I just returned from a trip to Canada that took me from Niagara Falls to Toronto to Montreal to Old Quebec, and then back to the U.S. Our final stop before getting on the plane home was the Norman Rockwell museum in Brockton, Massachusetts. The museum owns hundreds of Rockwell’s original paintings, many of which are iconic images that once graced the cover of the Saturday Evening Post. In the mid-1980s, the artist’s last studio was moved to the museum grounds, and curators have faithfully recreated it as it was when he was at his busiest.
Two items from his famous self-portrait remain in his studio, and it turns out that they had special meaning to him. Rockwell used to absent-mindedly empty his pipe into the metal garbage can to his right, which unfortunately was often filled with rags soaked with oil from his painting. The results were sometimes combustible and on more than one occasion, he had to stomp out the flames when the garbage caught fire. Unfortunately, one evening Rockwell missed a few embers and rose the next morning to find that his studio had burned to the ground. He always kept the bucket as reminder to pay attention to details, and the wisp of smoke rising from it in the picture is testimony to Rockwell’s sense of humor.
A second notable item — and the one I thought was most interesting — is the gold helmet perched on top of his easel. Rockwell paid a fortune for it on one of his trips to Paris when an antique dealer told him that it was a valuable piece of history. The next day a fire broke out in town and as the fire brigade drove past, Rockwell noticed that every fire
man had the exact same helmet. He was furious but kept the helmet to remind himself that he was not infallible. He called it his “humility helmet.”
As I listened to the story, I couldn’t help but think that as investors we could all use a humility helmet to remind ourselves that investing is all about managing our emotions, and our mistakes. The biggest investment fiascos occur when investors believe that they’ve found the one true path to investment success… and then dogmatically follow that path to a disastrous end.
Here at Pinnacle Advisory Group, we never forget to wear our humility helmets (at least figuratively). To that end we have developed several rules for managing portfolios that we believe prevent us from making catastrophic investment mistakes. For example, we maintain that there are two unbreakable rules for portfolio construction:
- Diversify the portfolio
- Don’t own overvalued assets
Furthermore, we find value in three ways:
- Market cycle study
- Traditional valuation
- Technical analysis
We add value for investors in three ways:
- Through tactical changes in asset allocation
- Through sector rotation
- Through security selection.
And we make our investment decisions in two ways:
- Qualitatively, by using our best judgment
- Quantitatively, by using rules-based mathematical models
The structure outlined above gives us the flexibility to pursue earning returns over and above what the markets will give, while helping us defend our clients’ capital against unnecessary risk.
Recently we have added another set of rules to strengthen our humility helmet – we consider them our beginning assumptions:
- Diversify by asset class
- Diversify within asset classes
- Don’t use leverage
These rules are essential for every investor, regardless of whether they actively manage portfolios or not. We relied on these rules for the sixteen years when we were in the investment business as strategic, buy and hold investors – long before we became the tactical and active investment experts that we are today.
The first point is the same as the first of our two unbreakable investment rules – diversify your portfolio with different kinds of investment assets. Stocks, bonds, cash, real estate, commodities, international stocks, hedge fund strategies, managed futures, timber, and anything else that represents a legitimate asset class should be considered for your portfolio as long as it represents a good value. Keeping from putting all of your eggs in one basket makes sense for everyone, regardless of investment sophistication.
The second point is to diversify within each asset class. This is easily done by using exchange-traded funds, mutual funds, or managed accounts. Don’t be fooled into thinking that owning “the three best” securities within any one asset class satisfies this second rule. For example, I would estimate you need to own at least twenty-five small cap stocks, and at least fifteen large-cap stocks, to even begin to diversify within each of those asset classes. Hence, a simple portfolio consisting of multiple mutual funds in a variety of asset classes will satisfy rules one and two.
The third rule is simple: Don’t borrow money in order to invest your account. Borrowing money, or leveraging a portfolio, makes it possible to increase your returns by multiples of the actual cash you invest… but it also makes it possible to lose everything.
Norman Rockwell was in an entirely different business than ours, yet we could all benefit from a reminder to be humble – especially those of us in the business of managing other people’s money. As we navigate what are sure to be difficult markets through the end of the year, we will strap on our helmets as tight as we can and make sure we don’t leave any embers smoldering in the garbage can.