Joss Delage

Investment theories and strategies

25 posts in this topic

All,

In the topic How well understood is the modern economy?, we had several exchanges on investment strategy and market theory, and I thought I would start a new thread for us to discuss those.

Fooey on the efficient market hypothesis! I've thought for some time that I ought to create an "Inefficient Market Hypthesis" -- and just like the academics, prove the market is always wrong!

The price of any good is set by "The Market" -- meaning the collective judgement of everyone involved in buying or selling that good or alternative goods (since $1 spent on the competition is a $1 vote against that good). Just like any human judgement, it is in accordance with the nature of human epistemology. That is:

- Every judgement is contextual. Every individual knows something about the market, and has his particular value hierarchy and financial resources to work with. Inside information is a factor here, but not the only one.

- Rationality is a volitional choice. For every Warren Buffet, there are fund managers that CONSISTENTLY fail to surpass their indices. There are libraries filled with all sorts of economic theories and financial approaches that contradict each other... and surely they aren't all right, but each has its proponents.

- People are fallible. A typo here or there, or mistaken addition, or a misunderstanding gets written into a contract, and people can (and do) lose money. How many earnings reports have to be reissued to correct mistakes? How many times do "The Experts" miss on their earnings estimates?

- Morality is volitional. How many Ken Lays, Enrons, and Global Crossings are there to deceive investors?

- Most people are secondhanders. How many people on Wall St are racing after the latest investment fad? How many people buy houses or dot com stocks under the "greater fool" theory of investing (i.e., buy high, sell even higher to an even bigger fool)? How many people buy stocks based on what they see recommended on CNBC? How many people go into massive debt in order to impress their neighbors with new homes and big SUVs they can't afford? How many people make risky investments without considering the consequences? (Or conversely, think any investment is too risky, and lose their wealth to inflation?)

- People often let their emotions override their judgement, selling out of fear and buying out of greed when a rational assessment would not support such actions.

- There's only so much time in the day to do the background work to look into a company. With all the companies out there, the better fund managers have their hands full just trying to keep track of a few big companies. Small companies get a fraction of that attention. With that disparity, I'd say the larger companies are generally more fairly values than the smaller ones.

I agree with Warren Buffett on this. In the short run, the market is a voting machine: the popular stocks take off. But in the long run, the market is a weighing machine: the better companies outlast and outshine the worse ones, and people eventually catch on to which is which.

Making matters worse are the work of professionals. Consider: Why are there so many more recommendations from analysts to buy then to sell? Why are their estimates often far off? Why do many funds churn their assets, instead of keeping turnover, costs and taxes low?

And of course, as any good capitalist knows, you throw government intervention and all heck breaks lose.

To my mind, I think we're lucky the market is as good as it is. In the long run, the market is efficient, which is why I think index investing makes sense for macro trends. Yet it is the inefficiencies in the market that keeps gems hidden in the short run, serving as potential home runs for the better investors who can recognize that value when others can't.

Here I want to address the following 2 statements:

"For every Warren Buffet, there are fund managers that CONSISTENTLY fail to surpass their indices."

"Yet it is the inefficiencies in the market that keeps gems hidden in the short run, serving as potential home runs for the better investors who can recognize that value when others can't."

Empirical evidence shows that very. very few if any fund managers consistently beat the market. There is only one Warren Buffet, and he might be the exception to this "rule" (by the way, the voting / weighing metraphor is originally from Benjamin Graham, not Buffett). A random investor is very unlikely to replicate that type of results. In addition, investigating companies and trading individual stocks is very expensive compared to buying and holding a diversified portfolio of index fund (one of the cost being your personal time spent doing the research). Therefore to beat the market isn't enough - one needs to beat the market by enough of a margin to offset all those costs.

Finally, many investors fail to consider the level of risk they're assuming. By investing in individual stocks, they generally build a much more volative portfolio than the market.

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I my opinion, there is no such thing as one size fits all when it comes to the market. Which investment strategy is best is very much a personal preference. It depends on how much money you have to invest, where you are in your life (your age and how long do you plan holding this money in investments before you decide to use it), how much risk you are willing to take, how much control you want to maintain over your investments, and how much time (if any) you are willing to invest alongside your cash.

