12 May 2020
A guide to the mountain of investment
In the inductive investment world of my last post, the over-riding goal is to survive. For the deductive capital asset pricing model (CAPM) investor, market-wide diversification is the best way to survive – for an inductive investor, it is not.
An example from outside the financial world comes in mountaineering. Nearing the summit of a mountain peak, be it in the Cairngorms or Himalayas, the shrewd climber returns back to camp if conditions deteriorate. Being prepared to avoid unquantifiable risk is the guiding light of any wise Sherpa. For the inductive investor, wealth preservation means devising ‘rules of thumb’ to guide us on the mountain of investment. Gleaned from the past, these signals are, by definition, imperfect and provisional. However, the fundamental point is that experience has a value beyond beta.
Such an investment approach needs both quantitative ‘process tools’ and qualitative ‘imaginative rules’. One simple quantitative tool is an Early Warning System (EWS) to flag when valuations may be vulnerable to sudden shocks. For the ordinary investor without access to sophisticated statistical tools, the easiest EWS is a Moving Average (MA), to gauge when valuations may be stretched. This can be built up with access to nothing more than a spreadsheet, with amber and red zones signalling when stocks are trading dangerously above the MA. Of course, an alternative approach is to delegate the management of uncertainty to an experienced wealth manager, and please allow me a plug for the excellent team at Investec, as an example.
The world is not static but dynamic; the vision required is broad not narrow; investing is an art as much as a science.
In terms of devising reasonable qualitative rules, I think it is better to read and distil the investment masters whose techniques have stood the test of time. There are at least two common themes that emerge from a study of acknowledged wealth management experts. The first rule is to seek context rather than the illusion of precision. The second is to be aware that this context needs to be reviewed continually, as it may change quickly and unpredictably. The world is not static but dynamic; the vision required is broad not narrow; investing is an art as much as a science.
As an example of the first rule, let’s turn to Benjamin Graham - the combination of precise formulas, with highly imprecise assumptions, can be used to establish, or rather to justify, practically any value one wishes. As an example of the second, we need look no further than Soros - I did not play the financial markets according to a particular set of rules; I was always more interested in understanding the changes that occur in the rules of the game.
A useful metaphor to keep in mind when thinking about investment is discussed in a different context by the British philosopher Iain McGilchrist. A little robin redbreast needs two types of attention to eat the breadcrumb on a path – a carefully focussed eye to grab the bread, and an equally broad awareness of its surroundings, to ensure it does not end up as lunch for a lurking fox. Investment, I would argue, is not that different.
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The blog does not aim to give investment advice, but is designed to afford relevant longer-term context to investors, encouraging a broad perspective where uncertainty is high and a spirit of learning is important. The views expressed are those of the author, not those of Investec.