2 The area where professional asset managers and private investors meet
2.3 Betting on the challenger and learning to diversify
In conclusion, if the investor truly aims to achieve a lifetime investment goal, such as securing his or her retirement, providing for children’s education and assuring the financing of a family health plan, then he or she has no alternative than taking an active part in the management of his or her wealth. Answering investment questions with confidence requires a financial strategy, the first step of which is assessing one’s current portfolio to assure it is working to meet established goals. To this are dedicated the three golden rules of investment in sections 2.3 to 2.5.
But as far as professional investors are concerned, it is their job to judge market trends and guess an equity’s peaks, lows and what comes after them.
This advice, however, runs contrary to the opinion of a professional broker who said he doubts anybody can really recognize the peaks and the lows in an equity’s longer-term life cycle. ‘Experts cannot and will not say where the peak is’, the broker commented, adding right after that he liked the first half of this rule: bet on the challenger. Another investment specialist pressed the point that rather than emphasizing peaks, savers should be advised to avoid overpriced stocks.
Analysis provide important help in reaching this and other investment objectives (see Chapter 6 on fundamental and technical analysis). Theoretically at least, the price of financial assets is determined by the present value of the future cash flow that investors expect to derive from holding the asset (see Chapter 9 on intrinsic value). Applied to the valuation of shares, the price of an equity should equal the sum of expected future dividends discounted by:
A risk-free interest rate, and
The risk premium which investors require for holding the equity.
Earnings expectations can replace expected future dividends in the valuation, if we assume that a certain percentage of earnings will be paid out as dividends. Such earn- ings expectations by analysts in financial markets are usually available for quoted companies (which leads to the fifth golden rule in section 2.4). Figure 2.3 provides the pattern of earnings growth and decline in the 1990 to 2003 time frame.
Some principles associated with the use of an approach which takes into account earnings expectations and market trends can be of interest to the investor. For instance, actual earnings growth generally tends to exhibit a more volatile pattern compared with twelve months ahead earnings growth expectations by analysts. Moreover, actual and expected earnings growth figures tend to move in tandem, and upward
–20 –10 0 +10 +20 +30
1991 1993 1995 1997 1999 2001 2003 Figure 2.3Actual earnings growth for the S&P index
JUST NOTE DIFFERENCE
1Q 2Q 3Q 4Q 1Q COPPER
TIN
NICKEL
ALUMINUM 250
100 175 225
150
125 200
2003 2004
Figure 2.4Trend lines of base metal prices which reached eight-year and fourteen-year highs in a span of less than one year
and downward changes in earnings expectations are usually followed by similar movements in actual earnings.
What the reader should retain from this discussion is that whether the investment choice is income or growth, the price of entry into equity ownership matters. If the investor pays too much for an equity, the income per invested dollar or pound will be proportionally less, and part of the expected capital growth will be lost in having paid too high a price. The same principle applies with all other investments, including bonds and commodities such as base metals.
From May 2003 to April 2004 (when this text was written) base metal prices soared thanks to strong demand from China. Copper and aluminum, for example, have hit eight-year highs, while tin prices reached fourteen-year highs. The trend lines are shown in Figure 2.4, where the reader will also notice the copper’s volatility.
For sophisticated investors, this example dramatizes the interest of diversification.
Returning to the third golden rule, which was discussed in Chapter 1, it is likely that up to a certain percentage both income and growth will be in an investor’s portfolio.
The challenge is to define which proportion of one’s wealth should be allocated to bonds and which to equities. This is a shot in the direction ofdiversificationwhich, by choice, must be part of the fourth golden rule.
Like freedom and democracy, diversification is an often used word, but one which is very rarely practised in a documented manner; or for that matter one which is long- lived. Practically all financial institutions and all asset managers, though by no means all individual investors, incorporate into their plans hypotheses about diversification of risk and return across their area(s) of operations. Knowledgeable bankers, however, appreciate that most of the statements concerning diversification are untrue.
If and when it is achieved, the diversification of risk and return is bound to be ephemeral because market forces change the rules of the game.
Therefore, investors must learn how to diversify dynamically both between debt and equities (and sometimes other instruments) and within the equities traded in the market.
As an initial condition, diversification of risk can be achieved by investing in more than one industry sector, or by investing in markets not correlated with one another – if such markets can still be found. Because of globalization, this policy of market diversification is becoming increasingly more difficult to implement. Even more taxing is how actually to keep such a policy as market forces evolve.
The reader should be careful on this issue of diversification and its sustenance because there is plenty of hype in the investment community around it. There is as well an issue distinguishing theory from practice. Theoretically, diversification is good for an investor; but, practically, holding too many different equities or debt instru- ments makes it difficult to follow their fortunes. Between these two statements, which contradict one another,
Every investor has to establish his or her diversification vs. concentration rule, and This must be done in a way which best fits the investor’s goals and risk pro- file, in conjunction with the fifth and sixth golden rules (see sections 2.4 and 2.5, respectively).
Looking back to the masters for inspiration and guidelines, Amadeo Giannini used to say: ‘I see nothing wrong with a man putting all his eggs in one basket. But watch that basket.’ The biggest problem with concentration is that the typical investor does not know how to ‘watch that basket’ – and the same is true with many of the experts, including several bankers and investment advisers.
‘Watch that basket’ means plenty of work and responsibility. Giannini did not build a financial empire by going on vacation or taking it easy. He slept, lived and breathed the bank, which he referred to as ‘my baby’. This type of hard work is no longer part of the morals of our society. A recent study in France has documented that those who profited the most from the thirty-five hour week (instituted by the socialist government of the late 1990s) are the managers who turned the shortened working week into longer and more frequent vacations.
True enough, the leaders of finance and industry still work sixty- to ninety-hour weeks, but not everybody is a leader, and it is likely that the investors’ accounts will not be followed personally by one of the masters of finance. At least theoretically, for the typical investor, diversification is a good policy. Practically, in the average case, four to eight stocks are enough for an individual’s portfolio – and a dozen or so bonds.
For diversification reasons, these equities and debt instruments should preferably be in different industries. The investor who knows what he or she is doing needs no more than these positions. If the investor does not, he or she should not be in the stock market in the first place. Even AAA and AA bonds in an investor’s portfolio require one to step up to the plate and play the game of investment management and risk control.