Probable Maximum Loss

You can control investment losses by determining your probable maximum loss and choosing an equity asset allocation that is consistent with your decision. How much of your investment portfolio can you afford to lose is one of the most critical questions you should ask yourself.

I believe most investors have been taught to invest too aggressively. We will examine why you shouldn’t listen to the industry and media which is dominated by institutions that want you to buy and sell their products.

Portfolio Volatility and Managing Risk

Risk management analysis is an important part of any investing plan. Volatility doesn’t seem to bother most investors during bull markets. This is one of the reasons investors are “lulled” into taking on additional risk as markets rise.

Studies show that investments with lower volatility tend to produce lower returns. This causes investors seeking higher rates of return to concentrate on high risk stocks. These more speculative stocks tend to lead the market up during rallies, but collapse in down markets.

The following chart exhibits the challenge of making your investment back after you lose it. Notice that the more you lose, the amount you need to break even grows exponentially.

Why Is It SO Important to Avoid Investment Losses?

Portfolio volatility by itself greatly reduces your returns. This is because the money lost is capital that is no longer available for investment. If you lose only 10%, you still have 90% of your capital available for investment. If you lose 50% you only have 50% of your capital available for investment, so a 100% gain is required to get back to break even.

When you experience large losses you have less to invest and then your portfolio is in a position that will probably take many years to back to break even. The reality of break even loss analysis makes losing 50% of your money intolerable! After losing 50%, IF the market gained 10% per year, and you were 100% invested, it would take 7 years (7 instead of 10 because of compounding) to get back to break even.

Controlling Investment Losses

Many investors invest too aggressively; they have been taught the outdated buy and hold strategy that causes them to sell in bear markets because they get to the point they can’t stand the pain of a bear market anymore. They often sell at the point of maximum opportunity!

What is your risk management plan? Many in the financial industry will tell you to place stops on your individual stocks. But is it possible they recommend this because it creates more trading and therefore more fees or commissions? Why should you sell a stock after it falls? If the companys prospects haven’t changed maybe you should buy more not sell at a loss.

Probable Maximum Loss – A Better Way!

An intelligent investor will determine what their probable maximum loss limit is for a one year period. Notice this is a “probable” loss not “possible” loss. Personally, I have decided that anything over a 20% loss becomes devastating to a portfolio. You may choose a different number. But I believe this approximates an ideal or optimum number for long term growth.

Calculating Your Maximum Loss Decision

Since 1926 there has only been 3 calendar years in which the S&P 500 total return was worse than a negative 30%. The only one greater that 40% was a negative 44% in 1931 in the great depression.

Here are the 5 largest drawdowns in the S&P 500 (from peak to trough regardless of time) of 30% or more since 1926. Although the largest was a devastating 83% from Sept 1929 to June 1932.

1. Choose an assumed probable maximum loss for equities. After looking at the past I assume the probable maximum loss in the stock market is 40% in a year. You may choose a different number.

2. Choose the maximum loss you are willing to take to your portfolio.  I have chosen 20% but you may choose a different number.

3. Divide your personal portfolio maximum loss by your assumed stock market probable maximum loss.

In my case this would calculate:

.20  divided by .40  =  .50  or 50%!

The result is my target equity asset allocation is 50%. This would be the average equity target for my portfolio when market valuations are average (or fair value).

Probable Maximum Loss and Asset Allocation

History shows that valuation is the key determinant of investment returns in the long run. Buying stocks when valuations are low provides greater that average rates of return with less risk. Buying stocks when valuations are high produces lower that average rates of return with greater risk.

A well planned tactical asset allocation allows you to be more aggressive when prices are low and more conservative when bargains are unavailable. In other words, I change my equity asset allocation based on valuations. Develop an asset allocation plan that controls your investment losses.

If I can find an abundance of stocks that meet my margin of safety requirements then I might raise my equity asset allocation to 65% (or higher).  If valuations are high and bargains are scarce I may lower my equity asset allocation to 25% (or lower).

Keep in mind 20% is the maximum limit. So I need to manage more conservatively when values are not compelling. Therefore, I have an investment loss “goal” of not losing more than 10%. If I manage with this approach, and I reach my first limit of 10%, then I still have the ability to buy low because I haven’t lost 20%.

