Why markets matter
Most investments are second hand. We buy them from other investors, and if we want to realise them (convert them back into cash) we have to sell them to other investors. Some assets we can buy and sell through an established market, for example, a stock market. For other assets we have to negotiate with individual sellers and buyers. Even if we don’t invest directly, many financial products (for example, endowments, unit trusts, equity bonds, annuities, and pensions) rely heavily on investments that are linked to markets one way or another.
Real assets, properties for example, often have values that depend on factors other than simply risk and return. House prices in the UK are not driven by rental values, in fact it’s the other way round. Desirability and affordability (how much you want it and how much you can afford to pay for it) are the key factors with residential property.
Financial assets on the other hand don’t have any such spurious attributes, and can be traded anywhere. We can buy and sell financial assets world-wide simply by picking up a phone or logging onto a web site. Often enough we don’t actually take delivery of anything: it is enough that our name and address appears on a computerised register somewhere. Millions of people trade financial assets each day in markets all over the globe. They are all willing buyers or sellers and are focused on only two issues: risk and return. And buyers and sellers always cancel out. Securities by and large don’t appear and disappear. If I decide to sell my shares in XYZ plc, somebody will buy them. I might not like the price Mr Market offers me but he will offer me a price as long as those shares are quoted on the Stock Exchange. It is up to me whether I take it.
The way financial markets match buyers and sellers, every one of whom is free to trade or not, lead to the concept of market efficiency. Since every market agent is assumed to be more or less equally well-informed, the prices of every security at any moment must represent everyone’s best guess as to its true value. For example, if I think the share price of BP doesn't reflect the true worth of the business, I am perfectly at liberty to put my money where my mouth is by buying BP shares. If enough people agree with me, the price of BP shares will rise until they reach a level where buyers and sellers balance again.
The efficient market theory (EMT) is difficult to argue against because really that’s how financial markets should work. And if they did always work efficiently there would be no way, except through pure chance, that anyone could ever beat the market and investment returns would be steady and predictable. Prices would follow what is known as a 'random walk' (which simply means that they are unpredictable). The only problems are that market prices are far too volatile, that investors are not always rational, and information isn't shared equally. Nevertheless, it is dangerous to assume that you will do better than average (or to believe anyone else who tells you that they will). The random walk model is a pretty good approximation to real markets a lot of the time.
What this means for investors
In a perfect world, asset prices would exactly track the economy. The prices of real assets are linked to their demand and to their affordability, and both will rise as wealth increases. Depending on whether an asset is of purely local interest (a house in a small rural UK town perhaps), or of much wider interest (oil for example) then we could be talking about the economic growth in that particular part of the UK, or world-wide economic growth. Financial assets represent rights to real assets or rights to part of the cash-flows of businesses, or rights to receive cash in the future. With equities, the values of these rights are again tied to the economies in which those businesses trade. We will talk more about growth on the next page.
Meantime, this isn't a perfect world and whilst asset prices do track the economy, they do it in a very hit and miss way. The benefits of economic growth are not shared equally. Some people do better than others and some businesses do better than others. The pecking order changes too. Companies that were once industrial giants have disappeared and many of those that currently dominate their markets didn't exist all that long ago. The same applies to jobs. Whole industries come and go. So although asset prices as a whole can be expected to track the economy, the prices of individual assets (properties, shares, whatever) may do very much better, or worse, than average. (Although keep in mind that they can’t do better indefinitely).
Even when you take a group of assets as a whole, for example the UK FTSE All-share index which tracks the share prices of around 800 companies, the market prices vary far too much to be explained by collective expectations of economic performance. If the All-share index was fair value at the level of 3000 at the start of 2001, how could it have been equally fair value at 1700 two years later? Did the market realistically expect every company in the UK to halve its dividend? Of course, there are all sorts of rational reasons why markets should rise and fall, but the fact that these changes are visible and widely publicised magnifies the effect enormously. It tends to make prophecies self-fulfilling. A pundit tells us that shares in XYZ plc are set to rise. This generates some buying interest; the share price rises; people see it rising and join the bandwagon. This can (and does) sometimes happen without any real justification whatsoever.
Financial markets are both a blessing and a curse. They provide us with the incentive to trade as well as making it possible for us. If asset prices were not so variable we wouldn't feel the need to try to be smart by speculating. And because we speculate, prices vary much more than they would otherwise. Instead of prices being driven by the income stream (or the prospect of one), the income stream is in danger of being disregarded. People focus instead on making a fast buck by exploiting short-term price changes.
The danger really arises when professional investors (pension funds, life assurance companies, fund managers) join the party. Because many fund managers are judged by the total returns to the funds that they manage compared to other funds and a ‘benchmark’ index, they feel bound to follow the herd and thus extend short-term trends. The final folly is when they believe that the paper returns notionally earned during a rising market will carry on at that rate forever.
However, markets are with us to stay. Asset prices are likely to remain excessively volatile, and as a result many market-based investments are riskier than they should be.
Investment is a zero sum game
A zero sum game is one where the winners and losers cancel out. The gains of the winners are the same as the losses of the losers. Because so many investment assets are second hand, investors rely on some sort of market to buy them and sell them. Since at least part of their return arises from the difference between buying and selling prices, you can do better at the expense of those you buy from or sell to. If prices tracked the economy reasonably well, the difference between winners and loser would be fairly small. But extreme volatility magnifies the potential gains and losses. How do you become a winner or a loser?
You win if you are smart enough (or lucky enough) to buy when the price of an investment is low in relation to its investment value, and sell when it’s high. You win if you are smart enough (or lucky enough) to spot companies or properties that do better than average, and if you buy and sell at the right times. Those who bought shares during the 1980s and 90s and sold before the end of 1999 probably did pretty well. Those who invested in Microsoft 20 years ago will have done pretty well. But those who bought shares in 1999, and still have them will probably be nursing a hefty loss at present, and for every success like Microsoft there are dozens of companies that have never gone anywhere and a good many that have gone belly up.
The winners are those who by good luck or good judgment got in and out of the markets at the right times and those who picked exceptional shares (and got in and out at the right time). The losers are those from whom the winners bought or to whom they sold, or simply those who didn't invest in the best businesses at all, or if they did, invested at the wrong time. Those who bought and held shares in UK plc have been winners some of the time and losers some of the time. During the 80s and 90s returns on the stock market were well into double figures, but in the last 3 or 4 years those investors have lost money.
Generally speaking, winning at investment means doing the opposite of what most other investors are doing. One way of winning is simply to avoid being tempted into trading too often. If you hold investments for long enough, the income stream produces most of the returns. Asset values do track the economy, and over long periods the short-term fluctuations in prices don’t look all that significant compared to the overall trend. For sure there are some pretty nasty falls from time to time, but the long-term trend is upwards.
Investors show some remarkably consistent biases in their behaviour. They are inclined to ignore the shares of steady cash-generating businesses that pay good dividends, and chase those that appear sexier. They exhibit herd behaviour, selling when everyone else is selling and buying when most others are buying. The resulting rises and falls in prices confirm that their behaviour was rational. In other words, if enough people believe that there is about to be a stock market crash then there will be!
|9 October, 2008 © 2008 K.R.Wade and Co Ltd|