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28 Jul 2015

Crystal Ball Investing

“Crystal ball investing” appropriately invokes images of smoke and mirrors, charlatanism and faux clairvoyance. None of these has any place in investment practice, as JULIE MACLEOD-HENDERSON explains.

Investment has a long-term perspective, the eventual outcome of which is almost certain. Speculation has a short-term perspective and an inherently uncertain outcome. The distinction is important. While both modes of activity are forward-looking, speculation often involves guesswork, conjecture and an absence of cogent evidence, whereas investment is grounded in a pragmatic assessment of the facts and a rigorous evaluation of the probable scenarios established by the factual matrix.

It is trite that alpha is earned by outperforming a benchmark. The outperformance of a benchmark typically has as its sources both asset allocation and security selection. Asset allocation is the exercise of apportioning a portfolio across geographies and industries, whereas security selection is the process of choosing the individual investments (whether particular shares, bonds or properties). Often, the former process is styled as “top down” and the latter “bottom up”, although these categorisations are unnecessarily limiting.

The crystal ball myth might manifest more readily in the asset allocation process. Whether or not to have exposure to one industry or another is partly a function of future economic conditions. With perfect foresight (that perennial impossibility), an investor might know if a good thing will keep getting better, or a bad thing worse. Moreover, such perfect foresight might also indicate turning points: when a good thing turns bad, or a bad thing turns good.

The very danger of crystal ball investing is that it seeks to divine an advantageous future akin to the products of perfect foresight. The identification of advantageous outcomes can only be predicated on what is known, what has been experienced, and the probabilities of particular outcomes. More particularly, essential in the assessment of future scenarios is a meticulous consideration of the risks of being wrong, the consequences thereof, and the measures necessary to mitigate and manage such risk.

Some might argue that certain investment managers are more intuitive than others in their assessment of future scenarios. Intuition is nothing more than the ability of the human brain to process vast quantities of information quickly; it also draws on previous experience to contextualize information. But as luck seems to improve with practice, so intuition might improve with experience.

Indeed, the very notion of investing being predicated on a trend is anathema. Momentum of itself is not a successful investment strategy. Time and again, through all manner of investment cycles and over the fullness of a long-term investment horizon, the practice of buying undervalued assets and selling them when they are priced well above their fair value, prevails. It is the discipline of, often, acquiring that which might appear out of favour and selling that which is favoured.

If anything, a successful long-term investment philosophy eschews trends. Without doubt, investing successfully takes good judgement – the better your judgement, the more successful you will be as an investor. The fact that good judgement is in short supply amongst market participants leads to market inefficiency and volatility. This increases opportunities for those with longer time horizons and better judgement of the probabilities of a range of future outcomes.

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