As the French saying goes, ‘Time takes revenge for what we do in haste’. In today’s world of mouse clicks and instant gratification, we forget all too often that nothing happens overnight, and that the longest-lasting gains are those made over the long term. Even the financial world cannot escape that rule.
Every long-lasting gain is built one step at a time
Our relationship to investment is linked to our perception of time. The rise of the internet has completely this relationship with time. We live under the influence of mouse clicks. In an instant, they bring closer what was distant, unveil what was hidden, and offer us knowledge and consumer goods that once were foreign to us. This hyperconnectivity has profoundly changed our sense of time: the immediate has become the norm. Whether it’s buying a book, arranging a trip, getting information or placing a bet, we want it to happen quickly.
And yet life’s own cycle reminds us that life moves in stages, that every crop begins as a seed and takes time to grow. As brilliant as they may be, musicians and athletes need time to improve and in particular develop a certain consistency in the quality of their performance.
The same goes for finance. Every long-lasting gain is built one step at a time. And each step is needed to enhance and consolidate everything that preceded it. Investing in a business, however successful it may be, calls for patience.
A new paradigm: speeding up the processes
The industrial revolution accelerated the pace of our lifestyles. The division of labour and automation of a large number of processes that previously had to be performed by individuals led to a continuous acceleration of the production and management of our resources. This was also the case with the management of financial asset. The increasingly invasive presence of the media had without doubt a role in this. The over-mediatisation of the stock market with stories of success resulted in many believing that randomly investing in the stock market is the easiest way to get high returns in the short term. It’s like saying we can buy a loaf of bread the day after sowing the wheat.
This trend has arguably been accentuated by the computerisation of asset management. At the end of the 1970s, computers began using certain algorithms not to decide on investment strategy but to alert portfolio managers to the best time to invest. Today, we are one step closer to automated asset management with ‘high frequency trading’ that uses algorithms designed to take short- or long-term speculative positions in any type of asset (equities, indices, commodities, etc.).
But artificial intelligence is only one of the weapons in what is known as the ‘passive asset management’ arsenal. This approach does away with analysing companies held in a portfolio. Instead it prefers to multiply tracker funds, the goal being to replicate the performance of the various stock market indices. There is little analysis, a bigger role for artificial intelligence and speculation. For fans of passive asset management, these are the ingredients that are expected to deliver extraordinary results in the short term.
The varying perception of risk
This approach is contradicted by many theories. In modern portfolio theory developed by Harry Markowitz in 1952, the focus is not only on profitability but also on the perception of risk. The main hypothesis is that investors’ decisions are influenced by their aversion to risk. However, because profitability is higher when more risk is taken, efficient portfolio management consists in offering the best return based on the amount of risk the investor is willing to take.
But is risk still perceived in the same way in different situations? Behavioural finance, which studies the difference between how people are presumed to make financial decisions versus how they actually make them, believes it is not. This is demonstrated in ‘Prospect Theory’, developed in 1979 by Daniel Kahneman and Amos Tversky. Their study led them to conclude, among other things, that we have a disproportionate preference for certain outcomes over probable results. If the outlook offered by a course of action is very positive, we will typically overestimate the likelihood for success, and vice versa. For example, people have no qualms about buying a lottery ticket, even though they have virtually no chance of winning the jackpot. Conversely, they are often nervous about flying on the basis that the aircraft might crash, and yet the likelihood of such an event is equally negligible. The lure of profit can therefore lead to reckless risk-taking.
The ground rules of investing according to Warren Buffett
Acknowledging the existence of risk and taking into account the human bias that causes certain probabilities to be over- or under-estimated based on the prospects they offer are the factors that investors must keep in mind. However, they are not the only ingredients for success, as the example of Warren Buffett demonstrates.
Born in 1930, Warren Buffet showed a prodigious ability, from a very early age, for investing in the right place at the right time. A millionaire at 30, he based his colossal fortune – $81.7 billion in 2018 – on an acute awareness of risk and the need to make investments that will pay off over the long term. For instance, the ‘Sage of Omaha’ has only ever invested in companies that have dominant positions and are active in stable sectors (Coca-Cola, Walmart, Kraft Foods, Wells Fargo, and so on). He believes that ‘the key to investing is determining the competitive advantage of any given company and, above all, the durability of that advantage’.
Two other principles are particularly important to Warren Buffett. Firstly, the need to buy shares in companies with high growth potential while they are still undervalued. And secondly, and this is his last guiding principle, you should only invest in businesses that you understand.
Simple principles for a complex world
Applying these principles on a daily basis
Bearing these different factors in mind, what is smart asset management? First and foremost it is a question of attitude. Investors who want both high returns and to avoid undue risk must understand that buying any given share means buying a long-term stake in the company. As Warren Buffett has done all his life, investing within a time frame that is compatible with the life of a company – in other words, long term – is one of the keys to success.
This is exactly the approach we take at Banque de Luxembourg, namely investing in high-quality companies that are well established in a stable sector (that we understand) and that promise a regular return. We analyse the market in depth and individually select companies that meet our objective criteria, without succumbing to market sirens. We think carefully about where we are going to invest, rather than pursue automated investments that are guided by the lure of a quick but unlikely profit. In short, we manage assets entrusted to us in the same way that our forebears managed their resources: over the long term, with care, and avoiding the risk of loss.