Personally, I decided on a balanced approach utilizing both mutual funds and stocks. Mutual funds are known to be less risky but a strategy composed of investing exclusively in funds runs a greater chance of over-diversification and thus underperformance. I also like the fact that with stocks I can take my profits (or losses) when I want to (for tax purposes) and that I can also invest in smaller cap stocks. I am comfortable with this strategy for now but perhaps it may change as I get older.

I do not find that investigating companies is very expensive. Research is a fundamental to investing and I happen to enjoy it so I do not consider it as an additional expense. I can pretty much find everything I need to know about a company on the internet free of charge.

In any case, there is no universal answer to the question: What constitutes just the right balance between risk vs. reward? I think it depends on person's individual comfort level.

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I largely agree with Sophia's post. Context is critical to investing approaches. Like Sophia, I have a mix of funds and stocks. I follow the stocks more closely than the funds due to the greater volatility and risk.

Investigating companies requires first knowing what to look for (good and bad). If you're looking to invest a lot of money in one company, you need to know quite a lot about it -- industry direction, management, cash flow, quality of products, potential for growth, track record, etc. A professional analyst might fly out to visit HQ, talk to customers, figure out how good the managers are, etc.

Time is another consideration. Dollar cost averaging broad index funds will most likely give you a good, solid return over the long run (20+ years). Yet if you suspect, say, a news scare over cel phone radiation is a bunch of hooey, and you see Motorola stock plummet, a good speculative play may be to buy up lots of shares and wait for the rest of the market to realize the truth and bring the price back up.

I think stock speculation makes sense only when you have a very definite reason why the market is wrong in its pricing. Being an expert in a specific field (say, genetic research) means you may be able to see an opportunity before others. Stock picking also may make sense as a long term investment for the dividend and stable but slow growth.

I see the role of fundamentals in stock picking, but less so the virtues of technical analysis. I know some people have made a lot of money using chart analysis, but if everyone is following the same chart patterns and buying and selling in sync, how does one make money? That eludes me, but I haven't written it off.

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When you talk about stocks, are you talking index / no load funds, or managed?

Obviously, context is critical. But within a specific context, I am not sure that there are so many valid approaches.

Regarding stock picking, how do you reconcile your approach with the empirical data that shows that even professionals can't do that consistently right and end up underperforming the market?

As to cost of research, it exists, if only the opportunity cost of not doing something else even more pleasurable or profitable.

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Whoa! Wait a second here! I believe that if we are going to have any beneficial discussion about how one ought to invest, we need to first contemplate the nature of investing. For instance, what is the definition of investing? What does one do when one invests? Only after we have settled on a correct description of the nature of investing can we have an enlightened discussion about how one ought to go about investing.

So, I will now offer my five cents on the matter.

I believe that investing is consuming in a reproductive way. This is done by converting part of one’s produce into an item of capital. As capital is a product, it may be either material, such as a farm implement, or immaterial, such as the advice of an expert. Investing is done so as to increase one’s productivity. Instead of just producing what human industry alone can afford, a yearly income now includes the further produce of past production.

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To invest: To allocate one's resources in order to satisfy future needs.

That's how I'd think of it.

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To invest: To allocate one's resources in order to satisfy future needs.

That's how I'd think of it.

Hmm...

Well, I'd definitly say that satisfying future needs might be a reason to invest, but I don't see how that is investing. I think you're touching more on the motivation than the act of investing. As for myself, I invest not for my future needs but rather to satisfy more needs/wants/desires/etc. Although the stisfaction of those wants will come in the future, I would not say that I am satisfying future needs as I have those needs right now. I am merely putting off satisfaction until a later time.

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Nicolaus,

Yes, I don't see any reason why that couldn't be added to the definition - and I make no claim that this is the ultimate definition. This being said, most people invest for (1) living expenses when retired, (2) college costs for a kid, (3) home purchase. Those are not present costs that are differed, but future costs that are anticipated. But again, I don't think it's a major issue.

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[M]ost people invest for (1) living expenses when retired, (2) college costs for a kid, (3) home purchase.

