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What You Absolutely Need To Know

June 23, 2018

Investment choices seem limitless and confusing. There are equities, bonds, and exchange traded funds (ETFs). Financial advisors and "Robo advisors". Infrastructure and "alternatives". "Active" versus "passive".

 

All of these things are closely connected to one another and are simply ways of categorizing investments and "portfolios" of investments.

 

An investment is a loan to or an ownership stake in an enterprise. Commonly these enterprises are businesses, but loans to individuals or to governments are also investments.

 

The portfolio of investments is simply all the investments you own, added up. The totality of the gains, losses and income from your collective investments (your portfolio) determines your success as an investor.

 

However, the most important concept in investing is the "market mindset".

 

The "Market Mindset"

 

The way the market works in investing is critical to understand. The market places a price on every potential investment, and its price appreciation (plus other cashflows, such as dividends) determines the extent of your investment's success or failure. 

 

At every moment, people worldwide are trying to assess the prospects for possible investments. When investments are seen to have a favorable outlook, they trade at a high price. Conversely, when they are seen to have unfavorable prospects, they trade at a low price.

 

A high price is an offsetting disadvantage to good prospects, as it makes further price appreciation more difficult. A low price is an offsetting advantage to poor prospects, making price appreciation easier.

 

Hence, making good investments is fundamentally different from determining which enterprises are promising and which are not. Most importantly, one has to compare that outlook to the price of the investment in question and determine whether the price is too low or too high given that outlook.

 

Investing in promising enterprises can often backfire because optimism raises the price too high. An example is China's Shanghai Composite Index. In 2008, its price was 5,200. Ten years later, after Chinese economic output doubled (after inflation), the Index price is now 2,900. Even though consistently favorable events occurred there, they weren't sufficient to raise the price above the optimistic 2008 price.

 

Similarly, avoiding investments with unfavorable prospects doesn't necessarily work. If the purchase price of an investments is low enough, its worth can increase simply by the acheivement of mediocre, yet higher than expected, results.

 

Most occupational and educational backgrounds do not lend themselves well to this mode of thinking - it needs to be learned. Investments can command a "wrong" price because their prospects are wrongly assessed in too extreme a fashion (i.e. as very favorable or completely hopeless). Yet the emotional reaction to selling investments whose prospects seem to be rising sharply (or buying investments that appear to have worsening prospects) can be a strong inhibitor for many. To achieve a market mindset, one must overcome these emotional inclinations.

 

Uncertainty

 

Another effect markets have on investment prices reflects market participants' general preference for certainty. Investments with uncertain future cashflows command a lower price than similar ones that have more certain cashflows. 

 

An important cause of the uncertainty of an investment is whether it is a loan or an ownership stake. A lender is (among) the first to receive payment from an enterprise and thus a loan represents a lower risk. An equity owner is the last to receive payment, after the interest, wages, and other expenses have been paid. This "residual" cash flow is uncertain as it can be increased, reduced or wiped out by changes to revenues and costs. Thus equity has higher risk than a loan to the same enterprise.

 

While equity is generally riskier than debt, both types of investments have different levels of risk. For example, the debt of companies which borrow heavily (i.e. having a high ratio of debt to the cash flows coming from their operations), the heightened chance that they may be unable to pay off their debts can make it even riskier than the equity of other companies. 

 

Investments

 

In addition to loans (debt) or equity (ownership stakes), investments are often classified into groups called "asset classes". While no single definition is used, commonly the classes include government debt, equity, corporate and individual debt, real estate, and private equity.

 

Very commonly, securities are offered to the market as potential investments. These securities represent loans or equity in enterprises. For the most part, they are readily bought, sold, and valued. 

 

While not securities, so-called "alternative" and "private" investments are still loans, equity (or both) in enterprises. These enterprises can be ones that:

 

- own and rent infrastructure (for example, pipelines or roads)

- own and rent real estate (e.g. office and industrial space)

- hold commodities (gold, copper, corn etc.) in anticipation of price increases

- speculate in financial markets (e.g. hedge funds)

- engage in other business activities similar to those conducted by securities issuers.

 

However, the accounting treatment and legal setup of these investments differs from that of securities.

 

In future posts,  liquidity, accounting standards, ownership control, and tax considerations of different investments will be explored in more detail.

 

The Portfolio

 

The key characteristics of a portfolio are:

- its potential for price appreciation and cash flows (often referred to as "return") and

- the level of uncertainty regarding potential losses (also known as "risk"). 

 

It is generally thought that the more risk an investment or a portfolio contains, the higher the return one can expect to earn. The theory is based on the fact that people in general prefer certainty to uncertainty, and hence require an incentive to take on more risk, i.e. a higher expected return. Many historical studies have been conducted on this topic and it's fair to say that the idea is largely borne out by the data.

 

For example, stocks, which have more uncertain return than government bonds, have generally earned a higher rate of return over the years.

 

A very basic way of thinking about setting the return and risk of a portfolio is deciding the proportion of stocks and bonds to be held in it. If the bonds are government bonds, then the rate of return is pretty certain, over the period of time is takes the bond to "mature" (pay back the original principal amount). Stocks have a much more uncertain return, but are thought to have a higher expected return.

