Intelligent investing is not necessarily easy, but that doesn’t mean it has to be complex. There are significant returns to be made if investors follow some simple rules, remain patient and maintain a rational outlook.
PRINCIPLE 1 – ACT SMARTER THAN THE AVERAGE INVESTOR
The first principle of intelligent investing is to understand that in the world of investments - unlike in other industries - value added (ie returns above the index) is a zero-sum game. That is, a relative gain on someone’s side is matched by a relative loss on someone else’s side. At first glance, this statement may sound stark or controversial, but let’s examine it in more detail.
"Only one party is getting the best deal, and you want it to be you!"
Generally, there are two types of investors: passive investors who look to replicate the returns generated by an index, and active investors who seek to outperform an index. Whenever an investor makes an active investment decision, that decision will either add or detract value from the passive alternative (in the case of equity investing, that would be the relevant index-tracking fund or exchange traded fund, ETF). By definition, it is impossible for everyone to do better than the respective index or ETF. On average, half will do better and half will do worse. This point is crucial because it helps you to appreciate that successful investing is about being better than other investors, or at least above average.
Consider this: when you buy something, you’re buying it from someone else; only one party is getting the best deal, and you want it to be you!
There are a four key ways that you can act smarter than the average investor:
1. You can have a ’better’ investment timeframe – Long-term timeframes tend to work better, ostensibly because you’re aligning your timeframe with that of the securities in which you’re investing. But this only applies with respect to decisions based on fundamental analysis, which involves evaluating investments based on central measures, such as economic and financial criteria. Technical analysis is the study of price patterns and lends itself more towards short timeframes. Warren Buffett from Berkshire Hathaway is a master of fundamental analysis, whereas Jim Simons from Renaissance Technologies is a highly skilled technical analyst. Both these famous investors have produced incredible returns, in very different ways. But for the general investor, fundamental analysis and a long-term timeframe are key components of an appropriate investment strategy (unless you’re a brilliant mathematician, with substantial financial resources!).
2. You can have a better appreciation of indices – When you are constructing a portfolio, it’s a good idea to take little or no notice of the index’s constituent weights. This is because a company’s weighting in an index will only tell you how big the company is right now. Smart investors are more interested in how big it will be in the future.
3. You can have a better analytical framework or process – An experiment was conducted to determine whether providing more information to a group of horse-race handicappers increased their ability to predict race outcomes. The handicappers were each asked to choose the 5 items from 88 that were most important to them when handicapping a race. Then they went on to choose the 10, 20 and 40 most important items. The results showed that beyond a certain point, more information did not mean better judgement. Judgement increased rapidly as the pieces of information went from one to five, but then levelled off. Average accuracy remained the same regardless of the number of pieces of information that were available, and almost half the group showed less accuracy as the amount of information increased beyond five items. Consequently, analysis that involves lots of inputs is not necessarily more effective than one that involves a small number; indeed, the opposite may well be true. In other words, better analytical frameworks or processes tend to be simpler ones (while this is the case in financial market predictions, it certainly does not apply with respect to, say, engineering or brain surgery). When assessing the prospects for different asset classes, a simpler and more effective method is to look at yields and growth prospects. You can also make a judgement as to whether valuations are likely to change and thus to add to or subtract from performance. If valuations are high (and therefore yields are low), the chances are that valuations will fall (and therefore yields will rise). Conversely, if yields are high, there’s a good chance that they will fall and valuations rise. The bottom line? Keep your analytical framework or process simple.
4. You can have a better behavioural framework than others – The main thing that investors need to avoid is selling near the bottom of the market or buying near the top, driven by fear or greed. Smart investors will be the ones doing exactly the opposite of this, so intelligent investing requires that you keep emotions out of the equation. Patience is also paramount. If you have a strong conviction about a company, or a particular asset class, it may take a while for others to agree with your point of view. During this time, prices may move against you, requiring you to have the mental strength to stick with your position.