... and (4) to start a business, (5) be a full-time, stay-at-home Mom or Dad, (6) take time off to write their novel or screenplay, (7) go back to school for a degree, (8) etc.

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Actually Betsy, I suspect that most people do not invest for those objectives - I suspect this only concerns a small portion of the population. The operative word here being "most".

With that say, I agree that those would be perfectly valid examples of investment goals. That why I made up the (tentative) definition broad enough:

To allocate one's resources in order to satisfy future needs.

Your examples further reinforce the point that investment strategies cannot be "one size fits all". Those various goals translate into different time horizons, risk tolerance, etc, that impact the strategy.

As a side issue, do people see a difference between investing and saving?

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As a side issue, do people see a difference between investing and saving?

Savings, to me, implies high liquidity and a near-zero chance of significant loss. Investing, conversely, trades liquidity and/or safety for the chance of higher long-term returns.

I suspect this would be a continuum with liquidity and risk low on the one side, and higher (in various combination) on the other end. A rough list progressing from pure-savings to pure-investment: gold buried in the back yard, cash under the mattress, money markets, savings accounts, CDs, stocks, mutual funds, bonds, real estate and maybe commodities or options.

--Larry

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As a side issue, do people see a difference between investing and saving?

Sure.

Investing is for long-term goals and saving is for unpredictable emergencies ("saving for a rainy day") and opportunities (the car of your dreams is on sale).

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As a side issue, do people see a difference between investing and saving?
Investing involves risking one's current assets for the reward of future long-term gains. Often, the long-term perspective involves letting the investment ride the short-term volatility in order to capture long-term, slow growth.

Specualting risks those assets for short-term gains. Typically the assets are placed in vehicles that will undergo large, rapid changes in prices with timing of purchase and sale critical to capturing the profit objective.

Saving is categorically different. It is a matter of managing cash flow, income and expenses. The assets built through saving are set aside for a variety of possible purposes, including consuming, investing and speculating. The money is not put at risk for a particular goal as happens with investment and speculation.

My 2 cents.

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When you talk about stocks, are you talking index / no load funds, or managed?

I distinguish between directly buying stocks and putting money in funds. I also distinguish between the types of funds (index, hedge, managed), and even between the approaches (value, growth) and areas they cover (international, small cap, sector, etc.). They each have their place,

Obviously, context is critical. But within a specific context, I am not sure that there are so many valid approaches.
I pretty much agree, but the issue is figuring out which are valid.
Regarding stock picking, how do you reconcile your approach with the empirical data that shows that even professionals can't do that consistently right and end up underperforming the market?

If you watch the market, opportunities appear. There is risk, and mistakes get made. But that doesn't mean one can't beat the indices. If you don't see something, it may make sense to put money into diversified indices to at least get the average return until something better appears.

As to cost of research, it exists, if only the opportunity cost of not doing something else even more pleasurable or profitable.
I think it's a lot more than that, though. Sure, you can stumble onto something good, place a bet, and win big. But it takes time and effort to build knowledge and experience to invest rationally.

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Whoops! I posted too soon:

I distinguish between directly buying stocks and putting money in funds. I also distinguish between the types of funds (index, hedge, managed), and even between the approaches (value, growth) and areas they cover (international, small cap, sector, etc.). They each have their place,

given one's objectives and what's happening in the market. That is, context matters.

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Actually Betsy, I suspect that most people do not invest for those objectives - I suspect this only concerns a small portion of the population. The operative word here being "most".

With that say, I agree that those would be perfectly valid examples of investment goals. That why I made up the (tentative) definition broad enough:

To allocate one's resources in order to satisfy future needs.

Your examples further reinforce the point that investment strategies cannot be "one size fits all". Those various goals translate into different time horizons, risk tolerance, etc, that impact the strategy.

As a side issue, do people see a difference between investing and saving?

I believe the definition is too narrow. There are many reasons to invest or even to allocate resources, and many people gave some in this thread. That gives us "to allocate one's resources" but this seems too broad. For instance, I could divest. Divesting is surely an allocation of my resources.

When I think of saving I think of, well, saving. I’m reminded of my piggy bank as a child or “that money under the mattress” that some people might have. It seems that I'm putting away or keeping safe, and not touching it until I deem necessary. Contrast this with investing.