I’ve only exceeded my investment loss goal with the AAAMP once. In 2008, with the market down 52% the AAAMP was down 12%(notice the market loss was greater than my assumed probable maximum loss of 40%). But because I had maintained my discipline I had 88% of my capital left. This allowed me to increase my equity asset allocation and buy stocks at bargain prices.

The market then rallied and the AAAMP ended the year down 2% (the AAAMP’s only annual loss!) compared to the market which finished the year down 37%.  I began 2009 with 98% of my capital instead of only 63% (the amount of capital left if invested in the S&P 500).

Investors who lost 37% in 2008 did not get back to break even until 2012, and only IF they remained 100% invested in equities. It’s amazing what compounding will do to a portfolio, good and bad! Choose to be on the good side of compounding!

This is how to control investment portfolio losses: decide what your probable maximum loss is and choose an equity asset allocation that is consistent with your decision!

If you need help with these calculations feel free to call me at 281-719-8904.

Deflation and Investment

The purpose of this post is to examine six indicators to analyze the probability of deflation and investment asset allocation choices.

A favorite quote of mine comes from contrarian investor Humphrey Neill, who said, “when everyone thinks alike, everyone is likely to be wrong”. There is an almost universal belief that we are headed towards inflation because of the Federal Reserve and their expansionary monetary policies. I contend it would be prudent to keep an eye on deflation too, especially since it is the most destructive inflation trend.

What is Deflation?

Deflation occurs when the general price level of goods and services decrease. This is the opposite of inflation, where price levels increase. Deflation increases the value of money or cash because it allows you to buy more with the same amount.

Deflation is the most dangerous inflation trend. Deflation is connected with a shrinking economy, high unemployment, collapsing revenues and profits, falling wages, and a propensity to hoard money instead of investing for the future.

Possible Causes of Deflation?

1. Decreases in the Money Supply

Many economists believe the Great Depression of the 1930s was exasperated by the Federal Reserve reducing the money supply. A falling money supply translates into less money in the pockets of consumers and investors, causing economic activity to diminish.

2. Too Much Debt

Leverage works both ways. It can boost returns in good times and magnify losses in bad times. An economy, government, industry, company, or family can be destroyed with too high a level of debt.

If an entity can not service its debt because of rising interest rates or falling revenue it will have to default or implement austerity measures.  Either option reduces economic activity and can put downward pressure on prices.

3. Productivity

Innovations and technology can have a profound effect on prices. Think about how much the computer has changed our way of life. From manufacturing to office work, almost every aspect of our lives changed. These technological advances have allowed us to make more for less, putting downward pressure on prices.

Deflation and Investment – Six Indicators To Watch

1. Difference between the 10-Year Treasury Bond Yield and the 10-Year Treasury Inflation-Indexed Security Yield (TIPS).

This will provide the inflation rate the market is discounting or expecting over the next 10 years. Treasury bonds do not adjust for inflation but TIPS do. Therefore the difference between the two yields represents the inflation expectation embedded in the market.

2. Money Supply

The Federal Reserve provides up to date statistics for Money Stock Measures including annual rates of change. This is the life blood of the economy, making it worth watching.

3. Money Velocity

The velocity of money measures the average turnover of the money supply. Wikipedia  defined money velocity as “the average frequency with which a unit of money is spent on new goods and services produced in a specific period of time”.

The Federal Reserve can increase the money supply, but if it is not circulated it does not increase economic activity. If the money is hoarded, for whatever reason, it could have a deflationary effect on the economy and prices.

4. U.S. Dollar

A falling dollar increases demand for our goods because they are less expensive, and in the global markets a rising dollar makes our goods more expensive and less attractive to foreign investors. A soaring  U.S. Dollar Index could be a sign that deflationary forces are increasing.

5. Gold and Silver Prices

I watch both the absolute prices of Gold and Silver as well as the relationship or ratio between the two precious metals. In general, gold and silver do well in inflationary environments. A sustained downturn in precious metal prices could indicate a deflationary environment.

The trend in the ratio between the two metals can provide important information. Silver is more economically sensitive than gold. If silver is falling faster than gold it may be indicating underlying weakness in economic activity and/or deflationary forces.

