Favouring realistic return expectations
There is a fine line between investing and speculating. Many of your clients believe that their day-to-day investment decision making places them firmly in the former category, when the reality is that their knee-jerk responses to financial market movements place them firmly in the latter. To paraphrase Jarrod Cahn, Head of Equities at Credo, a UK-based boutique asset management company: a lot of investors, and retail investors in particular, abandon the methodology and mindset that satisfies the investment definition in favour of the promise of quick returns from speculating.
Advocating for the long-term view
Cahn’s presentation to Investment Forum 2023 was titled ‘Investing, not speculating’ and was delivered against the backdrop of the firm’s Raging Bull success as Offshore Manager of the Year 2022, which achievement was largely thanks to the performance record of the Credo Global Equity Fund. Cahn started his presentation by warning that the short-term nature of the environment your clients invest in, coupled with their focus on instant gratification, was more conducive to speculating than investing. He then offered seven factors or ‘tests’ that financial and investment advisers could use to determine what drives their clients’ investment decision making.
The first test derives from investment time horizon, and the trick to remain in the investment ‘camp’ is to target realistic long-term financial goals. If you reflect on this point, you will no doubt conclude that financial planning is aligned with the investing methodology, as each decision that you and your client make is aimed at achieving a long-term financial objective. “Targeting long-term returns introduces what we call time arbitrage; the fact is that when you own a stock, and you have a thesis, you can ride through the short-term noise,” Cahn said. If you hold a share on a three-, five- or 10-year view you need not obsess over the impact of macroeconomic data, and are only forced to act in the event of structural changes in the competitive or regulatory environments. In contrast, speculators are short-term ‘scalpers’ who try to generate returns from market volatility.
Aligning strategy and return expectations
The second and third tests are closely aligned: investors follow a “carefully considered strategy” with “realistic return expectations” whereas speculators have an “erratic strategy, or no strategy at all” and “hope for abnormal returns. According to Cahn, the strategy informs how a portfolio manager goes about choosing stocks and what the return expectation from its investing activity is. “When you have no strategy, you have no idea what your return profile is going to look like; you end up just swinging for the fences and hoping that the news flow is going to be positive,” he said. Credo favours realistic return expectations and will make a careful assessment of the elements that contribute to a share’s total return before investing. Realistic return expectations, alongside considerations of risk, are cornerstones of the financial planning process too…
It should come as no surprise, therefore, that the fourth test relates to risk. Investors make a thorough consideration of the risks associated with each financial decision, whereas speculators take a somewhat rash approach. In fact, speculators tend to ignore risk in favour of return… “We are meticulous about understanding permanent loss of capital and volatility and speculation, and for that reason we are cautious in what we do,” Cahn explained. “We thoroughly consider the downside risks we are exposed to when we take a position in a stock … this is completely different to the short-term, speculative, negligible considerations of risk that a speculator has”. He then shared some wisdom from writer, Mark Twain, who said: “there are two times in a man’s life when he should not speculate: when he cannot afford it and when he can”.
Emotion and investment decision making do not mix
The fifth consideration shared during the presentation is rooted in behavioural finance, with investors making reasoned and unemotional decisions versus speculators whose decisions are often emotionally driven. To better understand the impact of emotion on financial decision making, just ask any financial adviser about the investment (sic) tips that his or her clients bring back from the Sunday braai. Investors are prepared to sit patiently while their long-term strategies pay-off; speculators have an acute FOMO on the ‘big profit promise’ from buying the next Bitcoin, Game Stop or Tesla. Basing your investment decision making on opinion or hearsay can be dangerous but that does not mean that others’ opinions should be ignored.
The sixth distinguishing feature is that investors exhibit a judicious reliance on outside opinion compared to speculators who harbour a reckless degree of reliance on outside opinion. “We are not so arrogant as to think that we know everything, and we are happy to look at outside research in terms of what we may be missing … we are always trying to find out if [others see] something differently, and if they raise a risk, whether that risk is real or overdone,” Cahn said, before sharing the seventh and final ‘test’, which centres on value. In short, an investor derives value “from the fundamental performance of the underlying investment” whereas the speculator is at the mercy of “being able to sell to someone else at a higher price”. The speculator swears by the greater fool theory: it does not matter how much they pay for a share because some idiot will buy it off their hands at a higher price.
Compelling argument for value-based philosophy
The price action of US technology shares through pandemic can be thought of as a speculators paradise, as cash-flush buyers outbid one another for their slice of high growth, non-profit technology stocks. Unfortunately, the wheels came off the tech markets late 2022. This real-world example of ‘the greater fool theory’ in action was an opportune moment to segue to a discussion on the merits of growth versus value investing philosophies. Credo identifies as a discerning value-based investor. “There are certain value fund managers that have a deep value strategy that can work amazingly well for periods of time; but we prefer to overlay our value focus with a qualitative strategy,” Cahn said, before offering a compelling case for value investing over growth investing.
Using market price data from the Kenneth R. French data library dating back to June 1926, he calculated a 96-year compound annual growth rate (CAGR) for a value basket versus a growth basket. Over this period, a value basket returned 12.7% annually while the growth basket returned 9.7%. These returns seem comparable; but if you had invested USD100,00 in each of the strategies, and allowed almost 100-years to pass, a value basket would pip a growth basket by a whopping USD9.853 million. PS, the writer was so shocked by this outperformance that he double-checked the calculation on an online CAGR calculator. Turns out the math was spot on! What a pity your average client’s investment time horizon is 20-years or shorter.
Writer’s thoughts:
The features or ‘tests’ shared in today’s newsletter should make it easy to determine whether an individual falls into the investor or speculator categories. Less clear, is whether some level of speculation should be allowed and / or tolerated in a diversified financial portfolio context. Your thoughts? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.
