bad things can happen to good companies. And because we're talking about predicting the future here, even when there's nothing wildly unexpected, sometimes investors are just plain wrong.
The old saw "Don't put all of your eggs in one basket" not only suggests that you have multiple baskets, but it also assumes that you have multiple eggs. An investor who's accepted uncertainty and wants to safeguard his or her retirement collects a bunch of eggs from a bunch of different birds and divvies them up into multiple baskets, combining stocks, bonds, real estate, commodities, and cash.
For stocks in particular, that could mean finding multiple attractive individual stocks, or going with some one-stop diversifiers like the Vanguard Dividend Appreciation ETF (NYS: VIG) or the Vanguard S&P 500 ETF.
4. Use time arbitrage
A couple of years ago, my Fool colleague Jeremy Phillips pounded the table on the idea of time arbitrage -- that is, buying when short-term concerns are weighing down the stock and profiting by hanging on for the long term.
This is a great strategy for not only dealing with, but profiting from, uncertainty. Looking at the yields on U.S. government bonds -- one of the assets investors equate most to certainty -- we can see just how expensive it is to buy with certainty today.
On the flip side, General Electric (NYS: GE) is a global industrial company with significant exposure to Europe -- which is more than enough to create significant near-term uncertainty. But for investors that are looking at GE as a long-term bet, the stock currently has a dividend yield of more than double that of Treasuries and an earnings yield (the inverse of the price-to-earnings ratio) of more than 6%.
In other words, having a long time horizon can help investors not only deal with uncertainty, but profit from it.
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At the time this article was published The Motley Fool owns shares of Berkshire Hathaway and Bank of America. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, Bank of America, and Vanguard Dividend Appreciation ETF, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.
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