6. TED Spread

The TED Spread TED is the difference between the 3 month Treasury bill rate and the 3 month London Interbank Offered Rate (LIBOR). The size of the spread represents the perceived risk in the banking system. The larger the TED spread the greater the perceived risk in the banking system.

Deflation can be devastating to the value of collateral held by banks. If banks are reluctant to loan to one another it is an indication of the perceived credit worthiness of the banking system. This makes watching the perceived risk to the banking system a valuable deflation and investment metric.

Deflation and Investment Today

Many economists fear hyperinflation from the huge increase in the monetary base. The Federal Reserve has staved off deflation for several years by printing money. But the unprecedented increase in the money supply has not produced the intended the results.

This chart shows the  velocity of money continues to collapse and currently (June 2013) turning over at the lowest rate in 50 years. The economy should be brisk and inflation rising at an alarming pace after the gigantic increase in the Federal Reserve balance sheet. Instead money is being parked in the banks that are reluctant to lend in an environment of high scrutiny from regulators.

The high level of debt in our society and the falling velocity of money should cause investors to consider deflation and investment policy. No one can know whether we will experience deflation. But the warning signs should cause us to watch the indicators carefully and and pay greater attention to the possibility of deflation.

A deflationary recession or depression would be very painful to those holding debt and illiquid assets. The federal government would be one of the hardest hit by deflation because of the massive 17 trillion (and growing) debt.

If we were to have a deflationary event; CASH IS KING! Cash becomes more valuable as asset prices decline. Of course debt becomes more onerous because it does not decline. We saw this happen to millions of people in the housing crash as values crashed below their mortgages.

There are two possible scenarios should we experience deflation. The positive path would be for it to cause the government to make the structural changes needed for a sustainable fiscal policy. The negative path would be to print LOTS of money and destroy the dollar and the middle class.

Which one do you think the current government would choose?

Investment Phrases About Emotions

The intelligent investor is likely to need considerable will power to keep from following the crowd.  - Benjamin Graham

The herd instinct is the strongest emotion; especially dangerous in investing.  (Unknown)

When making investment decisions your emotions are often a reverse indicator of what you ought to be doing.   (Unknown)

When everybody likes a stock, it must go down; when nobody likes a stock, it may go up.  (Unknown)

Never bet on the end of the world. It only happens once.   – Art Cashin, CNBC Contributor

Fallible, emotional people determine price; cold, hard cash determines value.  (Unknown)

When everyone rushes to one side of the boat, head to the other side to avoid getting soaked.  (Unknown)

Investors should start with a view of skepticism. They should become intellectual investors rather than emotional investors. they should be careful, and they should be skeptical.  - Arthur Levitt

The secret of making money in stocks is not to get scared out of them.  - Peter Lynch

Volatility signals fear, and fear leads to bad decisions.  - Michael Mach

When the market’s going down, it is not because you are stupid. And when it is going up, it’s not because you are smart.   – Ralph Wagner

The stock market is like a voting machine, polling investors on the future, not the present.   (Unknown)

An investor should be a judge, objective and unattached. Otherwise he loses the greatest advantage in investing – freedom to act.  (Unknown)

The bottom is always 10 percent below your worst case expectations.  (Unknown)

Intaxication: Euphoria of getting a refund from the IRS, which lasts until you realize it was your money to start with.  - From a Washington Post word contest

Each of these investment phrases about emotions teach us an important lesson that should make us better investors!

Be Fearful When Others Are Greedy

One of Warren Buffett’s most famous investment sayings is “Be fearful when others are greedy. Be greedy when others are fearful.” The late great global investor John Templeton said “The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell”.

It’s not an accident that Warren Buffett and John Templeton are two of the greatest value investors to ever live. It makes sense that when most investors are bullish asset valuations would be high, because everyone has already bought. The opposite is also true. When most investors are bearish asset valuations are low, because everyone has already sold.

Greed, Fear, and the Cycle of Emotions

Take a look at the following chart. Does it look familiar? All of us have experienced these emotions at some time or another. How we respond to these emotions determines whether we will be a successful value investor or the poor investor who buys high and sells low.

