If you read anything about the young Bobby Fischer growing up, he was interested in two things: chess and money. It's quite understandable. He was competing against Russian chess grandmasters who received stipends from the state. They were free to study chess and play in chess tournaments and never had to worry about how they were going to pay the rent. For Bobby, there was no government stipend. Chess cash prizes when he was growing up were paltry. When he won the United States junior championship, all he received was a typewriter. U.S. players qualifying for the Interzonal tournament, the most prestigious tournament held to determine which players were going to compete for the world championship, had to pay their own expenses to the competition. And the prize fund was only a few hundred dollars.

There is something about "Naked" decision-making that gets people excited, especially when talking about portfolio managers.

Jordon Kimmel is a portfolio manager, radio host, and author of a book called "The MAGNET Method of Investing." I had the opportunity to be a guest on his show last Thursday, and we discussed how a "Naked" approach to the investment process can improve how it's implemented. (CLICK HERE to listen to the interview).

"MAGNET" is an acronym; each letter is a guidepost for the factors that Jordon believes are key to creating winning portfolios. I told Jordan that while I thought his book could be valuable to anyone managing a portfolio, managers could implement his process even more effectively if they turn his guideposts into rules - in essence making his strategy "naked." Guideposts can be used to show a direction, but rules tell you exactly what to do.

Here is an example of what I mean: The M in MAGNET stands for "management." One way to identify a company with good management is to use your judgment based on what you read about the chief executive officer. But another way to judge management is to see if they own a lot of their own company stock. For example, choose only companies in which the CEO owns more than twice his annual compensation in company stock. This decision-making rule is based on the theory that the CEO has a vested interest in making the company successful.

Sure, there are probably some crummy managers who own a lot of their company stock, but there's no guarantee you could identify a good manager based on your judgment or what you read about them either. The key is following the rule. If you believe you should buy only those company stocks in which the CEO owns more than twice his compensation, then the rule can be applied flawlessly without human error. (I have not researched this rule. It's just an example.) Reading about managers to determine if they are good is obviously a process that can be flawed.

In my last post, I praised Sgt. Kimberly Munley, the civilian Department of Defense police officer who ran into a hail of bullets to neutralize the gunman at Fort Hood. There are very specific lessons that investors can take away from Sgt. Munley's actions. Let's review what happened:

1. Sgt. Munley reacted to a clearly defined situation; an active shooter.
2. Sgt. Munley knew exactly what to do; neutralize the shooter immediately by whatever means neccesary.
3. Sgt. Munley had rehearsed that exact action in SWAT training.

Now let's compare this highly stressful situation to what happens in a bear market. (In no way am I minimizing Sgt. Munley's bravery. My point is to show how training and preparation can and does benefit investors). Most investors don't have a plan for bear markets. Some use the "hold-on-as-long-as-I-can-stand-it" approach. Others sell in a panic. Data from Morningstar and DALBAR, two companies that study investor behavior, show that many mutual funds are in net liquadations during a bear market, indicating that many people are pulling their money out just as the market is bottoming. What can be done about this?

What if you used a naked investment appoach to investing? What if you had a strategy that:

1. Clearly defined when you were in a bear market using empirical data.
2. Told you exactly how to adjust your allocation so that you could increase your equity weightings as stock got cheaper.
3. Allowed you to periodically review your plan and spend time talking to your partner, spouse, or financial advisor about how you should paln to react in the next bear market.

Would that make you a better investor?

I will be a guest on Magnet Investing with Jordan Kimmel at 11:30am on Thursday 12 November. Jordan has interviewed some very prominent experts in the past including William O'neil, the founder of Investors Business Daily and Louis Navaliier, the famous fund manager. You can listen over the internet by going to  The Voice America Business Network  at http://www.modavox.com/voiceamerica/vportal.aspx.

Sgt. Kimberly Munley is the heroic police officer who stopped the crazed gunman when he went on a shooting rampage at Fort Hood on Nov. 5th. After she had shot and wounded the gunman, he turned toward her and began firing.

According to The New York Times, with the gunman repeatedly shooting at her, Sgt. Munley "ran toward him, continuing to fire, until both the gunman and Sgt. Munley went down with several bullet wounds." The Times continues saying that Sgt. Munley, an expert in firearms and a member of the SWAT team, had "received specific training in a tactic called active shooter protocol, which was designed for exactly this kind of situation."

What enables a mother of two small children to risk her life by running into a hail of bullets? No doubt in the coming weeks we will hear countless explanations that will revolve around her courage and bravery and desire to serve her fellow man. She is a true hero who probably saved many lives and she fully deserves all the laudatory comments and awards that she will receive. But, in my opinion, what enabled her to act as she did was her training. At the time of the attack her mind was focused on executing what she was trained to do. She was executing a previously rehearsed exercise, except this time, there were real bullets.

So what does this have to do with bear markets? During a bear market, talking heads in the media shoot "fear bullets" that can place investors at grave risk of undoing a sound strategy. And the best way to prepare for these times is to conduct bear market drills; in other words, selecting "naked strategies" or rule-based approaches in which the investor decides exactly what protocols he will follow in a bear market, before it happens.

I will talk more about bear market drills this week. In the meantime, please keep Sgt. Munley and her family and all the other victims at Fort Hood in your thought and prayers.

 
The above drawing is from The Naked Portfolio Manager and is illustrator Carolyn Schallmo's representation of what may go through a judgment-based manager's head before he buys a stock. It's a mysterious process: "Poof!"...and all relevant facts are processed and a decision is made.

As mentioned in my previous post, I had a chance last week to visit Sweet Briar College and review the progress of the class developing rules-based methods for portfolio management. After one student named Morganne Young explained her rational for selecting several different variables to construct her model, she asked an extremely profound question: "How do I determine how to weigh each of these variables in my model?"

Her question emphasizes yet another of the key advantages that statistical prediction, or rules-based decision-making, has over human judgment or intuitive decision-making. With statistical prediction, the model designer can use historical data to determine how much weight to give to each variable. With the "Poof!" process as illustrated above, it's unclear how the decision-maker weighs his inputs, or if he even gives any consideration to it at all.

Labels: Sweet Briar, variables

Last week, I had the opportunity to visit Sweet Briar College and review the progress the students are making in developing their "naked strategies," or rules-based methods for portfolio management.

Many of the ladies had the makings of really great models. I was especially intrigued by a model developed by Heather McPheeters and Andrea Jones designed to capitalize on opportunities in the currency markets. Lindsey Davis and Morganne Young also both seemed to have an excellent grasp of how to apply statistical prediction to making investment decisions.


[By the way, if your reading this at Sweet Briar and you don't have a copy of The Naked Portfolio Manager yet, I think the bookstore still has a few copies!]

Labels: emotions, human error, rules, Sweet Briar

Labels: bear market