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Home arrow Business & Finance arrow Investments: An Introduction

Lessons from the theories and maxims

Introduction

The plethora of investment-related theories and maxims is evidence of the importance attached by scholars to investments. While some of the theories have little empirical relevance, many of them have elements that do. The following sections cover the useful elements of the theories and maxims (in our view):

- There is no simple formula to make you wealthy.

- Top-down investing is wise.

- Diversification is critical.

- Base investment decisions on their FVP.

- Never fall in love with an investment.

- Do not be led by technical analysis.

- Be cognizant of behavioural finance (the psychology of the market).

- Appreciate market liquidity.

- Appreciate the life-cycle consumption theory.

- Appreciate the significance of the risk-free rate.

- Be aware of the principal-agent dilemma.

- Leave investing to the professionals.

- Understand macroeconomics and mean reversion.

There is no simple formula to make you wealthy

The only way to reach one's FSG at a desired age is to ensure that I > E, i.e. to save and to invest wisely over a long period. Dave Foord in this regard states: "To be successful at [investing] you need patience and a long time horizon. And few investors have either."

There are many examples of people investing in one company's share based on the "hot tip" of another person and its price falling sharply or to zero. Investing in one company is only wise if the company is your company and you manage the company successfully over a long period, or if you are an employee of a company which you believe utterly will succeed in the long-term. For the employee without a share incentive scheme, the first paragraph applies.

Mr Warren Buffett is often cited as "the world's most successful investor". This is so because managing investments is his full-time occupation. He only invests in businesses that he has a deep understanding of and can analyze and value. He is a value investor (seeks value in the long-term, i.e. healthy future cash / dividend flows and discounts them at the rfr - as described above) as opposed to a growth investor (past high returns will continue in the future). In the early history of Berkshire-Hathaway Mr Buffett managed the invested-in companies either directly or indirectly.

In this regard Dave Foord47 states: "The first lesson that all prospective investors should learn is that there is no simple formula to make you rich. The markets certainly do not exist to make you rich. On the contrary, there is a friction, a cost or vigorish against you."

Top-down investing is wise

Many fund managers are of the opinion that if you get the "big picture" right, i.e. accurately analyze and forecast the international and domestic economic situation, and allocate funds to the asset classes in appropriate slices, overall performance will be higher than the market average return.

A number of fund managers are of the opinion that up to 80% of performance is forthcoming from accurate asset allocation. The proviso is that prime assets that offer value are bought.

Diversification is critical

As we have seen, appropriate diversification reduces risk. Diversify locally and internationally with the emphasis on local. The reason for only allocating a small proportion (say 10-20%) to foreign investments is that one's liabilities are in the local currency. In this statement we assume a sound local currency.

In this regard Dave Foord49 states: "Diversification means reducing risk of loss by investing in a variety of assets. A diversified portfolio as a whole will often display less risk than the least risky of the component investments. Diversification is the only 'free lunch' available to investors. It is critically important in risk reduction. Use it as often as possible, but not as much as possible, because too much diversification reduces return ("diworsification"). Note that the more conviction you have, the less diversification you need. Again, it comes down to one's judgment of when and how much diversification to use."

 
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