Cycle of Market Emotions

The cycle of greed and fear plays itself out over and over. Many investors let their emotions cause them to make exactly the opposite buy/sell decision that they should be making at the time.

To be fearful when others are greedy is not the same as being afraid; it means being skeptical and expanding your required margin of safety. Investors should be particularly skeptical of what is being promoted by the culture and media.

Following just this one piece of advice from Warren Buffett will greatly improve your odds of being a successful investor. I admit, it is harder than it sounds. You must do your homework. You must learn to control your emotions.

Those investors who follow value investing principles will naturally find themselves to be fearful when others are greedy. Like Benjamin Graham’s imaginary Mr. Market, you can become the intelligent investor who takes advantage of the greed and fear of investors who let emotions affect their investment decisions.

Related Reading:

Consensus Theory and Contrarian Investing

Stock Market Bubble Signs

Mutual Fund Expense Ratio

Every investor should have a basic understanding of the mutual fund expense ratio; including how much it can hurt investment performance.

What is a Mutual Fund?

Mutual funds are an investment vehicle created by portfolio management companies to combine or pool the money of many investors. The owners of the shares then share proportionately in the income, capital gains, and expenses of the fund.

What is the Mutual Fund Expense Ratio?

The mutual fund expense ratio is the percentage of fund assets that go toward managing, administering and, in many cases, advertising the fund. These expenses are deducted from the fund regardless of whether the portfolio has profits or losses. There are 3 main types of mutual fund expenses that make up the ratio.

Management Fees

The management fee, or investment advisory fee, is used to compensate the managers of the portfolio. On average this fee is about 0.50% – 1.0% annually of the funds assets

Administrative Costs

The administrative costs are the expenses of running the fund. This would include record keeping, customer service, mailing, communications, etc. These costs can vary greatly, expressed as a percentage of fund assets.

12-1b Distribution Fees

The last and most controversial fee is called the 12-1b distribution fee that is collected by many mutual funds. This fee is collected for advertising and promoting the fund. Yes, many mutual funds charge their shareholders to market and promote the fund.

These three fees make up the percentage of assets deducted from a fund, and are referred to as the mutual fund expense ratio. The average mutual fund expense ratio is about 1.4% of assets annually.

How Does the Expense Ratio Hurt Performance?

The long term average real (after inflation) rate of return of the stock market is 6.5%. But if you invest in mutual funds with an expense ratio of 1.4% you will only net a 5.1% real rate of return. Remember, these expenses are deducted from earnings of the fund, therefore lowering your rate of return.

With self directed investing an investor can keep his expense ratio much lower by investing in individual stocks and ETFs, but avoiding mutual funds. An investor who lowers his expense ratio to 0.4% can save hundreds of thousands of dollars over a lifetime. Let’s look at what this does to a $100,000 investment portfolio over a 30 year period.

Assume:

-$100,000 lump sum investment for 30 years.

-6.5% real rate of return less 0.4% expense ratio for self directed investor.

-6.5% real rate of return less 1.4% expense ratio for mutual fund investor.

=Real Rate of Return of 6.1% for self directed portfolio grows to $590,829

=Real Rate of Return of 5.1% for mutual fund portfolio grows to $444,715

The Difference is over $146,000!!!

The higher expense ratio costs the mutual fund investor $146,000 in value for every $100,000 investment over a 30 year period. In this example the only variation is a 1.0% difference in the expense ratio. Pretty amazing, right!!

Investors should consider these facts before buying investment vehicles. Thirty years ago mutual funds were a good option for investors, but times have changed. Commissions on buying stocks and bonds have fallen over 90%. In addition, the advantages of investing in exchange traded funds (ETFs) include many of the advantages of mutual funds, but usually at a lower cost.

A high mutual fund expense ratio will hurt investment performance and should cause investors to consider self directed investing. Investing in a combination of individual stocks and ETFs can lower expenses and save hundreds of thousands of dollars over a lifetime.

Related Reading:

Disadvantages of Diversification in Investing

Risk Control Strategies: Focus on What You Can Control

Disadvantages of Diversification in Investing

We rarely focus on the disadvantages of diversification in investing because we are taught the purpose of portfolio diversification is to lower portfolio risk. In fact a certain amount of diversification is crucial, otherwise you will be taking risk that you will not be compensated for.