 

A portfolio with a known (so-called "risk free") return to a certain date, consisting of government bonds, represents the lowest possible risk portfolio. A very high risk portfolio, which is expected to earn a higher return, can consist of 100% stocks.

 

In an effort to construct more attractive tradeoffs between risk and return, many investors also include so-called "alternative" investments. While they are not literally stocks and bonds, they still represent debt or equity stakes in enterprises. But used wisely, they can lead to better portfolios.

 

A key reason for including different investments in a portfolio is that they lower its risk without necessarily lowering its expected return.

 

Diversification

 

With the riskier investments in your portfolio, diversification of them (that is, spreading those investments out among many opportunities) is generally a good idea. It doesn't reduce the amount you expect to earn, but it lowers the risk that any single investment could seriously hurt your portfolio.

 

There are limits, however, to the benefits of diversification. Ultimately, whether we are investing in corporations, households or governments, we stand to lose when things go worse than expected and benefit when things go well. In the last crisis, all investments fell in price but for government bonds of creditworthy countries. In the next crisis, even this exception may not hold.

 

Time Horizon

 

The length of time that one puts new cash into a portfolio, plans to hold its investments, and the timeline for withdrawals from it are key considerations in setting up a portfolio.

 

Common time horizons correspond to the age at which a person aims to retire, or the funding of education and other expenses.

 

Whatever the horizon and the goal, the investment strategy should seek to both maximize the chances of reaching the goal and minimizing the impact of falling short of it, given the investor's financial resources today.

 

The longer you plan to make future investments and go without making withdrawals, the more risk-taking capacity you have. A major portfolio loss, when 99% of your investment contributions are yet to be made, has a very much milder impact on reaching your goal from one incurred as a retiree living on portfolio cash flows.

 

This means that one can afford to take much more risk when the time at which one plans to "cash in" the portfolio is far into the future, for example, a 30 year old starting a retirement fund. A retired 65 year old, depending on the remainder of retirement savings as the sole source of income, cannot afford to take much risk.

 

Even "risk free" returns are only possible on a fixed time horizon. For example, a 30-year bond has a known 30-year return, but may experience considerable fluctuation on a monthly or even daily basis.


 

Performance, Benchmarking, and Alpha

 

The investment industry is obsessed with measuring its performance.

 

While investors generally think of performance as the price appreciation of their portfolio, the industry is focused on comparing its portfolio results to a "default" strategy - that is, what else the portfolio could have been invested in. This imaginary portfolio is called a "benchmark", and is typically a broad portfolio called a "market index". A market index is designed to be representative of the market segment invested in (US credit, US large company equity, etc.)

 

Examples of market indexes include 500 of the largest US equity issuers (the S&P 500); 125 of the largest North American credit issuers (the CDX Investment Grade Index), and so forth.

 

A continuing debate in finance is whether it's better to "passively" invest in market indexes or to "actively" attempt to perform better than these indexes. 

 

If you want a product which generates results close to that of a market index, then the statistics suggest that the index product is the best long-term choice because most managers, after fees, fall short of index results. Index-tracking exchange traded funds (ETFs) or other low cost index tracking funds are good for this. If you want something with significantly different investments from those contained in the market index, you probably want an "active" non-index product (which could even mean owning individual investments directly). 

 

ETFs are funds can both track market indexes or give investors other exposures. They get their name from the fact that they trade on a stock exchange like a stock. Other funds give investors an opportunity daily to withdraw from or enter the fund at its "fair value", while others have more limited ability to withdraw money.

 

Occasionally, "active" managers use the fact that riskier securities tend to have higher returns to create a part of their "alpha" - return over benchmark. Their portfolios tend to include more of these securities which generally boost portfolio results, though they can hurt the portfolio in adverse conditions. It's important to understand the risk taking in any product when assessing its performance and its suitability for you.

 

It's also fair to note that some fund managers focus on risk reduction rather than index outperformance. Risk reduction is a serious issue, as significant losses are harder to recover from. For example, a 10% loss requires only an 11% gain to break even, but a 50% loss requires a 100% gain to break even. 

 

An important design goal is to produce good results in good times but contain losses in bad times. In future posts we'll examine how that might be done.

 

A key question to ask oneself as an investor today is: If another global financial crisis occurred, how would my portfolio react? How would I?

 

Summary

 

The market mindset is the key to investing: the relationship of price to prospects that determines whether an investment is attractive.

 

Investments can be debt or equity, with debt being less risky than equity as a general rule. "Alternatives" differ in that they are not offered as securities or traded openly, yet share many of the same qualities as debt and equity securities.

 

In designing a portfolio, one needs to decide the tradeoff between return and risk. One's time horizon is one of the key considerations when making this decision.

 

Portfolio diversification is generally a good idea, as it reduces the chances that one investment can seriously hurt your portfolio. But there are limits to how much risk can be reduced, as we are still essentially investing in the global economy no matter how many investments we own.

 

"Passive" investments, such as Index funds and exchange traded funds are useful products that are included in most portfolios. But there is still a place for active management, especially with regard to containing negative portfolio outcomes. This value is only collected when bad times arrive.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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