There are different versions of this but a very good one was put forward by Peter Thornhill this morning in his delivery to those assembled for the current Perpetual update (Perpetual is a major fund manager in the Australian market, with an active, value “style”).
Peter’s delivery was focussing on the supposed “rationality” of markets, and the observation that markets would appear far more rational were it not for the activities of investors…! Something along the lines of the “Yes Minister” episode where the most efficient hospital in the UK was the one that had no patients. A little tongue-in-cheek perhaps but arguably correct even in its broad sense. That is, people make irrational decisions, which can make it appear that the world of money is irrational. As example is the inability of many people to accept the true nature of their activities. If a person buys and sells shares actively based on the price then they will be speculating on that price movement and are then subject to the vagaries of everything that has the potential to move the price – from interest rates through to rumours of government taxes. Eventually, such trades are for reasons that fail the rationality test. Again, the example is to consider buying a bank share for the price appreciation. If you were to poll the directors of the bank they would most likely confirm that they do not run the business with the intention of obtaining a good sale price at the end of the year. They run the bank to obtain a solid, ongoing income stream to reward the capital sitting in the bank assets. Hence, purchasing solely for price appreciation is speculating about the price attributed to the bank assets at any given point in time rather than investing in line with the underlying business.
Peter’s version of investing is the aim of achieving that ongoing, increasing income stream. Anything that fails to offer an income stream will be dealt with according to price – which then involves waiting for someone to be willing to pay more than you paid for whatever you are selling. Hence, you are speculating on the availability of someone prepared to do that. Under this logic, collectables and precious metals/stones are liabilities, in that they have a holding cost (insurance, storage, security, maintenance) but no income. This is a purposefully antagonistic and probably even narrow-minded but highlights the point that you are speculating for price rises, as that is the ONLY way you will obtain a profit from your transaction.
As you would have guessed from previous posts, it is my opinion that the world is beset by speculation to an extraordinary degree at the moment. Part of this is funded by the almost ‘free’ money made available by central banks to the major trading houses of the world. The US government allowed Goldman Sachs to become a commercial bank (as opposed to an investment bank), which allowed GS to use their “best guess” valuation for assets they (and many others) held rather than their current market value. This helped to stabilise a large chunk of the trading world. However, it also gave GS a free kick, in the form of massively subsidised access to capital. The value to GS of that will far exceed the naked government handout that they received at the base of the Global Financial Crisis. So now one of the world’s great institutional speculators has access to not only buckets of capital – but buckets of extremely cheap capital. And so that money washes around the world (along with that of all the other major trading desks, hedge funds, etc) looking to find profit in any short term arbitrage play that exists. It provides liquidity to the markets (in other words, there is always a sucker around to buy what you are selling) but at the cost of increasing price spikes – both up and down.
As an example of that speculation, consider the movements of the Greek sovereign debt overnight. With the release of the European “rescue package” (in true European form, it is a backstop that could be used rather than an action step that will be used), the yield on Greek debt dropped 4.84% overnight! This is an unbelievable level of volatility on sovereign debt, especially when you consider that European leaders had already pledged to help Greece. An argument could be raised that the “contagion” fear had taken hold, with Ireland, Portual and Spain all experiencing the beginnings of Greeks open market credit raising problems. However, that doesn’t take away the smell of large scale speculation.
And if we consider the Australian market today, we can see that same speculation driving events here. The US sharemarket was up well over 3% last night, and the Australian market started up a little to reflect that “renewed optimism”. However, around midday the Australian market saw a wave of selling, falling around 50 points. Trawl your way through the commentary and you’ll find articles that suggest “investors are concerned about the cost and implementation of the $1 trillion European rescue package”. Excuse me while i pick the stitches of my pants, so that i don’t split them while i laugh! So we are worried about the possibility of Greek default. Leaders say we won’t let that happen. Then we are worried about the other countries that could be in similar trouble. Leaders assure everyone that they will fix this as well. Markets continue to fall. Leaders come out with a massive rescue package. Now we are worried about the extra debt that this may cause. And the way in which the money will be spent. And who will get it. And who will pay for it. And on and on it goes. This post has been written in amongst many other activities, and it is now the end of the market trading day. News-just-to-hand suggests that the latest fall in the market was triggered by the release of data from China that suggests inflation is on the ‘up’, real estate prices are increasing too quickly and the government will need to take stern measures to rein in the economy. And so the speculators have a new story to punt on.
So you can see from this that the speculator is having a wild time at the moment – busily beavering away to work out the next piece of news likely to move markets up or down, and how best to take advantage of this.
How is an investor to act in such times? How about focussing on the income side of the equation, and letting the price side be set day-to-day in markets as it always has been/ By looking at costs and making sure that they are lower than the income received. If borrowing, try to borrow less than the maximum that you can. This last one is at the heart of the residential property market myths. “Stretch yourself”, we are told. It will be better eventually. However, as many borrowers have found, stretching too far will leave you exposed to the kind of large shocks that really do happen from time to time. Such as larger-than-expected interest rate rises or sudden drops in income. Unemployment in Australia was very tame over the GFC. This helps to keep confidence high, as employment is likely to have a bigger impact than interest rates – if you still have your income then you can probably deal with higher interest rates. If you have lost your primary income then you most likely won’t be able to meet even your basic costs without eating into your capital – and that can only ever last just so long. So be careful not to let current market confidence impact your own decision making.
The Australian sharemarket still needs to gain 49% to regain its 1 November 2007 peak (4873 for the All Ordinaries Index and 6851 for the S&P/ASX 200 Index). Historically, falls as large as that suffered through to the 10th March 2009 low point (down 55% to 3091 for the All Ords and down 54% to 3121 for the S&P/ASX200) are followed by eventual recoveries and movements past those previous highs. This can be seen when considering the All Ords for longer time periods.
Spot the impacts of such events on the long term exposure to markets. Naturally, current legislation and “best practise” suggest that at this point in time it should be noted that past performance does not guarantee future performance etc, etc, and that would be true were the world to enter a period of massive dislocation to the underlying assumptions of capitalistic activity or if Australia were to enter a sustained period of deflation similar to Japan. These more remote possibilities must always be considered. There are ways of dealing with them but that is a matter for another day. For the moment, let’s just consider that if we assume that Australia’s growth will retain a positive slant over the coming decades (a generally held assumption) then it is reasonable to expect that growth to translate into greater incomes from the listed market overall. Hence the assumption that it makes sense to buy on large, unexpected reductions in market price as a methodology of retaining access to that long term growth. Again, legislation urges me to point out that this is not personal advice as it does not take into account your personal situation etc (as hamstrung as good discussion becomes under this regime, the core issue driving regulators is valid. An example is the recent dip where for some clients we were buying investments to take advantage of falls, while for others we were assisting in the sale of particular assets as trigger points were reached. So as much as i dislike having to assume that everyone who reads this note is borderline stupid, the underlying objectives of making such disclaimers is valid).
In summary, the investor is looking to participate in the generation of an ongoing income stream, and hopefully one that grows, while a speculator is interested in buying and selling at a profit. Argue that one as much as you like, ’cause it’s a great geek dinner-party conversation starter.
As a further point for discussion, when considering issues such as making investments it is always a good idea to look at how risk is to be addressed, and the bias that you or anyone else will bring to the decision table.