LOGIC AND JUDGMENT IN SECURITIES SELECTION
AND ASSET
ALLOCTION
We discuss the principles of logic that pertain to
portfolio management, and then describe the consolidating concept of
judgment. This essay also illustrates that the trading of stocks at prices
reasonably related to real earnings depends crucially upon institutions. prices reasonably
related to real earnings depends crucially upon institutions.
Aristotelian logic is a major constituent of what we
generally understand to be science. Kant wrote, "Logic is ... the right use
of the understanding and of reason as such, not subjectivity ... but
objectively, i.e. according to a priori principles ...." As
summarized by Floy Andrews (1996), Aristotelian logic
takes the form of three principles:
1) The
Principle of Identity, requiring that an object be thought of as
having an immutable nature. A is A.
2) The
Principle of Contradiction, where an object cannot be thought
of as having a certain character and not having a certain
character.
A cannot be B and not B. In mathematics, this
is the way of deriving truth.
Take a
situation purported to be true. Assume the opposite and show that
this leads to a derived contradiction. Therefore the
situation is true.
3) The
Principle of the Excluded Middle, where an object either has a
certain character or it does not. A is either B or not B.
These logical principles, regulating reason, enable the
discovery and derivation of truth. These are also econometric assumptions. Are
these principles relevant to portfolio management?
There are two major equity investment styles: value
investing and momentum investing. Value investors (such as ourselves)
buy stocks that have gone down, in companies whose fundamentals are likely to
improve. Momentum investors buy stocks because they have gone up. In a thought
experiment, create a portfolio consisting half of value stocks and half of
momentum stocks. Consider now what will happen if the portfolio drops. Value says
buy; momentum says sell. This suggests the advantage of having a consistent
investment style that is appropriate to your own circumstances and temperament.
Bonds are usually less risky than stocks, but consider
what will happen if you invest 100% in long-term bonds. With this asset
allocation, it obviously doesn't matter how the stock market does. Over the
long term, however, your portfolio will be compromised by inflation because,
although stocks are more sensitive to inflation than are bonds, within an
economic cycle; across economic cycles, shareholders will benefit more
than bondholders because they will capture the benefit of profit increases.
Keynes (1938) wrote that bonds are for "really
secure" current income. A junk bond is therefore an oxymoron, a
contradiction in terms. Stated otherwise
the reward for successful, and of course more volatile, stock investing is
increased bond investing when you rebalance your portfolio. This is to keep in
mind for the future. At the time of this 7/02 writing, we would not purchase long-term
bonds due to their high valuation relative to stocks and to absolute interest
rate risk.
Aristotelian logic allows us to derive useful conclusions
for non-contingent matters, that is in matters of
theory and principle. It does not result
in useful conclusions in matters regarding the contingent future,
that is for issues of timing. He wrote, "For what holds for things
that are does not hold for things that are not but may possibly be or not be
...." Andrews writes about this, " When
things are indeterminate either because they are not actual or not completely
given in their causes, propositions about them must be similarly indefinite
.... There are, no doubt, eternal truths in the temporal world but not all
truths are eternal." It is possible to handle valuation with some degree
of rigor. The dimension of time, however, is what makes stock market investing
an art. The ancient Greeks made distinctions among several different modes of
thought. The most general was theoria; or what
we call the theoretical knowledge that comprises beliefs: for instance about
logic, mathematics, or now economic
principles, beliefs involving either the idea of truth or its discovery.
Another kind was praxis, or what we call the practical knowledge that
results in action, for instance on when to buy and sell stocks. (There are
about 1,900,000 references on the Internet to that term.)
The crucial difference
between theoretical and practical reasoning, as philosopher John R. Searle (2001) points out, is the dimension of time.
Theoretical knowledge is applicable for all time, to everyone, and in all
places. Valuation is a theoretical and static measure of a stock's profit
potential. It is the major factor when discussing long-term investment
concerns. On the other hand practical knowledge, which in the following linked
market analysis includes valuation only as a factor among others, exists in the
world of unique situations, of timely
weighed contingencies.
