Monday, October 13th, 2008
where we draw the lines

As a consultant, I sometimes find that simple illustrations can convey powerful concepts.  If you are a regular reader of this site, you know that as a result you are, every now and then, faced with a crude drawing in my hand.  Here’s another one:

These squares are, of course, the famous style boxes popularized by Morningstar,Morningstar | This article by Christine Benz does a good job of outlining some “facts and myths” as she sees them regarding the use and abuse of style boxes.  Disclosure:  I have a business relationship with Morningstar (that does not include giving them advice about such things).  I used style boxes because they are the most recognizable categorization scheme extant, not because I believe that they are in immediate need of adjustment. and used broadly within the industry.  Morningstar and many other firms have created numerous adaptations and permutations of this basic yet effective design.

The urge to categorize is unavoidable, as is the inclination to measure and judge.  Why do we draw the lines where we do, and what are the implications?  Very simply, we look backwards first and foremost, creating choices and consequences that may perpetuate themselves past their useful lives.

One of the easiest ways to determine how an investment firm looks at the world is to examine the output of its computer systems as used for internal decision making and external client reporting.  In fact, it is usually possible to “carbon date” the categorization scheme simply by looking at where the lines of demarcation have been drawn.  Even today, when it’s easier to adjust our ways of looking at the world than it was with hulking mainframes, the description of the world lags the reality of the world itself.  Consequently, ascertaining a “date of adoption” of the classification approach frequently is possible just by comparing it to the observed evolution of the markets across the years.

That is true at every level of the investment process.  Individual securities are codified and analyzed within frameworks defined by our categorization schemes.  Investment managers suffer the same fate; some are happy to take on the role as defined, and others bristle at the holding pen created by the drawing pen.  And asset classes are perhaps most susceptible to what appears to be easy but misleading definitions.  Call something a bond, even if it has equity-like characteristics, and it finds its way into a part of an allocation structure that has rules of the road that differ from those of similar instruments with other names.

Organizations are built and investments are made by virtue of where we choose to draw our lines.  The artificiality and temporality of our labels is lost on us as we get more and more comfortable with the parameters within which we have chosen to operate.  The challenge, then, is to keep fresh and relevant our maps of the world.

One result of the drawing of lines throughout the industry is the creation of opportunities.  Time and time again, successful investors ignore those lines to great effect.  The limitations described and enforced by others is the lifeblood of innovation.

A comparison to the world of music demonstrates the point.  Whatever your favorite type of music, think of an artist that burst onto the scene with a new sound.  Invariably, you can hear hints of other styles, but the end result seems totally unique (but soon to be widely copied).  Such is the case with the process of investing.

Which of the lines that you have drawn has outlived its usefulness?