However, some lessons can be over learned. Diversification done improperly, including over diversification, can be very harmful. Here are some investment diversification disadvantages:

Disadvantages of Diversification in Investing

1. Reduces Quality

There are only so many quality companies and even less that are priced at levels that provide a margin of safety. The more stocks you put into your portfolio the less concentrated your portfolio will be in the best opportunities.

2. Too Complicated

Many investors include so many assets in their portfolio they don’t really understand what’s in them. Diversification in investing is important, but keep your portfolio simple enough that you can stay on top of your investments.

3. Indexing

If you have too many assets in your portfolio it essentially becomes an index fund. If you want an index fund, buy an index fund; don’t waste transaction fees on purchasing numerous assets that morph into an index fund.

The more stocks you own the more correlated your portfolio will be to market returns. While passive management or indexing might work in bull markets it does not work well in flat or bear markets. Most indices are skewed toward stocks that have already risen and underweight stocks that have fallen, and may be at bargain prices.

4. Market Risk

Before you buy an index fund be sure you understand how the mathematics of portfolio volatility lowers your portfolio performance. Few investors ever achieve even close to “average” returns because of volatility caused by market risk.

5. Below Average Returns

Indexing and over diversification are disadvantages of diversification because  quality suffers when you own inferior investments along with good investments. Below average returns result from transaction fees or mutual fund expenses. In addition to portfolio volatility lowering returns, many investors let their emotions cause them to buy high and sell low.

6. Bad Investment Vehicles

Most investors who over diversify use investment vehicles such as index funds, or even worse, actively traded mutual funds. Actively managed mutual funds trade in and out of stocks and have a tendency to focus on short term trading instead of value. Studies show these funds underperform market indices in the long run.

7. Lack of Focus or Attention to Your Portfolio

If someone else is managing your portfolio you probably don’t pay as much attention to it, or you wait until it’s too late (i.e. after your quarterly statement arrives).

Proper Diversification

Allocate your money based on valuation and not some wall street manufactured formula. That may mean holding more cash when bargains are not available. When purchasing stocks stick to the highest quality companies priced at valuations that put the odds of success heavily in your favor.

You can avoid the disadvantages of diversification in investing by managing your own portfolio. Diversification is one of the most important concepts in investment portfolio management, but proper diversification is the key.  While building your portfolio keep in mind the disadvantages of diversification in investing to help you achieve optimal diversification.

Asset Correlation

Definition of Asset Correlation

Asset correlation is a measurement of the relationship between two or more assets and their dependency. The correlation measurement is expressed as a number between +1 and -1.

A zero correlation indicates there is no relationship between the assets.  A +1 indicates an absolute positive correlation (they always move together in the same direction). A -1 indicates an absolute negative correlation (they always move together in opposite directions of each other).

Examples of Asset Correlation

Positive Correlation

When two or more assets move up and down together. Stocks in the same industry would have a high positive correlation. They would probably be affected similarly by events.

Zero Correlation

When two or more assets show no relationship to each other. Combining multiple assets with no correlation would be an ideal diversified portfolio because volatility (risk) of the whole portfolio would theoretically be minimized. In the real world most assets have some correlation; so a low asset correlation such as between gold and S&P stocks, would be a good example of near non-correlated assets.

Negative Correlation

When two or more investments move inversely to each other they have negative correlation. Two assets that were perfectly negatively correlated would eliminate risk of the combined assets.

Perfect negative correlation is mostly only found in synthetic instruments such as futures contracts or inverse ETFs. These instruments can provide near perfect negative correlation and therefore can be useful tools to reduce portfolio volatility. Of course these instruments, particularly futures contracts, can be very risky if not employed properly.

Problems with Asset Correlation

In the real world very few asset classes have a perfect positive correlation (+1), zero correlation (0), or perfect negative correlation (-1). The vast majority of investments will have some correlation (between 0 and +1). The goal is to have low asset correlation. The fact that most investments are positively correlated is a problem and means finding the right mixture of assets more challenging.

