[caption id="attachment_437" align="alignleft" width="150"] John G. Finley, CFA[/caption]
In Part 2, we looked at why the perfect investment does not exist. Here, we will discuss the best strategies for making the best investments.
Framing Questions To Find Solutions
Most experienced investors accept the idea that risk and return are really just two sides of the same coin. Risk is best understood as the probability that your investment will not perform as expected in the future, that the cash flows you expected to receive (dividends, interest, higher sale price) may be less than you originally planned for, maybe considerably less (i.e., losses). Since investing is always forward looking, the question could be framed as how much risk is reasonable to bear for the expected (hoped for) future returns in whatever asset class I am considering?
Can you do anything to mitigate the potential for future losses? When are such risks the greatest? Howard Marks addresses these questions in his recent book, The Most Important Thing (Illuminated): Uncommon Sense for the Thoughtful Investor (2013). Marks, a wellknown value investor, ascribes to the Warren Buffett philosophy of investing. And, like Buffet, he has thrived by buying stocks (or whole companies) when they are cheap and selling them (or avoiding them) when they get expensive.
According to Marks, the greatest risks don’t come from high volatility in the markets or owning “low quality” investments (such as junk bonds or distressed debt) instead of “high quality” (such as “blue chip” stocks). The greatest investment risk comes from paying too much for an investment. Paying more than the intrinsic value for a security implies that you will receive a lower expected return in the future, which exposes you to more downside risk when the price eventually adjusts.
But how do security prices get overpriced in the first place? Security prices get too high when driven by overly confident investors who lack a good sense of risk aversion. When investor psychology begins to get dominated by feelings of euphoria, greed, the pressure to conform (herding), fear of missing out, envy and ego, financial bubbles can form. Bubbles, of course, eventually pop, causing security prices to crash. Financial history is replete with stories of bubbles that formed in all kinds of markets in many different countries from investor over exuberance and irrationality, recently in the U.S. with the NASDAQ bubble in the late 1990’s, the real estate bubble just seven years ago. We could also mention Apple stock, down almost 37% since its high on September 19 of last year. Well-known financial journalist Jim Grant makes the case that the latest bubble is happening right now in biotech stocks2.
At Coyle Financial Counsel, we hire investment managers who pay close attention to the fundamental analysis and who have a clear sense of which markets are attractive (undervalued) and unattractive (overvalued). Managers with a dedication to seeking out value may miss out on some of the next bull market, but may also avoid some of the downside as the investor psychology pendulum inevitable shifts back the other direction. We like the idea of winning by not losing over the long term.
We would love to discuss your best investment options. Email us or give us a call:
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Posted on Fri, June 14, 2013
by John Finley