Октябрь 2010

Investment Gobbledygook

There are no orphan shares …
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A lot of what passes as serious investment commentary is simply «gobbledygook» i.e. nonsense or drivel. It defies share market realities and is at odds with the philosophy that markets work.

Yet, unfortunately, some of the people and organisations generally regarded as finance experts are the main proponents of this gobbledygook. Let’s consider a couple of examples.

In a recent article in the «Sydney Morning Herald», a private client adviser of a major stock broker explained why the share market had fallen for the past three days, after a period of strong gains, as follows:

«I think it comes down to a bit of profit-taking. I guess the market is acknowledging we’ve had it pretty good for the last couple of months and it’s time to take a breather.»

In a similar vein, the finance reporters on the evening television news will often attribute a rise in the share market, after a period of weakness, to «bargain hunters» taking advantage of lower prices. Sometimes, more glibly, since they believe they are stating the «bleeding obvious», they will explain a rise in the market as due to «more buyers than sellers».

But all these types of comments overlook one indisputable share market fact. That is, for every buyer, there must be a seller – there are no orphan shares. So if a seller is «profit taking», what is the buyer doing? Or, if the buyers are «bargain hunters», what does that make the sellers?

Share markets do not move because of the weight of buyers or sellers. Rather, they respond to changes in expectations of the factors that drive share prices i.e. expected profits and the discount rate used to convert those profits to today’s dollars.

Lower current share prices compared with two years ago almost certainly reflect lower expected company profits. And, perhaps, a higher discount rate (or expected return) to entice investors to take the necessary risk. It is not because investors have «fled» share markets as is often suggested in the financial media. Because, in aggregate, they simply can’t.

«The Arithmetic of Active Management»

Another prevalent example of investment gobbledygook is the claim that depressed share market conditions are best suited to active, stock picking investors as opposed to passive investors who simply hold share portfolios designed to replicate the market’s overall performance.

Since the share market peak of November 2007, hardly a day goes by without a financial journalist opining or quoting some stock broking source that «it’s a stock pickers’ market». No proof is provided. It is simply asserted.

We recently received an invitation from a major financial institution to a seminar to hear three prominent active fund managers present on why they believed they would outperform the overall share market in these difficult times. The invitation explained:

«At the peak of the bull market most fund managers were able to produce strong absolute returns with ease. Moving forward active management and fund manager skill will play a far greater role.»

The implied claims appear to be:

1. now is a good time for active funds management; and
2. you can pick the most skilled active managers.

A response to Claim 2. will need to be the topic of another article. However, in summary, the best available research suggests it is very difficult (some say, impossible) to distinguish luck from skill.

But rebutting Claim 1. doesn’t require research – simple arithmetic will do. The essential message of Nobel prize winning financial economist, Professor William Sharpe’s classic 1991 paper, «The Arithmetic of Active Funds Management», is that:

* since active and passive investors make up the entire share investor universe; and
* passive investors earn the return of the total share market less their relatively small costs

it follows that active investors, in aggregate, must also earn the same total share market return less their relatively high costs.

This will always be the case. There are not good times and bad times for active investors, compared with passive investors. In our view, given the higher costs of active investment, there are only bad times!

The moral of the story …

Often, in investment markets, propositions that sound plausible, and are being put forward by people or organisations with apparent expertise, prove to be total bunk when subjected to appropriate scrutiny.

As a smart decision maker, serious questions you should ask yourself are:

* do I have the knowledge and wisdom required to distinguish between often self serving investment gobbledygook and the opinions and research of the world’s leading financial economists and behavioural scientists;
* if not, is it the best use of my time to acquire that knowledge and wisdom;
* what are the costs, risks and foregone opportunities of not accessing that knowledge and wisdom; and
* am I prepared to accept those costs, risks and foregone opportunities?

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