PRINCIPLE 2 – UNDERSTAND PRICE MOVEMENTS
The second principle behind intelligent investing is to understand the difference between a price that follows a ‘random walk’ and is thus unpredictable, and one that follows a pattern. If a price follows a random walk, its change on a particular day is not influenced by changes on previous days. For a price movement to be predictable, it needs to be influenced by previous price movements. This happens in one of two ways: either the price will move in the same direction as previously, or it will move in the opposite direction. These two patterns are known respectively as ‘momentum’ and ‘mean reversion’. The weather is an example of something that exhibits a momentum pattern – research shows that tomorrow’s weather is more likely to be similar to today’s than different from it; that’s why we use the phrase ‘weather pattern’. Patterns can also be found in financial markets. For example, asset classes can behave somewhat predictably when they become very overvalued or very undervalued.
In other words, they tend to revert to their long-term average or trend (mean reversion). Herding behaviour often takes markets or individual securities far away from their mean – the skill comes in predicting when prices will revert.
PRINCIPLE 3 – KNOW HOW MUCH TO WAGER
The third principle for intelligent investing is to understand how to translate your view or prediction into a position in your portfolio. To continue with the horse racing theme, when betting on horses, if you feel you have an edge with respect to the performance of a horse, you will decide on an optimal bet size (as a percentage of your purse). Bet nothing and you waste your edge. Bet everything and, despite your edge, there’s a chance you’ll lose everything. Thus, your optimum bet will be somewhere between 0% and 100% of your purse. The bet size should be proportional to your edge, and inversely proportional to the market odds, which makes complete sense. The bigger your edge, the bigger your bet; and the longer the odds, the smaller the bet.
The same theoretical approach can be applied in financial markets. You can create an edge through research and develop an insight into potential investments. Thinking about the extent of your edge, with respect to a prediction about the future direction of a security or market, is a very worthwhile exercise. It will help you to avoid either wasting an edge by not investing enough or exposing yourself to excessive risk by over-investing.
PRINCIPLE 4 – KEEP RISK IN PERSPECTIVE
The fourth and final principle behind intelligent investing is to keep risk in perspective.
Previous issues of Investment Fundamentals have stressed that investors should not be concerned about short-term movements in prices, but rather the risk of permanent loss of capital. However, volatility is not a good measure of risk because it only measures day-to-day or month-to-month fluctuations. To use an extreme example, a bank deposit that gently accumulates interest would be considered very low risk. However, if the bank goes bankrupt, investors lose everything and this should be a more important consideration for depositors.
The problem is that, unlike in the case of volatility, there is no simple measure for the potential for permanent loss of capital. If there was, the financial world would be a very different place. Assessing the scope for permanent loss of capital requires investors to carefully determine the intrinsic value of a company or asset class – that is, the value below which you would not expect the price to fall. In the case of companies, this involves thorough and intricate financial analysis. But the same principle can be applied to asset classes and consequently multi-asset investing.
For example, Tobin’s Q ratio is a good gauge of equity market value. James Tobin proposed that the combined market value of all the companies listed in an index should be equal to the replacement value of all those companies’ assets. After calculating this, investors should be able to see whether the index as a whole is potentially overvalued or undervalued.
In the case of government bonds, the yields on inflation linked bonds (real yields) will give direction on whether bonds are cheap or expensive. A real yield above 4% would generally be considered cheap, while anything below 1% should probably be avoided. With corporate bonds (issued by companies not governments), you need to consider the additional yield (the spread) offered over the government bond with the equivalent time until maturity and compare that with expected defaults over the next few years.
Commodities such as oil or gold are problematic, because unlike equities and bonds they yield nothing. Assessing whether or not the inflation-adjusted price is above or below the long-term average would be a good place to start.
In conclusion, whether you’re investing in a single security, a single asset class, or multiple asset classes, there are principles that should be common to each. Mastering them should lead to intelligent investing.
Published in Aberdeen marketing
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.