Why investing is hard

InvestSense
Jonathan Ramsay
Jonathan Ramsay
InvestSense Director
Do you ever wonder why being consistently good at investing is not like business or sport - one person or firm never seems to stay at the top for long?

Many people that are new to investing are a little disturbed to find out that there is literally no-one on the planet that can reliably predict where markets are going to go next. Three hundred years ago Sir Isaac Newton, after formulating the laws of motion and gravity, was famously flummoxed by market cycles and after losing a fortune on the stock market remonstrated that he 'could calculate the motions of the heavenly bodies, but not the madness of the people.' Warren Buffet, arguably the world’s most successful investor has repeatedly said similar things. Yet most investment managers still exude confidence. This is because at any given point in time there will be around half of the market pundits who may have had luck on their side making a lot of noise and making you believe that they saw it all coming. The other less lucky half tend to be a little less vocal so the overwhelming impression for the retail investor is that most people got it right even though the statistics tell us otherwise. 

The start of the problem is that all investments involve some level of risk and risk also entails lack of predictability. Consider two types of risk when investing in a rental property. Firstly, there is the probability of receiving the cash flows that you expect to receive from tenants. These cash flows are not guaranteed but we can attach a probability based on the circumstances and reliability of tenants combined with the likely future economic backdrop to come up with a range of possibilities. Then there is the question of how much that property might be worth in three, five or ten years. This is where it gets much more complicated as we now have to assume we know what all the other potential buyers will be thinking at that time. This is the really mind-bending part of investing, mainly because it starts to involve a view about how other people are going to feel in the future. 

Let’s break it down with a familiar example: 

  1. If you think that property prices are generally going up, you will feel confident about paying more for a property. If you have held these views for a while and property prices have been rising you will probably feel quite validated, and increasingly confident. 

  2. But you are probably acting on similar information to everyone else. So if everyone has been thinking along similar lines we can see a virtuous circle of ever-increasing confidence where the underlying cash flows (yield) become less important, property becomes more expensive, and the ability to find someone down the track who is even more confident than yourself to pay more for the property becomes more important. This is called greater fool theory in financial circles (although no-one admits to being the potential fool!)

  3. At some point something breaks the cycle - the individual properties become implausibly expensive (as happened in Japan in the late eighties) or some investors become forced sellers (as happened immediately before the GFC) due to a change in lending conditions.

  4. Then the whole cycle goes into reverse with falling house prices until some brave soul looks at the cash-flows compared to asset prices (yield) and decides that it is unlikely that they could fall any more. Importantly, this investor is the one that stands to make the most out of the arrangement as he is buying something cheap with a lot of upside. The only reason why he can do that is the very fact that he is alone in his views and no-one is competing very hard with him to buy these properties. 


If this all seems a bit too mechanical then we can throw in some uncertainty and unforeseen actions. For property investing this might include unknown future borrowing rates (a property is worth around half as much if you can borrow at 10% interest rates as opposed to, say, 5%) or government interaction (like a suddenly implemented first home owners grant for instance). Now the timing of these cyclical turning points starts to look a bit less simple.  

Now consider the infographic below depicting the path of global stocks over the last 50 years through the same lens. In the early ’80s market optimists were few and far between but once the market had risen by almost 300% in 5 years it was difficult to find many pessimists. One can easily fit the same cycle of fear and greed through all the cycles we have seen since, and in each case, the greatest euphoria has been followed by the biggest losses. 

On the other hand, even being overtly contrarian and doing the opposite of the crowd is no sure-fire recipe for making better decisions, even if you have the stomach and the wherewithal to question the crowd’s judgement. Who would have thought that the ‘87 crash would be such a temporary blip and the precursor to the 1990’s bull market? Many fund managers went out of business pre-empting the dot com bust just a few years too early. Ben Bernanke, the widely respected Chairman of the US Federal Reserve, and many others famously underestimated the ferocity of the GFC. More recently many people quite rationally thought the 2015 wobble in markets marked the end of the current cycle. Yet the market bolted up another 40% instead.  Sir Isaac was onto something when he intuitively suggested that it was something to do with people and their emotions that makes the whole endeavour so difficult. 




So what do we do with all this information? Throw our hands up in despair and put the money in an index fund? Tempting as that might be at times we think that this has its own dangers (and on that, we respectfully disagree with Mr Buffet). Instead, we bring our focus back to the cash flows and underlying asset values in order to weigh the odds gently in our favour, accepting that the vagaries of the market will mean that we can easily be on the wrong side of market movements for a few years at a time. In our view this is the art and the science of ‘valuation based investing’ and it guides our thinking with respect to asset allocation (which markets we think your money should be invested in) and product selection (which investment vehicles you should use to invest in those markets). So at this point in the cycle we are not necessarily trying to make ‘the hero call’ on which way markets are going, instead, we must sensibly help you manage the uncertainty that markets, central bankers and politicians are throwing into the mix. 

Over the next few weeks, we shall write some more about both these topics (where and how your money is invested) and use some case studies to illustrate the kind of decisions we are making on your behalf. Hopefully, we might also persuade you that transparency and knowledge can provide more comfort than that afforded by a mere promise from a confident sounding investment professional, and with better outcomes. At times this conversation might get complicated but as Albert Einstein reputedly said: “Everything must be made as simple as possible, but no simpler.”

Thanks, this a good explanation of the psychology that underpins the markets.

Thanks for the feedback Andrew, we're glad you enjoyed!

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