We believe that most investors enter into an investment with the view that they want the investment to increase in value. If we ignore some exceptional reasons, for example tax planning, then there can only be two fundamental purposes to any investment chosen by an investor. Either the investment is chosen to generate an income or to make profit with an increasing value between the date that it is purchased and the date it may be sold. In many cases investors may be seeking both these requirements, i.e. income and growth.
So what is it that makes an investment produce a positive return?
With respect to income the position is relatively straightforward. One needs to look at the way income is generated from the investment. For example, an investment into Gilt generates income because the Gilt produces a coupon or a rate of interest which is pre-determined by the terms upon which the Gilt was issued by the Government. A 3% treasury stock produces a 3% per year income and so on. Gilt generally are deemed to be safe and depending on how they are traded could possibly go up and down in value but if held from inception to maturity will return the original sum invested. They produce income in return for the investor effectively loaning money to the government.
Shares on the other hand are far less certain both in terms of any increase or decrease in the share price and also in the dividend (income) they may or may not produce. With most shares one could expect regular dividends albeit at a level that is difficult to predict in advance.
We believe that with any investment there needs to be a reasonable understanding of what will make an investment go up or down before the investment is made. This may seem or sound like a self-evident proposition but once analysed is it as straightforward as it first seems?
The easiest example to work with is investing into a share, buying shares in a company. Most investment into company shares is done with a view that the share price will go up. If you are investing through funds that hold shares, the same principle would apply.
Why will shares go up? There are very few reasons why shares will increase in value. One is that the value at purchase has been completely misread and underestimated by the market and the investor has picked up on this and believes that the market position will adjust and the share price will eventually come back to reflect a more appropriate value. Professional Investors who have taken this sort of view have included Benjamin Graham and Warren Buffet, who for this very reason are known as value investors.
Another reason the share may go up is because it has increasing dividends year after year and investors want to capture the dividend rises as part of their portfolio. This makes them ever more valuable and investors may deem that a company that is showing regular increasing profits and dividens will once again produce higher prices. Another reason a share may go up is simply down to the laws of supply and demand for that share. The underlying strength or weakness of the company may be secondary to the fact that, for whatever reason, the shares are in vogue and there are more buyers than sellers of the shares and with any economic situation of this sort, that will normally lead to price rises.
Investing into any type of investment, shares or otherwise, there needs to be some fundamental reason why an investor believes that particular investment will go upwards in value in the future.
We suggest that in many cases investments are bought because of pre-conceived ideas about what goes up and down. Taking another example, look at property. There is an inherent belief in the UK that property prices over time increase and history certainly supports this. But fundamentally there could be a counter-argument that this is an historic anomaly. In many other countries, property prices don’t increase, certainly not above the rate of inflation and even in the UK the historic position is such that there have been long and sustained periods where prices don’t go up.
Fundamentally, therefore, if one was to pick a property investment, what would be the reason for thinking that property is going to increase in value, over and above simply that this is what it has always done in the past? We strongly suggest that investors look at the fundamental of any part of their portfolio and ask why that holding is in place or if selecting the portfolio for the first time anwer the question why a particular investment is being chosen.
We believe there are great dangers in investors choosing investments based on historic reasons and attitudes.
One final additional point to this is that in considering these reasons investors need to detach what we would describe as the macro and micro reasons for choosing investments. An example of this is that there is good historic evidence to suggest that markets do not align themselves with economies. If an economy is doing well it does not necessarily mean that the market will do well and vice versa. In the UK, for example, the economy boomed between 2000 and 2007 yet the market for shares hardly performed at all.Some investors will often look at the macro positon and say that this country or this economy will do well and immediately translate that into meaning markets will do well in that same economy. This is what we mean by a macro view. One that takes a big picture view of a situation but does not look at the inherent investment argument which then follows. It is true to say that the opposite may also not work, in other words, just because a market is doing badly it may not reflect on the economic position.
Our conclusion to this article is that investors need to look the fundamental reasons for selecting an investment and need to ask themselves what is it that they investing into, and why they are investing and what is it that is going to make this investment pay back. What the reason is for pinning this selection?