When I think of investing it is stocks, bonds, investment real estate, and bank accounts that come to mind. What happens here is something more than saving. I'm not just simply keeping it; I'm getting a return on my assets. The return doesn’t come from nothing, so something is happening. Where does the return come from?

When I loan out my money (bank account, bonds) I’m giving it to somebody else to use in order to start/run a business or buy a house. When I buy stock in a company or a piece of real estate, I’m buying an asset(s). I believe that what’s happening here is that the values one invests are earning a return because they are doing something productive. The values I own are turned into a house or equipment and those things produce values such as protection from the elements or a toy. Since I’m giving up possession of the assets, but not ownership, I still have a claim to the produce of those assets and hence why I earn a return on them.

Further notice that producing value requires an exchange. Whether it’s a friendship or a factory, one must do something to keep it or even to get it in the first place. In terms of using previous values to produce further values, one must exchange the first value to get the second. The machine in the factory eventually wears out and needs repairing/replacing. The house eventually needs a new coat of paint or furnace. What one does is to destroy one value in exchange for another. The destroying of value is what I call consumption.

This is why I believe that investing is consuming in a reproductive way. From the loan, to the investment property, to owning the assets of a company, what I believe is similar between all cases yet different from all others is that values are being destroyed in order to create more values.

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For instance, I could divest. Divesting is surely an allocation of my resources.

Yes, but not for future needs.

Do you think that putting money into a CD account to pay for a car one year from now is saving, investing, or both? Do you think that buying gold (a not productive asset) for a % of your retirement portfolio is saving, investing, or both?

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Yes, but not for future needs.

Do you think that putting money into a CD account to pay for a car one year from now is saving, investing, or both? Do you think that buying gold (a not productive asset) for a % of your retirement portfolio is saving, investing, or both?

Well, I still hold on to my "for future needs" disagreement. The final cause is seperate from the formal cause. I'm seeking the formal cause. With that said, I could very well divest for future needs. If I believed that there was no investment that would return at least my principle, I could very well divest and choose to hold it in another form.

I would classify a CD as investing. A CD is a loan.

Why isn't gold a productive asset? If a company that held gold in a cash account for the purpose of paying its workers/raw materials/repairs/etc. and then replenished that gold as the company sold it's produce would definitly be using the gold in a productive way. The gold is used to produce and then replenished through its use. I believe they call it working capital.

I would call this saving. While gold does rise in price, and one might argue that gold is then productive, notice that a price rise here is not in response to gold being of any more value. In terms of anything other than dollars, the price of gold does not change (or so little as to basically not change). So, it seems that actually gold isn't producing any value through holding it, which would be speculation. In this case, gold is indeed just a stock of value or a savings.

Hmm... Something just occured to me. I think that i might have to revise my definiton of saving. It seems that saving does produce a value. The value is immaterial and thus consumed as soon as it's produced, but it's still producing a value. The value it produces is something along the lines of security, though the particular value probably changes with every person. Perhaps saving and investing are the same thing? Well, I'll think about it and get back to you all.

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Do you think that putting money into a CD account to pay for a car one year from now is saving, investing, or both? Do you think that buying gold (a not productive asset) for a % of your retirement portfolio is saving, investing, or both?

The way I view it, there are three mutually exclusive things you can do with your money: spend it, save it, or invest it.

Savings and investments both involve doing something with unspent funds, but the difference is that with savings, you can spend them any time you want and with investments, you are either locked in for a period of time or the funds are earmarked for spending at a later date. The essential characteristics of savings are liquidity and the absence of a particular future purpose.

So I would say that the CD is definitely an investment because it is not very liquid before maturity and the funds are being set aside for a future purpose. The gold is an investment too because, although it is very liquid, it is earmarked for retirement expenses. If the gold were being kept for use in case of a monetary crisis, it would be savings.

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Do you think that putting money into a CD account to pay for a car one year from now is saving, investing, or both? Do you think that buying gold (a not productive asset) for a % of your retirement portfolio is saving, investing, or both?
Both are allocations of assets. Each is a vehicle for investing. Depending on the reasons for buying gold, that could be classified as speculation. For instance, if you see the price of gold going up as a reaction to inflation fears, buying gold with the intention of selling when the price has gone way up ought to be classified as speculation.

