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10 Investment Guidelines: Part 1

Scott Rothbort

Bernstein's final report at Merrill Lynch, published on April 14, was called 10 Guidelines Learned in 20 Years. The report, whose guidelines were listed without elaboration like the Ten Commandments, was so compelling and enlightening in its simplicity that I've decided to incorporate it into a lesson for my students at the Stillman School of Business at Seton Hall University. This and the following Finance Professor articles will serve as the outline for that lesson.

Here are the first five of Bernstein's guidelines, with my interpretation and analysis.

1. Income is as important as are capital gains. Because most investors ignore income opportunities, income may be more important that capital gains.

When it comes to investing what counts above all is performance. Performance is based on total return, which encompasses capital gains and income, the latter of which is generated through interest and dividends.

In the stock world, this boils down to the classic growth vs. income tradeoff. However, as biases are created toward growth (capital gains), income-oriented stocks become shunned and undervalued. As supply and demand imbalances are created, relative opportunities in income-oriented investments result.

2. Most stock market indicators have never actually been tested. Most don't work.

This is a very broad and general statement. My interpretation of this guideline is that technical analysis does not work. Many technicians use market indicators in various forms, including charts, ratios and volume, as the basis for trades. Many market indicators are derived through data-mining and form-fitting.

Developing trading rules or models requires formulating and testing a hypothesis through a great deal of careful data collection, observation and back-testing. Very few trading strategies can make money, and even fewer can consistently beat market averages over long periods of time. Again, it comes back to performance.

3. Most investors' time horizons are much too short. Statistics indicate that day trading is largely based on luck.

Here Bernstein clearly lays down the gauntlet at the feet of day traders. Frankly, I am in his camp. Theories espoused by some of the most successful investors, such as Bernard Baruch, Benjamin Graham and Warren Buffet, rely on valuation techniques, which require holding periods of more than just a few hours. Day traders will argue that "buy and hold" does not work.

The problem with this argument is that successful investors will not buy and hold forever, as day traders contend. Rather, they will research, buy value, monitor, reevaluate and eventually sell. This process could take years but will not take forever. Furthermore, it is an interactive process with feedback loops. Only lazy and complacent investors will buy and hold blindly.

Day traders are more akin to gamblers than investors. Even successful gamblers gamblers can't win all of the time and will rely on unquantifiable luck. You have to separate gambling as entertainment from gambling as a career, as my good friend and superb handicapper Mitch Rosen is able to do. There are very few career gamblers.

Finally, Bernstein would not mention statistics that indicate that day trading does not work unless he is confident as to its source and conclusion.

4. Bull markets are made of risk aversion and undervalued assets. They are not made of cheering and a rush to buy.

The advice here is to buy cheap and sell rich. Whether at the top or at the bottom of markets, investors exhibit emotionally irrational behavior. Pervasive selling stems from investors acting on emotion to avoid risk. This creates value, from which bull markets are born. An emotional rush to buy that is often accompanied by cheerleading will result in valuations being stretched and elevation of risk levels. This occurs as the "marginal morons" enter markets. Tops in market are formed from cheering and a rush to buy.

5. Diversification doesn't depend on the number of asset classes in a portfolio. Rather, it depends on the correlations between the assets classes in the portfolio.

The concept of modern portfolio theory, as made famous by Nobel Laureate Harry Markowitz, states that investors will diversify their portfolios in order to optimize portfolio returns. Key to the theory is the relationship of returns among assets in the portfolio.

In statistical terms, covariance is the way that two random variables change together. In order to maximize diversification, one would seek to include assets or asset classes with low levels of covariance. Adding more assets or asset classes to a portfolio would not necessarily increase diversification and decrease risk. In fact, if the marginal assets have high levels of positive correlation, then you might be taking on more risk and volatility. For example, adding more financial companies to one's portfolio in 2008 would have been detrimental.

Look for Part II of this lesson from Richard Bernstein's farewell research report in the next Finance Professor article.

Scott Rothbort will be on Stockpickr Answers on Monday, June 8, to respond to investing and trading questions posed by members of the Stockpickr community. Not a member? Join the Stockpickr community today -- free.