The Art of Investing
A Review of the Novel, "The Counting House"
There are not a lot of novels about investors because such people sit at desks, look at Bloomberg screens, take meetings with other desk sitters and don’t often get themselves involved in the adventurous aspects of life that make for great fiction. That said, Michael Lewis can bring the drama to quantitative financial work and I think that private equity investor Gary Sernovitz puts an emotionally moving tale together in The Counting House, a story about the Chief Investment Officer of a well-regarded, but not Ivy League university who loses his confidence to imposter’s syndrome.
Our CIO, who defines himself by his professional role and doesn’t get a human identity until he earns it, has a very hard job — he has to supply the university with a quarter billion dollars a year, whether the market is up or down. If he fails, students don’t get scholarships. Particles are not accelerated in the physics department. Art is not historied in Art History. The tenured professor with the man bun who thinks he knows everything will not be paid to Tweet that the CIO should divest from oil, gas and Israel. Okay, Israel divestment isn’t in the book, but if it had been written a year later, it would have been.
To meet his obligations to the university, the CIO has to generate between 7-8% a year, which is what the stock market does on average, over long periods of time, but with incredible volatility that the university trustees cannot stomach. The CIO can’t just buy all the stocks and wait because, every now and then, the market drops 40% in a few months and takes five to seven years to make it all back. So, the CIO farms out his $6 billion endowment to an army of selected asset managers, all claiming to run niche strategies that can deliver what investors call “equity-like” returns without equity-like volatility.
Sernovitz tees up all the classic strategies — there’s the quantitative hedge fund that is such a black box that the managers not only refuse to tell him what the fund owns, but they refuse to tell him if they know what the fund owns. There’s the private credit strategist that the CIO describes as “high interest loans to dentists,” which are all over the market right now — these are hedge funds lending to the small business markets that regular banks abandoned after the Financial Crisis. If you remade It’s A Wonderful Life in 2024, Mr. Potter would own either a fintech lending service or hedge fund, not a community bank and trust. There’s the fund that invests in legal cannabis infrastructure, another flavor of the month.
Very few of these managers have an enduring edge because the market destroys enduring edges. If you find a corner of the marker where outsized returns can be earned, it will eventually be noticed and others will show up to arbitrage it all away. Or, investors will give the manager so much money that they will no longer be able to manage their strategy effectively (which is kind of the same thing). Or, the manager will become lazy or bored. Nobody wins forever. Time always gets the last word.
So, our CIO tries to find thoughtful people. He asks each manager why they do what they do and never gets a satisfactory answer. When he asks himself the same question, he doesn’t have a good answer either. Also, when we meet our CIO, he has underperformed for two years running and now doubts his own skills and judgment. It all wraps up with a philosophical debate between the CIO and Michael Hermann, an alumnus of the school who is one of the richest men in the world with his own hedge fund and an $11 billion personal fortune. Hermann, who I imagine played by a young Gene Wilder with an “on the spectrum” overlay, tears down the facade of “modern portfolio theory” and forces the CIO to confront first principles and his own humanity.
In my career, I have worked with a lot of professional investors. Some are great, all are very smart and good. They all faced these pressures. I remember one scoffing to the CEO of the company, “I am trying hard to make the stock prices go up, David!” I’ve worked with managers who believe that losses are acceptable so long as they are not total losses. Any stock can come back, they say, unless it goes to zero. The strategy is to avoid “permanent impairments.”
Most of these managers have admitted that what they do is more “art than science,” and this, more than anything, is something I’m convinced is true. Even putting all of your money in a low cost index fund is a strategic and aesthetic choice. Every index out there was created by people and they all represent a point of view. The S&P 500 is all the big companies. The Vanguard Total Market Index is all the world’s companies. The Russell 2000 is all the little companies. Every sector index is somebody’s judgment call. There’s no escaping the art in any of this.
Think about it this way — you’re told an S&P 500 index is a “safe” investment, right? Because you are “buying the market” and you are not arrogantly trying to outsmart the collective intelligence of the rest of humanity which, the “wisdom of crowds” crowd tells us, has turned the market into an efficient valuation mechanism that does not make mistakes because every stock that’s traded is fairly valued based on what we know at the time.
Well, as Donald Rumsfeld said, there are always unknown unknowns. Enron was fairly valued before its fraud was exposed. Then it was fairly valued after. Unknown unknowns. Buying the market doesn’t protect you from that, it just diversifies away some of your risk. But as Marty Whitman famously said, “Diversification is a substitute, and a damned poor one, for knowledge, price and control.” Now, control is tough to get, but just buying the index gives up entirely knowledge and price.
Knowledge and price matter. They tell you to buy low and sell high, right? Well, the S&P 500 index does the opposite because it is weighted by market cap. Microsoft and Apple are the two largest companies in the S&P 500 right now and so they are the top two holdings of the index. If their prices go up, what happens? The index buys more. If it goes down? The index sells. So, you’re buying high and selling low and relying on the diversification to make up for that blunder. Now, it mostly works, on average. But you have to recognize you’re making a real choice when you invest that way.
You can solve for this by buying an equal weighted S&P 500 Index fund. In that case, the index is formulated so that all 500 stocks are held in balance. When Apple and Microsoft goes up, the fund sells shares to keep the weights even, and uses the proceeds to buy shares of struggling Pfizer, which are cheaper. You are then buying low and selling high and you’re diversified. But, now you’re giving up on momentum. If the market is efficient, after all, Microsoft is going up for a reason and Pfizer is going down for a reason and you are the contrarian about it all. As I said, equal weighting works sometimes but not all the time.
Active management works sometimes but not all the time. Individual stocks work sometimes but not all the time. Say what you will about Bitcoin but we all should have put $100 bucks in back in 2009. Investing is an art and returns in art are chunky, unpredictable, sometimes considerable and often “meh.”
All of these market efficiency people are marketing products that are supposed to take all the messy humanity out of investing. At the same time, all of these people have read the classic finance text, Extraordinary Popular Delusions and the Madness of Crowds by Charles McKay which proves that, yes, 50,000 Frenchmen can be spectacularly wrong.
One thing that comes through in The Counting House and in my professional experience watching and working alongside money managers across asset classes, is that large investors don’t want to talk about artistry — they want repeatable processes that seem scientific. A lot of what the public sees now from ChatGPT is decades old also stuff on Wall Street — everybody wants to take the human, creative element out of the process because people and institutions need reliable returns in a world that doesn’t provide reliability.
The world of investing is full of stories, many of them true and all of them once true. A lot of the stories outlive their usefulness but continue to be told. Some just fall out of favor for long periods but come roaring back. Almost all of them are easy to understand but difficult to implement. Consider this favorite observation of Warren Buffett, which is that great investors strive to “be fearful when others are greedy and to be greedy only when others are fearful.” How do you know when others are fearful, though? Is it when stocks are down 20%, which is the technical definition of a market correction? Or is it at 40%, when we fairly say the market has crashed? The S&P was up 24% last year. Should you sell all your stocks for fear of the greed of others? Does Buffett’s advice apply to individual stocks, or the whole market or both? Does it work in bonds and currency? I’m barely scratching the surface of questions here.
But I do believe this, and The Counting House reminds me — investing is a creative endeavor that cannot truly be mechanized, though its essence is often hidden beneath flashy machinery.