To discuss longer-term securities selection: Valuation is
a theoretical and calculated variable. Timing is a practical consideration.
When a stock is undervalued and in an industry group whose earnings are
likely to improve with the economic cycle, it will most probably increase,
assuming all other things being equal. This is an example of Aristotle's
consolidating concept of phronesis, the
considered choices involved in practical belief when handling complexity,
simultaneously considering both the general and the particular.
The concept of phronesis
is useful when doing asset allocation. The closest modern translation of this
is common sense or judgment, when acting within the sphere of human goods. Your
asset allocation relates to your overall goals and requirements, investment
time horizon, and tolerance for volatility. The average pension asset
allocation consists of something like 60% stocks and 40% bonds. This is a
starting point from which to determine the asset allocation that is appropriate
for you. In Ethics, Aristotle (384-322 B.C.) wrote:
"... (phronesis)
is thought to be the mark of a prudent man to be able to
deliberate rightly about what is good and advantageous
..."
Although outperforming the S&P 500 is important, a
portfolio structure that is appropriate for your life circumstances is usually
the best way of handling the short-term volatility of markets.
At this writing, the stock market has plummeted to new
lows unseen since 1997. On 7/23/02 the S&P 500 closed at 797, below its
equilibrium value of approximately 1000, and even below its 965 close a few
days after the terrorist attack on the World Trade Center. The stock market is
undervalued, earnings are in the process of improvement, and Fed policy is
accommodative; however, it is having problems with the crucial ceteris
paribus assumption of economics, all other things being equal.
Financial statements that "present fairly, in all
material respects," the financial positions of companies underpin the
markets, a part of their infrastructure. The current plethora of accounting
frauds strikes at the heart of the valuation process, which enables investors
to value stocks and then to compare these values with those of other companies.
Creative accountants at the Enrons and WorldComs have increased the general level of uncertainty
for all companies, undermining the crucial resource of social trust that the
markets require. Investors, suspecting a stacked deck, are leaving the stock
market with every rally.
A
bright spot in this grim situation is a democratic society's ability to effect
reform. Congress, accountable to the voters this November, is discussing the Sarbanes-Oxley bill. To remedy conflicts of interest, this
bill will help restore the credibility of corporate accounting by proposing
that independent auditors not audit their own work, not function as a part of
management, and be further supervised by an independent board. To remedy moral
failure, the SEC requirement that a CEO personally certify the accuracy of his
company's financial statement affixes the responsibility for accurate financial
reporting where it belongs. Alan Greenspan stated in his second most famous
speech on July 16, 2002:
"Why
did corporate governance checks and balances that served us
reasonably well in the past break down? At root was the
rapid
enlargement of stock market capitalizations
in the latter part of
the 1990s that arguably engendered an outsized increase in
opportunities
for avarice. An infectious greed seemed to grip much of our
business
community. Our historical guardians of financial information
were
overwhelmed ...The effects of the recent difficulties will
linger for a
while bit longer but, as they wear off, and absent
significant further
adverse shocks, the
sustainable growth."
To turn now from venality to the venial
sin (in investing) of logical inconsistency. Does the same
principle always pertain? In the rhetoric of public debate, exceptions are not usually
discussed because they dilute the main argument. A legitimate exception, we
contend, has these three characteristics:
1) It must be
openly discussed.
2) It must be
considered reasonable by most.
3) It should be
limited in scope. This point merits some further discussion.
Consider,
for instance, the law. It is codified, it is consistent with modern
concepts of civil rights and democratic process, and
contains legitimate
exceptions. In a preface to Mills' essay "On
Liberty" (1859),
Harvard
Law Professor, Alan Dershowitz (1993 ed.) writes,
"... it is far better
to argue about the limits of the principle itself than to
accept it as an almost
biblical (or constitutional) rule of action and then to try
to find ways to
squeeze what are really exceptions into the parameters of
the principle." He
also writes, "... exception ... should not, in my view,
be expended beyond the
narrow areas in which it is appropriate."
There is an exception to the asset allocation rule we
have been discussing. This limited exception occurs when the stock
market is very overvalued. We have discussed this in, "Is the Stock Market Rational?"
