• Gus Crennan

The applicability of military art to investing

Updated: Jun 13, 2019

Every kid who has played a strategy game could tell you that you don’t set a weak piece against a strong piece – as the famous Polish WW2 example goes try not to charge cavalry into tanks unless the gesture alone is worth the sacrifice.

Reflecting on this inherently ‘manoeuvrist’ philosophy is it appropriate to select a passive investment strategy, for example remaining 100% invested in shares or real estate, regardless of market conditions?

Markets move hard and fast. We saw that in the final quarter of 2018 where global shares markets lost 16% in a few weeks. Active management within that environment is critical for preserving capital which of course is a pre-requisite to generate investment returns. A great investment opportunity is of no use if you have no capital.

At present we have great financiers like JP Morgan CEO Jamie Dimon noting ‘the near-term economic and political backdrop is increasingly complex and fraught with risks’ and ‘The extremely volatile global markets in the fourth quarter of 2018 might be a harbinger of things to come’. In general markets are skittish after a very long bull market backed by uniquely supportive central bank policies – there was no real new information which caused the 4Q18 sell off, which is what I mean by ‘skittish’. Sentiment is fragile.

So how is military art relevant here and now for investors?

I have always loved history. Has everyone heard of the Maginot Line? It was a series of border fortresses on the border of France and Germany built between WW1 and WW2 and the centre piece of France’s defensive strategy. When the Germans invaded France the second time how did they approach the Marginot Line? They most certainly did not just grind their armies to dust against it, rather they went around it and concentrated their efforts on a few key points. Two other examples to make this point: the Battle of Thermopylae was a famous Spartan v Persian battle where a superb use of terrain allowed a small force to hold off a large force for a period which changed the course of human history. Sir John Monash’s Creeping Barrage balanced trench warfare.

These three military history examples are all famous long after their successful implementation because they worked. These three strategies were designed to achieve a clear objective given significant constraints. Military history is important because it teaches us the importance of initiative and flexibility.

Here is the crux of my argument; if you know your opponent has lots of tanks, it’s a sure bet you need to arm your guys with lots of anti-tank weapons if you hope to prevail.

Equally if our best assessment is that we will be in a volatile environment why would we not tool our portfolios to that environment? If we hope to prevail we should.

There is an argument that we cannot know markets will be volatile. Play that uncertainty out in you mind. Imagine you are an Army General addressing to your troops:

‘Listen up – we think they have tanks, but we cant be sure, so we will just be giving you rifles and grenades. Good luck.’

Investment markets will always be uncertain, that should not stop active management of investment portfolios. Journalists and consultants should sit on the fence, decision makers should consider the information they have then make calculated decisions.

So what information do we have? Markets are up handsomely since December – if you have been fully invested since end of 2018 what would be the catalyst for you to trim growth positions?

If you sold some of your investments then the likely opportunity cost in the near term is the foregone yield we earn from asset classes like shares and real estate. If markets do head higher in the near term you also miss those added (unrealized?) capital gains which can look like poor performance in a mark to market environment (although really this is just a communications challenge). For positions which would realise large capital gains taxations considerations should also be carefully considered and may even appropriately change a decision.

A military context might be the third bridge in Operation Market Garden where the allies stretched their airborne elements too far from support. Ambitious and bold action needs to be balanced with realistic risk assessments with a key element being a clear understanding of what is a good outcome and what is an unrealistic and therefore highly risky expectation. We should target a good outcome given the market conditions while avoiding the excessive risks.

So as an alternative to prices of real estate and shares relentlessly marching higher, if markets instead experience an anxiety event like what we experienced in November and December 2018 then the portion of capital we repatriate in good times is not exposed and can later be utilized to buy investments at more attractive prices.

Unlike Market Garden we don’t have to be in a hurry. The opportunities will come. A key part of managing this judgement call and making the right decision in any situation is what is the probability and severity of each of our scenarios? In answering this question we have to first reflect on what is our real aim. For an investor preserving capital always comes first because without capital we cannot grow our purchasing power. A portfolio that falls 50% then needs to increase by 100% to get back to where it was! There is an uncomfortable asymmetry in investment losses.

I know its against common investment wisdom however in volatile environments where you might be up 10%, down 10% then end the year where you started, I cannot help thinking a retailer attitude is appropriate. ‘Owning pieces of good businesses for the long term’ is a good and proven approach. However if you can sell a tradeable security at $10 and then buy it back at $7 several months later, and you can repeat that action twice in a year, then you will have created something good (returns) from an otherwise tough environment. This then allows us to invest more capital when the time is right into our chosen investment with the freedom to then not sell that investment – we can modify our level of activism as the situation evolves.

For military people this would be widely understood as considerations like aim, flexibility and depth. For investors we can call this active exposure management, portfolio construction and buy/sell discipline.

We know markets move because people experience emotion. Being smart and using that means working with the conditions we are given.

In my view 2Q19 is a time for patience, building reserves and waiting for opportunities.

Regards, Angus

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