I get a lot of questions regarding my actual approach to portfolio management so it’s useful to elaborate on the way I view the macro investment world. The attached diagram shows my overall approach. I use what is called a top down approach. This means that I formulate a big picture view and then apply money making strategies to that overall macro outlook. This is different from a bottom up approach in which investors try to find pockets of the market that are mispriced while ignoring the macro picture. They assume that markets will adjust over time and reprice the mispriced asset to reflect its true value.
Formulating the macro picture is largely what you read here at Pragmatic Capitalism. There are a huge number of variables that go into this formulation. What is the government doing? Where are earnings going? What are the inflation/deflation trends? How is the global economy impacting the markets? A great deal of understanding and education is required for this sort of approach. If you don’t understand how monetary systems work you probably won’t understand where interest rates are headed. If you don’t understand where interest rates are going you won’t know where bond prices are going. So on and so forth. Markets are highly interconnected. If you don’t understand the bond market I would venture to argue that you probably understand the stock market less than you think.
All of this analysis results in some sort of macro outlook. Currently, I believe we are in a long lasting balance sheet recession that has caused a secular bear market in stocks. High debt levels have resulted in extreme excesses and the bursting of this debt bubble has resulted in private sector balance sheet implosion. The recovery period out of this recession will involve below trend GDP growth, low historical inflation and a generally difficult investment environment.
Once I’ve formulated the macro environment type I can begin to apply specific investment approaches. As I often say, I think it’s important to remain flexible. I am not against using a buy and hold strategy or any strategy for that matter. I just know that there is a time and a place for specific strategies. Buy and hold does not always work. With the exception of a brief window in 2009 when everyone was saying distressed debt was too risky and buy and hold was dead (I was saying the opposite at the time – see here & here) this has remained an environment in which traditional long-term value oriented investing strategies have resulted in low risk adjusted returns.
Next I can decide which of my strategies to apply to this macro outlook. Because the choppy macro outlook leads me to believe short-term strategies will produce higher risk adjusted returns I have to reach into the trading toolbox. I always use a multi-strategy approach. The key here is that I have several short-term or medium-term strategies working all at once. While I have my favorites the multi-strategy approach ensures that I am never pigeonholed. If the opportunities in one strategy appear favorable I can allocate more of my overall approach to that strategy.
Within each strategy I have specific approaches. Some of this is actually elaborate bottom up investing, but varies enormously from strategy to strategy. Running this sort of platform requires an enormous amount of work and research, however, I have come to believe that it best suits my needs and has helped me to produce high risk adjusted returns over a sustained period. Every investor is different, however, having a detailed process in which you work is necessary for investment success. What you see here at Pragmatic Capitalism is largely the first step in this process – the macro outlook. This is probably why I appear to have a bearish emphasis most of the time. This is true only at the macro level. As a risk manager I think it is important to focus more on the potential dangers. Within this macro outlook I have been and will continue to be wildly bullish at times in a micro sense.
So there you have it. That is my flexible, multi-strategy, global macro investment approach to a tough investment environment.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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