"True wisdom comes to each of us when we realize how little we understand about life, ourselves, and the world around us." Socrates (c.470-399 BC)
The "Socratic Method" originated with Socrates and was formalized by Plato. In the philosophical context, the method is based on the logic of critical reasoning by answering a particular question by asking another question and generally applies to the examination of concepts that seem to lack any concrete definition. Studying the behavior of financial markets, in my view, this Socratic method fits well into the context of investing by encouraging the investor to open his or her mind to alternate investment ideas and solutions, often with a contrarian bias. In my "Socratic Model" portfolio, with regard to asset allocation, the investor will follow a similar method in determining their asset allocation and, ultimately, their investment selection...
For example, it would be quite natural for an individual to make the current observation that stocks have been in a bull market for over four years and continue to reach record levels. That individual may ask the related question, "Should I invest more in stocks now?" A student of the Socratic Model may respond with a question, such as, "Could the long run for stocks and recent investor euphoria indicate that a major correction or bear market is more likely now?" Asking this type of logical question opens the mind to a wider range of possibilities. Ultimately, in my view, my Socratic Model will lead the investor to construct a "contrarian" portfolio model that pro-actively looks to market and economic cycles for clues to leverage these cycles for long-term benefit while avoiding the "herd mentality," that is often dangerous to most investors.
My Socratic Model builds on Post Modern Portfolio Theory (PMPT) that is central to my "Balanced Model." Expanding on PMPT, we can construct a portfolio that may maximize returns while minimizing losses. PMPT, if you recall, is founded on the view that an investor is more risk averse than they are risk tolerant, meaning that the average investor would prefer frequent and above-average returns while accepting only minimal losses that occur infrequently as opposed to seeking high returns that occur infrequently, accompanied by larger losses.
My Socratic Model investor is willing to allocate assets to areas often considered "risky" by the average investor, but, because of their investment knowledge and sophistication, the Socratic investor, ultimately, is reducing overall risk with the leverage of prudent diversification. It should go without saying that my Socratic Model is not for the "average investor" as is my Balanced Model or Rote Model.
Furthermore, my Socratic Model is certainly not market timing, a trading technique, or chartist theory; however it does call for active portfolio management, a passion for investment and financial market knowledge, and the study of macro-economic historical trends. If a market timer is seeking to precisely "sell high and buy low" based on charts, signals, and trends, the Socratic Model investor pro-actively seeks "time in the market" by "selling higher" and "buying lower." Market timing is not a strategy. Stated another way, the investor seeks to "sell into strength and buy into weakness" while maintaining a target allocation range that receives its ques from market and economic cycles. I eluded to this strategy in the immediately preceding post, "Stock Investors Having a Ball" and cited The Callan Chart as a reference. After looking at the chart again, review this asset allocation range for a primer:
- 25-45% Large Cap Stock (receives lower end of range during and immediately following recession, moving toward the higher end of the range as the economic cycle matures)
- 10-30% Small Cap Stock (receives lower end of range at the end of economic cycles and gradually moves to the higher end of the range once recession begins)
- 10-30% Foreign Stock (typically moves with Small-Cap Stock but, ideally, requires study of overseas economic cycles)
- 5-15% Defensive Sector Fund (I prefer Real Estate, Health Care, and Energy, usually whichever is currently out of favor.)
- 10-30% Multi-Sector Bond (receives lower end of range as economy emerges from recession and only moves higher as recession draws near)
- 0-15% Money Market (builds higher once economy is most obviously in latter stage of cycle: cash is a tool for buying on dips of 2% or more, gradually moving back into stocks after recession, and capturing yield in a high interest rate environment)
Now we'll apply these ranges using today's stage of the economic cycle, which, I believe, has recently entered the final stage before recession:
- 40% Large Cap Stock (Use an index fund here but actively-managed funds everywhere else; move to 45% by early 2008)
- 10% Small Cap Stock (Hold this steady until we are in recession, then move higher)
- 20% Foreign Stock (Most foreign economies are booming or maturing now. A large-cap foreign fund would be best; decrease to 15% by early 2008. Avoid emerging markets now.)
- 10% Health Care (Real Estate and Energy are too hot right now while Health Care is somewhat out of favor and set for leadership as the Bull market ages. Increase to 15% by early 2008. Look at this article and chart for more on sector performance and economic cycles.)
- 10% Multi-Sector Bond (Move to 15% by early 2008 and gradually to 30% by 2009)
- 10% Money Market (Hold steady until recession, buying opportunities)
In the second part of this post, I'll offer some tips you can follow to begin your own path to "invest like a philosopher" with my Socratic Model...
TFPAuthor, Kent Thune, is the President and Owner of Atlantic Capital Investments, LLC (ACI), a fee-only, registered investment adviser based in Mount Pleasant, SC, near Charleston. ACI specializes in retirement, investments, and comprehensive financial planning.
It seems to me that your analysis does not take into account the "deficit financing" route that US government is currently taking. With the dollar continuing to decline due to record trade deficits, there seems to be scope for the US economy to continue its bull run in dollar terms - though our share of the world GDP will continue to shrink. Foriegn stocks are likely to do even better because of the same reason.
Bottomline - it makes sense to base the indexing strategy on world stocks, not just US stocks. Atleast till we have a president or congress that will do something about the deficit.
Posted by: Madhu | July 07, 2007 at 05:44 PM
Madhu:
I appreciate your comment. I believe you may be mostly correct in your assessment of "world stock" investment. My assessment is that there is more information available about large cap domestic stocks than there is for foreign stocks (in general); therefore US large cap stocks are more efficient. Furthermore, my model portfolio is quite basic and assumes the investor does not have a high tolerance for risk. As you may guess, a philosopher doubts everything, including himself. A philosopher also employs critical reasoning and inspires it in others. I am constantly doubting myself and seeking knowledge so I appreciate your criticism...
Posted by: The Financial Philosopher | July 07, 2007 at 06:32 PM
Most investors are looking for quick money these days. These kind of model would work miracle for investors who have patience. Very informative. Great work.
Posted by: Narendar | July 29, 2007 at 11:24 PM