Reblog: Sun Tzu, The Art of War and your portfolio

Investing is full of sports metaphors, most of which are drawn from blood sports such as boxing, strategic team sports including football, and individual sports where brains are as important as brawn, such as golf. Those sports are all full of common metaphors drawn from warfare. In fact, all sports are, in essence, proxies for warfare, which makes a 2,000-year-old text particularly relevant to sports, but also to investing as well.

Translated into many languages and still referred to as one of the great works on military strategy and tactics, the lessons of Sun Tzu’s The Art of War are particularly relevant to investors as they navigate increasingly complex asset classes and investment strategies.

Where victory is defined as achieving one’s investment objectives and the enemy is defined as any movements in the portfolio that stand in the way, the 13 chapters of Sun Tzu’s tome read like a class in post-modern strategic and tactical asset allocation. Elegant in its simplicity (it’s amazing how the simplest ideas are sometimes the most relevant), this work can be a guide for contemporary portfolio construction and management.

For example, chapter one, The Calculations, spells out the importance of surveying fundamental factors such as seasons, terrain, leadership and management. A commander is capable, with the right analysis of these factors, of handicapping his chances of victory. Similarly, ignoring these factors is a recipe for disaster.

In investing, these factors can be translated into global macro elements, shifting trends, leading indicators, and alpha generation. Understanding them is critical. Ignoring them can lead to swift defeat.

Another chapter focuses on the plan of attack, which is the equivalent of determining investment strategies, setting a portfolio’s strategic asset allocation and choosing best-in-class investment managers. This critical element avoids the “I have no idea where I’m going but I’m making great time” scenario in investing.

Chapters four, seven and eight (Tactical Positioning, Manoeuvering and Variation in Tactics, respectively) all speak to what is commonly referred to in portfolio management as tactical asset allocation (TAA). TAA’s primary driver is the avoidance of assuming undue risk in unfavourable conditions — that is, not engaging the enemy when unprepared or overmatched.

The secondary driver of TAA is changing the battle plan when the enemy is on the defensive, using the investing equivalent of a military surge to win a battle.

While these two approaches — one defensive, one offensive — appear to have contradictory objectives, they are part of the grand scheme of winning the war by properly recognizing the appropriate times to attack and to retreat.

Finally, chapter 13, The Use of Intelligence, teaches us about the importance of military commanders developing and managing good intelligence sources, without which the power of the first 12 chapters is significantly muted. So, too, is the sourcing, due diligence and monitoring of investment managers.

Without devoting proper resources to gathering and maintaining intelligence on the ongoing quality of the managers to whom you deploy capital, the instructive elements of strategic and tactical asset allocation will be significantly mitigated, if not eliminated.

Of course, real life has a way of blurring lines that seem straight and identifiable on the page. The distinction between strategic versus tactical decision-making can be hard to determine in a drawn-out war against multiples foes. In these instances, the strategy must be reviewed on a regular basis as conditions shift, while tactics must still be chosen for each manoeuvre to ensure that, in the larger picture, the grand objective remains within reach.

Or, in the words of famed English field marshal Bernard Montgomery: “Strategy is the art of the conduct of war, tactics the art of fighting.”

This article is written by David Kaufman, appears on financialpost.com and is available here.