Buying something requires spending money, even if the purchase is intended to be sold for a profit at some point in the future. Saving, on the other hand, involves spending less money than one takes in, and setting aside the difference. Saving and investing are very different.

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I agree with most of the definitions in this thread.

Investing: Purchasing an asset in order to earn a profit over the long term. Saving is delaying consumption. Thus, investment is a type of saving. I think the main difference between investment and speculating is simply the length of time--short or long term. One can also gamble their money, but that's not really related to this discussion.

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The way I view it, there are three mutually exclusive things you can do with your money: spend it, save it, or invest it.

So, after some more thinking on the subject, I believe that Mrs. Speicher is on the right track, but I'd tighten things up a bit. Here's how I'd state the matter:

There are three mutually exclusive actions one may do with their produce: unproductively consume it, hoard it, or productively consume it.

Using the above categories, I’d say that saving and investing are two different types of productive consumption. My first response given the new categories is that saving is passive and investing is active. Saving is giving your produce to another who consumes it for you and gives you its yearly produce in the form of a rent (interest) or dividend. Investing is undertaking the consumption yourself.

Something to notice here is that, all other things equal, the returns on investing are higher than the returns on saving because of the value added by the entrepreneur*. The value of the industry of the entrepreneur is paid to whoever undertook the consumption. Under saving this value is paid to another while you receive only the value produced by the capital. Whereas under investing the value is paid to yourself as well as the produce of the capital.

* Interesting fact: entrepreneur is French for “undertaker” and was first coined by Jean Baptiste Say in the same context that I used above; one who undertakes the reproductive consumption. Since the word “undertaker” is already used in the English language the word was originally translated in Say’s works as “adventurer” but modern usage is to simply retain the French.

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I think there has been some progress made in clarifying these concepts, but I'll add my views.

I think of an entity's savings as being the accumulation of production less consumption. It involves a stocking up of a value for future uses. Producers with a surplus of values are typically savers.

I think of an investment as a deployment of capital with the goal of generating profits (given a rational context of expectations).

Typically, savings are channeled into investments.

Note that a person may save, but not invest, if they simply store money or other goods/values.

Note also that a person or productive enterprise may invest without having accumulated savings, by borrowing and deploying capital from savers.

A healthy financial industry facilitates the most efficient chanelling of savings into investment.

I do not consider investment to be a form of consumption. I think "reproductive consumption" is an oxymoron. Consumption terminates, or uses up economic value. Investment transforms and increases economic values - it converts rather than terminates.

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I think there has been some progress made in clarifying these concepts, but I'll add my views.

I think of an entity's savings as being the accumulation of production less consumption. It involves a stocking up of a value for future uses. Producers with a surplus of values are typically savers.

I think of an investment as a deployment of capital with the goal of generating profits (given a rational context of expectations).

Typically, savings are channeled into investments.

Note that a person may save, but not invest, if they simply store money or other goods/values.

Note also that a person or productive enterprise may invest without having accumulated savings, by borrowing and deploying capital from savers.

A healthy financial industry facilitates the most efficient chanelling of savings into investment.

I do not consider investment to be a form of consumption. I think "reproductive consumption" is an oxymoron. Consumption terminates, or uses up economic value. Investment transforms and increases economic values - it converts rather than terminates.

It seems that the biggest difference between your ideas and mine is that there is such a thing as "reproductive consumption." Although, I must say that I agree with what you said in the last paragraph as you have identified reproductive consumption. Reproductive consumption transforms and hopefully increases economics values. Through the consumption of a value you reprodce that value in the product. There is a termination as the machine eventually needs repairs, replacment, etc. and so a part of the value is used up, but is used up in producing a value. If all goes well, then the value produced is actually greater than the value used up, but this is not necessarily so even though I doubt that negative returns or even break even returns are pursued for any great length of time.

Also, I'd still call saving but not investing something else since I do make the distinction between two types of consumption.

Other than that, I agree wholeheartedly with you views. :D

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Oops, last line of first paragraph should read:

...necessarily so, though I doubt...

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