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Portfolios in the black

Investment decisions in 50 shades of grey

Investing newsroom
Frank Jasper, Chief Investment Officer

Frank Jasper
Chief Investment Officer | Email Frank »

04 September, 2020

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This year has seen one of the most rapid shifts between fear and wild optimism I have ever seen. It has meant some of the toughest months on record and, like last month, some of the best. It’s easy to find your views getting increasingly polarised in times like this. That doesn’t help make great investment decisions. Appreciating the shades of grey that exist in the real world and understanding how changing prices imply changing probabilities about the future can help make better investment decisions and fashion more robust portfolios.

 

Well that was quite the month.

Auckland back into level three lockdown. The rest of the country in level two, and economic activity once again taking a hit. The Reserve Bank of New Zealand shouting from its mountain top that negative official cash rates are on the way. New Zealand’s version of quantitative easing, the Large Scale Asset Purchases, extended in size and duration. All in all a lot for the pessimists to worry about.

On the flip side, a lot for the optimists too. The US S&P 500 index hit at all-time highs rising 7.0% for the month; the strongest August monthly return since 1986. New Zealand’s share market performance was a little more muted rising 1.8% but still reaching a new high. And wow. Tesla share price up 74.2%, for the month. Apple up 23.8%. Salesforce up 39.9%. An incredible month for tech investors.

Depending on what you read and how you are wired you could be forgiven for thinking this is one of the best investing environments ever, or one of the scariest.  There’s something for everyone.

Humans are wired to think in black and white, buy or sell, yes or no. Life doesn’t actually work like that. To borrow from the infamous book (and no I have never actually read it before I get a lot of emails!!), life, and financial markets, really are painted in 50 shades of grey.

Rising share prices, in the absence of dramatically improving fundamentals like increased profits, mean the market is putting a higher probability on a rosy future. Lower share prices often mean the opposite, that the bear or pessimistic case is upmost in people’s minds.

Being a successful long term investor requires being comfortable with shades of grey and being able to overlay a rational assessment of what the future might hold on top of the market’s current “mood”.

Embracing grey

Embracing the shades of grey approach isn’t easy, we have a tendency to gravitate to absolutes, but there are things we can all do to help us along the path:

  1. Avoid the hype and reframe how to think about rising share prices – there is no doubt that parts of the market are getting increasingly exuberant. I use words like exuberance cautiously because in many ways they aren’t that helpful.

    Using our “shades of grey” approach a better way to think about a share price is to consider what needs to be true for it to be justified and then compare that to what might reasonably happen in future.

    For example, automotive company Tesla is now worth the same as the combined market capitalisation of Toyota, VW, Daimler, BMW, GM and Ford. To be happy buying Tesla shares you need to believe it can grow from producing around 400,000 cars a year to rival the combined might of the global automotive industry titans who produce roughly 40 million vehicles a year. And that’s just to justify the current price. For the share price to perform even more strongly, things need to get even better. That feels like a courageous bet to me and one I would be cautious of.

  2. Don’t get too pessimistic – as much as hype can be damaging only seeing the bad in things is not likely to be a successful strategy. One comment on my ever present twitter feed stood out for me on this exact topic.

    "Negativity sounds intelligent. Positivity makes you rich." It is so true. There are always things in markets to worry about and some very smart people will have a lot to say about those things. It’s best not to give them too much weight.

    Pessimists routinely underestimate the ability of human beings to adapt to new situations and to find solutions to the most seemingly intractable problems. It’s far better to be a balanced and cautiously optimistic in your outlook. That not only makes you a lot more fun to be around and it is more lucrative for your portfolio.

  3. Embrace “grey” in your overall investment strategy – it is as important to balance optimism and pessimism when considering your overall portfolio, as it is when looking at the economics of an individual investment.

    None of us knows the future with enough clarity to build the perfect investment strategy. Having a robust strategy that can perform in different scenarios is key to building long term wealth.

    Each part of your strategy has a job to do.  In some versions of the future one asset type will be star. In another it may be the laggard. But each element in a well-diversified strategy is important. Cash modulates risk and provides flexibility to buy if asset prices fall. Fixed income provides some protection against equity drawdowns. Inflation linked bonds, an asset class we like in our multi asset portfolios like KiwiSaver, provide inflation protection, and equities give us the chance to participate in economic growth.

    Sensible diversification, while more challenging in the current low interest rate environment, is as important as it has ever been.

  4. Think long term and stay the course – in the short term markets vacillate between bouts of pessimism and optimism. Time tends to balance these short term moods out. Thinking long term is the best antidote to getting caught up in the market’s short term moods.

    Fisher Funds investment approach, STEEPP, is predicated on investing in high quality businesses that can grow their earnings over time, and buying these at sensible prices. By focusing on long term earnings growth and business quality we have engineered long term thinking into our DNA.  This helps us avoid getting caught up in either hype or pessimism and instead can let the long run compounding power of earnings growth do its magic.

    We know it works. Warren Buffet, the guru of long run, quality investing has proven it. Last month he had his 90th birthday proving that a long run approach and staying the course in quality businesses is not only good for your wealth but is pretty good for longevity!   


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