One of the best investors I ever met was a former broker at Legg Mason. I estimate that he amassed a personal fortune in excess of 50 million dollars before he died. I’ll call him Tom for purposes of this tale. By the time I met Tom he was in his 70s and had been a broker for over 40 years. He taught me a lot. His investment approach at the time was so simple he could explain it in minutes. He had a list of 20 stocks that were his total universe of potential stocks that he could buy for his clients and he had developed a way to identify which were the best to own at any given time. He compiled the list himself. He called these 20 stocks Rip Van Winkle Stocks because as he liked to tell the story, Rip Van Winkle fell asleep for 20 years and when he woke up the world had changed. Tom felt that he should only invest in companies for his clients that they could hold for 20 years and so he focused the list down to the 20 that he felt would exist 20 years from now.
What else did he do for his clients? He didn’t reinvest dividends and he liked to keep a portion of his clients’ money allocated to bonds. The less risk the client could take the more bonds he had in their portfolio. When the situation called for it, he had an all-stock portfolio. The other rule he had was never own more than 4 of these 20 stocks for any one portfolio at any given time. If you read A Rebalancing Tale you will understand that Tom was a strong believer in the concept of rebalancing and is the first person to explain it to me the way he did. His list of 20 stocks were surprisingly similar in that he held no technology stocks for example, since he didn’t know if they would be around in 20 years. He focused his attention on companies that sold products that people used every day and were priced at under $25 per item. These types of stocks are called consumer non-durables in today’s financial nomenclature and they included stocks such as Coca Cola, Johnson and Johnson, Pepsi, Gillette, Budweiser, Bristol Meyers and Proctor & Gamble to name a few. I’m sure that the reader can come up with a similar list of Rip Van Winkle stocks. He showed me his methodology and I immediately recognized its elegance.
One day Tom comes up to me and shows me three checks. They were dividend checks. He liked to receive them and not have them sent directly to his account. I thought he was kidding at first. He wasn’t. The amount of each check was larger than what most people earn in a year and only came from three sources, The Templeton Fund, Johnson & Johnson and Proctor & Gamble. I knew the 4 stocks that he currently held for his clients and none of these 3 checks were from those companies. I asked him why they were different and then he said that he didn’t invest for himself as he did for his clients. I was curious and somewhat suspicious because I was thinking that he did something better for himself than he did for his clients until he explained.
He explained that he developed a very successful approach to investing in the 1950s and that he had employed it for himself ever since as well as a modified version for his clients. He explained that through trial and error that as an advisor it was impractical to do the same for others because of 3 reasons. The first is because his clients couldn’t stand losing money when the markets went down, so he learned to add a bond component to their portfolio. Secondly, his advisory business wasn’t flourishing because he would lose clients to other more active methodologies espoused by competitors because he wasn’t active enough in their portfolio. The clients would go elsewhere because they felt Tom wasn’t earning his money. Lastly, he wasn’t earning as much money as his fellow brokers because his methodology didn’t generate many transactions so he tweaked his methodology to accommodate his clients’ need for activity and need for safety. By doing this everyone won. The client stayed with a superior advisor and Tom made more money. His reasoning was pure behavioral finance and was the first time I understood that a client is their own worst enemy.
What did Tom do with his own money? He only had three investments as I’ve indicated. Every paycheck he took 30% of his income and invested equal parts in each of the three. Tom was a big saver in that 30% is a substantial percentage to save out of every paycheck and beyond the capabilities of most people. He would review his portfolio on a quarterly basis and if any one of the three investments was greater than 40% or less than 25% of the total portfolio he would rebalance. Once again, see A Rebalancing Tale if you don’t understand this concept. His reasoning is that he was buying when the management team was at its worst but that it was great management and would eventually do what great management does which is increase shareholder wealth. His approach was simple, elegant and it worked. As testament to Tom’s ability to see the future, all three of these investments are still around today.
So why couldn’t he do this for his clients? Like he would say, “You know there are a lot of ways to make a lot of people a lot of money that you can’t do because they won’t let you.” “You can’t do for people because they can’t stand the bad times when they happen.” Tom wasn’t one to use big words when he spoke. He said that he learned to temper his client’s human tendency by adding bonds to the portfolio for stability. He recognized that it lowered the long-term rate of return but it was a lesser evil because it let people stay in the market when they otherwise would have bailed.
It made sense to me why he had bonds in most portfolios but I was still curious as to why he had developed the Rip Van Winkle approach ? He was brutally honest when he indicated that he needed to make a living and that it satisfied the client’s need for activity. He said that initially when he just added bonds to the portfolio that yes it stabilized the returns and because of this stability more clients could stay with the portfolio during bad times but that he kept hearing from people that he wasn’t trading enough or active enough and that they would fire him for this reason. He would lose clients that despite significant portfolio advances had the perception that he wasn’t minding their money. He had to develop a strategy that let them think that he was minding their money, even if he wasn’t adding any value to their portfolio compared to his preferred methodology, so that they could stay with him and reap the benefits of his approach because otherwise they were going to go off with some other fellow that wouldn’t produce the results. His Rip Van Winkle approach was the best of all worlds for the client.
Old Tom understood human behavior and people’s tendencies well before the realm of Behavioral Finance even existed and employed it successfully. He understood that people have a need to transact in their portfolio and that to satisfy this need he developed a technique that satisfied their desire to do so. This is a behavioral tale because it focuses on client as well as advisor behavior in the classic feedback loop. Feedback loops can be positive or negative. Tom was able to create a positive feedback loop because he had experienced what real people do in real situations and had adapted his pure strategy to deal with the uncertainties of reality. He understood that theory is fine until people throw a monkey wrench into the equation. Tom’s client strategy was able to deal with the monkey wrench while his personal strategy would not have done as well. The other lesson I learned from Tom was his supreme confidence. He knew that his client approach, though not as good as his personal approach was better than anything else his clients could get with the competition.