Friday, November 14, 2008

You Are What You Eat

“Der Mensch ist, was er ißt.”
(Man is what he eats.)

Ludwid Andreas Feuerbach

As the market swings from the rafters and then down to the basement, friends and neighbors who know I am work as a stock analyst have begun asking for advice. Since I am not a financial planner, I always feel at a loss when faced with such questions. I know it is probably not very meaningful to suggest they strive for a stock/bond mix that “maximizes the Sharpe Ratio” of their portfolio.

Some individuals have experienced such a drastic reduction in their net worth they must re-orient their entire investment perspective. Particularly disoriented are those who had previously considered themselves sophisticated investors and even “qualified” investors in SEC terms for those allowed to invest in higher risk private transactions. The new day of “socialized capitalism” has left fewer so-called qualified investors around. They are now starting over!

As a first step financial planners suggest individuals maintain cash holdings equivalent to six times their monthly budget. This is the equivalent of working capital at the corporate level. Then the rest of assets are dividend among stocks and bonds. The entire exercise appears to eliminate consideration of the individual’s home, which is not generally considered an investment.

To determine how much should be held in stocks, some financial planners suggest subtracting the individual’s age from 120 (women) or 110 (men) to get the percentage of optimum stock holdings. The balance of assets should be held in bonds. The simple two step allocation process says nothing about particular circumstances such as the number of dependents or marital status.

I have tried these simple rules of thumb out on friends. Most take it right in stride. It is the investment selection process that has them stymied, especially as they see prices gyrate wildly and investment gurus like Jim Cramer advising to “sell, sell, sell” even after prices had already fallen.

So I have devised a simple stock and bond selection strategy for my friends that is based loosely on simple, easy-to-remember dietary concepts.

First, “never eat anything that disagrees with you.” In other words, do not take on more risk than you can tolerate.

Second, “eat a variety of foods in moderation.” I have been surprised at the number of individuals who are not familiar with the concept of diversification as a means to reduce risk and increase returns.

Anyone who fails to see the downside of too much leverage has probably just emerged from a coma and has not read the news headlines lately. Investment bankers and fund managers are now regretting excessive borrowing against assets that are now selling for a fraction of original value. Therefore, “never eat a piece of meat larger than your fist.”

Fourth, “the lunch special is always the best choice.” Always go for value. This works for stocks and bond alike and works whether the investment strategy is a bear case short-sale or a bull case long-buy.

Fifth, “push away from the table before you are full.” Too many investors - professionals and regular folks alike - hold onto investments well past maturity, holding the security even as the price collapses to a loss position. Take profits and move on.

I do not expect my food metaphor guide posts to make it into a financial planning text book. Nonetheless, it is true that “we are what we eat.” Where would this be more apropos than with our investments?

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