Another problem is correlations are dynamic. You know the saying “Past performance does not equal future returns”. This is especially true with correlations because they change. The world is becoming increasingly interconnected, so many investments that formerly had low correlations are now more correlated.

In recent years when we experienced turmoil in global markets almost everything suffered. In other words, because of globalization, asset classes are tending to be more correlated than in the past.  This problem is making proper asset allocation more difficult.

Asset Correlation and Cash

The shrinking number of asset categories with low correlations should give cash and cash equivalents an increased and higher priority to asset allocation models. Cash has a zero correlation with most other investment assets and provides a means to preserve capital in bear markets.

Why is Asset Correlation Important?

The financial concept of asset correlation is important because the goal of asset allocation is to combine assets with low correlation. The purpose of asset allocation is to lower portfolio volatility. By putting low correlation and/or negatively correlated investments in a portfolio, the overall volatility of the portfolio is lowered.

Combining asset categories that have a low correlation reduces the volatility of the portfolio as a whole and allows the portfolio manager to invest more aggressively. In other words, a portfolio manager willing to accept a given amount of volatility can invest in higher return/risk investments. This is because the volatility of the overall portfolio is lower due to combining non-correlated assets. This is called portfolio optimization.

Understanding asset correlation can reap huge rewards for your portfolio. Small differences in rate of return can make gigantic differences in portfolio value in the long run. If you can increase your returns by 1% annually a $100,000 portfolio will return you an extra $146,000 over a 30 year period.

AssetCorrelation.com

AssetCorrelation.com is a website to learn more about asset correlation. In fact you can sign in (free) and set up an investment portfolio. It will produce a matrix where you can see the correlations between each of your assets.

Related Reading:

Portfolio Risk Control Strategies: Focus On What you Can Control

Position sizing is an essential yet often under appreciated money risk management concept. It can be the difference between success and failure. Position sizing is among the most important concepts of stock trading, but is also absolutely critical to long term investors. We are going to explore position sizing as it relates to long term value investors.

Position Sizing - Money Risk Management

What is Position Sizing?

Position sizing is simply the size of an individual buy or sell transaction. Position size can be expressed as a monetary amount or as a percentage of a portfolio. Some investors choose to purchase or sell their entire position all at once. Most successful investors scale in and scale out.

Scale In

Scale in is a process of purchasing positions in smaller increments than your ultimate position size might be. It can be used as a form of dollar cost averaging, although there are many variations and strategies for scale in.

Scale out

Scale out is a process of selling portions of a position in increments rather than selling the entire position at once.

Both scale in and scale out are an admission by the investor that trying to time exact tops and bottoms is impossible. No one can consistently buy at the exact bottom and sell at the exact top.

Why is Position Sizing So Important?

Avoid Devastating Losses

One of the most common mistakes made by investors is taking positions that are too large. The purpose of diversification is to avoid devastating losses caused by one or two investments that go bust.

• Never Put More Than 5% in Any One Stock

I put a lot of emphasis on the importance of reducing portfolio volatility and preserving your capital in bear markets. Position sizing is critical to taking measured and appropriate risks.

Related Reading: Preservation of Capital and Asset Allocation Investing

Many investors get excited about an investment they really believe in and are willing to take risks that torpedo their portfolio if they are wrong. Attention to proper position sizing allows an investor to avoid devastating losses caused by losing a large percentage of a portfolio.

Position Sizing Example

When an investment achieves my price target for purchase I try to take a small enough position that I can increase my position 2 – 4 times if the stock becomes a bigger bargain. Let’s use a hypothetical $100,000 portfolio as an example.

If stock XYZ reaches my target price I might buy a 1.1% ($1,100) position. If XYZ falls 10% my position size is now ~1.0% (~$1,000). I re-evaluate the company and if nothing has fundamentally changed I have the opportunity to buy XYZ for 10% less than my first purchase. Now I might buy a 1.2%  (~ $1200) position (more than the first purchase) because it is a better price and provides a greater margin of safety than before. Now my position is 2.2% (~$2,200).

If XYZ falls another 10% my position falls to ~ 2.0% (2,000). I re-evaluate the company; if nothing has fundamentally changed I can buy more! This time I might buy a 1.3% ($1,300) position, increasing my position size to 3.3% of my portfolio.

