The Long and the Short of It: A guide to finance and investment

by John Kay

The 80/20 per cent hypothesis – that the world of business and finance is best understood with the aid of models that are partly true, partly false, is at the heart of this book.

A few years later the Frenchman Louis Bachelier presented a thesis, on the mathematics of securities prices, that is generally celebrated as the foundation of mathematical finance.

deregulation effectively substituted supervision of behaviour for regulation of the structure of the industry and the incentives of firms and individuals. This shift in regulatory philosophy, which occurred in both Britain and the United States, has proved to be a mistake.

‘Thinking total return’ means treating both income and capital gain as part of the yield on your investment.

Robert Shiller, who achieved wide attention by publishing Irrational Exuberance (Shiller, 2000) at the peak of the New Economy boom, has become the intellectual leader of the sceptics.

Prices rise or fall in the short run on ephemeral changes in sentiment, with little, if any, basis in fundamental value.

Assets will always tend to be bought by people who are too optimistic about their value rather than people who are too pessimistic, and sold by people who understand what they are selling better than those who are buying.

Buffett shouts from the rooftops that markets are only imperfectly efficient.

The David and Goliath notion that with a home computer, a proprietary software package and a book of trading rules you are likely to succeed where the best-resourced institutions in the world have largely failed, is laughable.

Beliefs – true or false – affect prices and may even affect fundamental values themselves. George Soros describes this phenomenon as ‘reflexivity’.

As a result, many allegedly ‘actively managed’ funds virtually replicate an index, a practice known as closet indexation.

Today these opinions include excitement and paranoia over China’s economic development, an obsession with climate change and a new wave of indiscriminate enthusiasm for new technology.

Value investing was once the purchase of tangible assets at levels below their market value. Value investing today is buying sustainable competitive advantages at a good price.

The government economists who thought some risks could be completely diversified used a different frame of thought from the business people who worried that a risky project might bankrupt their companies.

The scheme of thought that I will call the theory of ‘subjective expected utility’ (SEU) is so universally accepted in financial economics that any other behaviour is described as ‘irrational’.

Ramsey and Savage, the founders of SEU, proposed a means of taking the mathematical tools of probability theory far beyond their initial field of application – the gaming saloon – into the boardroom and on to the trading floor. They are the founders of modern risk management techniques.

Keynes and Knight emphasised the uncertainty that arose from the necessarily imperfect nature of human knowledge. The future was not just unknown, but unknowable.

This chapter will mainly be about risk – the things we know we do not know. The next chapter will deal with uncertainty – the things we do not know we do not know.

A risk-averse individual can build a low-risk portfolio from a collection of risky assets through hedging and diversification if the risky assets are appropriately selected. It is impossible to overstate the importance of this idea for intelligent investment.

A security will have a beta of one if a 1 per cent market movement will change its price by 1 per cent.

The implication is that what appear to be risky securities – shares in Robb Caledon or oil exploration in Kazakhstan – would offer lower yields than boring blue chips because the speculative shares have specific risks while the blue chips suffer market risks. This idea is the basis of the CAPM, which won the Nobel Prize for its inventor, Bill Sharpe (of the Sharpe ratio).

These uncertainties of the 1980s have largely been resolved, and in ways that few people expected.

Scott Fitzgerald wrote, ‘The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function’.

That was before publication of the Black–Scholes model of derivative pricing, which analysed the relationship between the option price and the security price.

Buying derivatives because you think they are cheap, rather than as hedges in a programme of portfolio diversification, is almost certainly a mug’s game.

The municipality of Orange County went bust after trades made by the appropriately named Robert Citron came unstuck. The London borough of Hammersmith and Fulham was spared similar embarrassment when the courts ruled that the council had no authority to gamble with local residents’ money and the banks could get lost.

The ‘junk bond’ was invented by Michael Milken, whose graduate school thesis demonstrated that the premium interest rate attached to risky bonds was more than sufficient to offset the probability of default.

The prudent spending rate is a key concept for the trustees of endowments: the managers of the Norwegian oil fund, the overseers of the Harvard endowment, the trustees of the Gates Foundation. Because sophisticated investors like these think total return, they are no longer bound, either legally or in their own planning, by the traditional convention that you should match your spending to the income you receive – the total of the dividends, interest, rents, etc., arising year by year.

For the intelligent investor, risk is a characteristic of a portfolio, rather than of the individual security. This is the illuminating insight of the capital asset pricing model, and that insight remains valid independently of reservations about the truth of the CAPM.

But the most rewarding strategy for the intelligent investor is to construct a low-risk portfolio from a collection of assets which the conventional investor perceives as risky.

Closed-end funds move to large discounts to asset value when the sector in which they specialise falls out of favour, and this is an opportunity to buy.

Three simple rules – pay less, diversify more and be contrarian – will serve almost everyone well.