1 Golden rules of investing
1.6 Caveat emptor and human nature
investors poured $312 million into them during that same year. This compared with withdrawals of $6.7 billion the previous year (2002), when technology funds lost 43 percent on average. Even more red ink ran in 2001 and 2000.
But jumping on the bandwagon also has a downside. The Jacob Internet Fund provides an example. It led shareholders into a three-year tunnel, losing 79.1 per- cent in 2000, 56.4 percent in 2001 and 13 percent in 2002. While the fund gained 101.3 percent in 2003, Jacob’s record of volatility suggests the fund is willing to take on a high level of risk in pursuit of big rewards which sometimes prove elusive. This may be acceptable if the investor understands and appreciates the risks he or she is getting into, but it is wrong if he or she believes that high returns are achievable at no risk.
investments, starting when one begins a career, seem to be the only way to provide a reasonable income at retirement.
The answer to the query ‘Why do I save?’ asked in section 1.2, is different today than ten or twenty years ago. Politicians do not have the courage to openly say so, but most definitely the trend is towards reducing entitlement programs and benefits. On 25 February 2004, testifying about the ballooning US Federal budget deficit, Dr Alan Greenspan demanded reducing Social Security and Medicare benefits for workers at or near retirement age.10
There are reasons behind this stance. The Fed chairman said that ‘We will eventually have no choice but to make significant structural adjustments in the major retirement programs’, adding that this should be done ‘as soon as possible’ on the grounds that the government was overcommitted to spending on:
Required benefits, and Health insurance.
‘I think it is terribly important to make certain that we communicate to the people who are about to retire, what it is they are going to have to live with’, Greenspan stated, urging Congress to push up the retirement age for Social Security and Medicare, and to reduce the cost-of-living increases, which are linked to inflation. According to Greenspan the main fiscal problem is Medicare, partly due to the fact that:
Advances in medical technology allows people to live longer, and
Longevity as well as higher technology increase the level of spending for retiree health care.
But if savers become investors – either directly or through mutual funds and pension funds – then they want to see that the law is making company executives accountable to their stakeholders. Laws alone, however, would not change the investment landscape, because laws need to be enforced. Even if some codes of corporate behavior have been published, and these are sparse in continental Europe, companies are not rushing to comply with them.
The law enforcement industry has a major job to do, human nature being what it is.
Supervisory authorities must have expertise both in regulation and in policing, short of which caveat emptor would be an empty term. By themselves, codes of conduct are making little more than general statements of good intentions. In a survey of thirty- nine different codes existing in European countries, the European Commission’s (EC’s) lawyers found that:
Many were outright failures, and
There were gaping holes in investors’ rights.
For instance, one survey documented that only 9 percent of UK-listed companies it reviewed fully comply with all the recommendations of the corporate governance code. In Belgium, which has four different codes on subjects relating to investments, there has been evidence that control over corporate governance activities is slowing.11 Evidently, this is to the detriment of investors.
Moreover, the caveat emptor principle is being challenged by a 3 June 2002, US Supreme Court ruling in favor of a Securities and Exchange Commission action against a broker. The Supreme Court stated that the securities markets’ regulations introduced in the 1930s ‘sought to substitute a philosophy of full disclosure for the philosophy of caveat emptor, and this to achieve a high standard of business ethics in the securities industry’.
According to this ruling, analysts may have a legal duty of care for their retail customers, which means, for example, offering them only such advice as they would give to themselves. On this ground, even prior to the aforementioned US Supreme Court decision, countless private lawsuits have been pending against financial services firms, and they seem likely to drag on for years, some of them expecting to result in huge payouts. As a matter of principle, investment advice must be characterized by independence, impartiality and neutrality.
Independence means the absence of any objective link – personal, business, or otherwise – between the analyst and any of the equities which he or she covers.
Impartialityrefers to the lack of subjective attitude by the analyst, who should not favor any one of the equities he or she covers, for any reason.
Neutralityis a concept connected to a position of the analyst who should have no interest, and no conflict, resulting from the outcome of the research he or she is doing and the investment advice being given.
Rigorous investor protection rules are vital both for professionals and for retail investors. Their aim must be to provide a shield against malfeasance, not to take care of investors’ risks. And because prudential regulation is necessary but not enough, both speculators and investors much be proficient in risk management in regard to every transaction and portfolio position. Risk control is the common core to all types of investments, as Figure 1.5 suggests.
Beyond the understanding of risks assumed with investments, a sound method- ology and first-class technology are instrumental in the control of exposure. Timely and accurate data washes out wishful thinking, which is destructive because it takes attention away from diagnostic processes. Whenever traders or investors gets com- placent or careless they abandon basic principles, and therefore lose their position.
Another similarity between good trading and sound investing is the delicate balance between:
The conviction to follow one’s own ideas,
The ability to recognize when one made a mistake, and
The courage to correct it without loss of time, though money may be lost.
The policy outlined by these three bullets is of fundamental interest to all investors, since they are bound to be wrong on a number of choices they make. Extensive experi- ence and rapid self-correction of mistakes helps in learning how to gain confidence in one’s own investment skills. Big egos destroy self-confidence, because confidence and humility share the same mind.
BONDS PREFERRED STOCK
CONVERTIBLE BONDS COMMON
STOCK
RISK MANAGEMENT:
THE COMMON CORE
Figure 1.5There is a common core in risk and return valuation with investments