See how this works? This is a form of dollar cost averaging. Not only do I purchase more shares because the price is lower, but I increase the position size of each trade to take advantage of the better price!

The same strategy can be reversed to sell a stock as it moves higher. Sell a small increment and then sell larger positions if the stock continues to move higher. Reducing your position size as the stock becomes less of a bargain reduces the risk of holding too much of a particular stock as it moves higher.

Money Risk Management Concept

Position sizing is a critical money risk management concept. It is important because it protects your portfolio from a single investment causing devastating losses.

Is Gold a Good Investment?

Is Gold a good investment? It depends on why you are buying the precious metal. You need to ask yourself: is gold an investment or a store of value?

What is an Investment?

There are many definitions of investment, but I like to use the economic definition because I believe it gives clarity to my point. An investment is an amount set aside for future production; consumption is delayed in order to use the resources from future production or benefits.

Some investors may choose to use a broader definition of investment that includes speculation on asset prices. But speculation that is not based on benefits from the asset is a form of gambling. As an investor you will be better off to distinguish the difference between the two kinds of investments.

If an asset provides cash flow, dividends, or rent, the value of the asset is dependent upon those benefits produced. How do you value an asset that produces no economic benefit? You must hope that someone else is willing to pay more for that asset than you did. Is gold a good investment or a hopeful speculation?

What is a Store of Value?

Any physical asset can be considered a store of value if it has value as a medium of exchange, can be stored, and can be reclaimed at a later time. What is considered a store of value can be different around the world. What might be of value to one society might hold little or no value to another.

Gold is a commodity that would be considered of value almost anywhere in the world. Given the fact it is one of the rarest substances on earth and is easily stored and traded, gold is an excellent example of a store of value.

Why Do You Want to Buy Gold?

Do you want to buy gold as an investment because it’s going up and others are making profits? Or do you believe your finances call for having a portion of your net worth as a store of value? If it’s the latter, that is a decision you can make and feel comfortable with ! If it’s the first then you should consider other options (i.e. gold mining stocks).

Buying an asset that never produces cash flow because you believe someone will pay more at a later time is speculation or a form of gambling; not sound investing. Investors who invest directly in gold should be seeking a store of value, not a good investment.

Consensus Theory and Contrarian investing

In this post we will explore how the value investor can use consensus theory and contrarian investing to take advantage of mis-priced assets.

What is Consensus Theory in Investing?

In investing consensus theory there is general and widespread agreement in the investment community. This agreement could be about the prospects for a particular individual investment, industry, sector, asset class, or even a particular investment strategy.

When the vast majority of people are in agreement a community is vested in maintaining the status quo. This reaction causes the majority to shut out different ideas and close their minds to anything that conflicts with the consensus.

This “group thinking” becomes a universal mindset, and in consensus theory, can reject all conflicting views. This leads to critical points where a value investor should look for opportunities in under priced assets and avoid the risks of over priced assets.

What is Contrarian Investing?

A contrarian is someone who attempts to use consensus theory to recognize when conventional opinion is wrong. Contrarian investing is a form of value investing and attempts to buy and sell assets that are mis-priced due to consensus buying or selling of an asset. A contrarian investor needs to think ahead of the crowd.

Recommended Reading:  Mr. Market and the Intelligent Investor

Thinking ahead of the crowd often means thinking the opposite or contrary to what the vast majority believe. Following the herd can be destructive to a portfolio.  If investors reach a consensus and have a particular outlook on an asset, the current price already reflects that outlook.

In other words, if 90% of investors believe an asset is going higher they have probably already bought; leaving few buyers to drive the price higher. Conversely, if 90% of investors believe an asset can only go lower they have most likely already sold; leaving few sellers to drive the price lower. In both cases, it takes very little to spark a major change in direction, leaving the majority fully invested at tops, and under invested at bottoms.

Consensus Theory and Contrarian Investing

The value investor can use consensus theory and contrarian investing as another tool in looking at valuation. Don’t let the culture and the crowd draw you into group thinking. Just because the majority are in agreement doesn’t make it true.

Related Reading:

Stock Market Bubble Signs

Investment Probability Theory