Investor sentiment

Such an investor blogged at the time: “Equities – at least the larger ones – oscillate in value. The rational idea seems so simple. You buy when they are cheap.

“And you slice some profit off when they recover. Buy cheap. Sell dear. The main reason that equities are available in the market so cheaply today (and they seem to me still to be cheap today) is that people like the original blogger found it vital, for the wrong reason, to pile out yesterday.”

Simplicity of markets

Maybe that particular investor is sufficiently in command of his emotions to be successful, but few of us are. Indeed, even professionals in bank dealing rooms need a little help to succeed, hence the prevalence of crooked banking behaviour such as the price fixing of the Libor and Forex rates.

Moreover the development of high intensity dealing shows banks are fully aware that, without customer order flows to guide them, dealing profits are hard to come by, and are often only available for split seconds of time.

That oft repeated mantra of ‘Buy on dips’ only works in a bull market, so the question that every investor must always be asking is, “has the bull market ended and a bear started, or will markets just go sideways for a while?” This is only ever clear in retrospect.

Market sentiment is an explosive compound of greed for gain and fear of loss. Good dealers and investment managers can isolate themselves from these market emotions to some extent – better at least than ordinary investors – but they have other problems, chief of which is fear of losing their jobs if they calculate wrongly.

The function of most investment managers is not to invest client money safely but to avoid mistakes that might suggest that they or their employers are less than competent. So the sensible manager sticks to the consensus view, maintains a portfolio not that different to the index being tracked, and hopes for the best. This is the way to maintain, and hopefully to increase, funds under management.

Single capacity and the agency problem

Until the 1987 Big Bang, the financial industry was simple. Financial scandals during the 19th century finally compelled reform of the stock exchange with market makers and advisers split apart into what were known as ‘single capacity’ firms. Stockbrokers by the start of the 20th century were effectively private bankers, looking after the financial affairs of families through generations; market makers were known as jobbers.

To some extent this solved humanity’s most enduring problem – that of agency. If you need professional advice, how do you know if it is good and in your interest or, alternatively, that your adviser is not ripping you off? Stockbroking profitability depended on numbers of clients, and growth through introductions to their friends, and clients were predominantly concerned with the income generated by their portfolios. This was easily calculated.

This social world changed significantly as a result of the Second World War, followed by several years of financial repression and then high and persistent inflation. Investment became more democratic. All savers needed protection against the declining value of money and first the insurance companies, and later the unit trust companies, offered what appeared to be safe and cheap ways to invest. And in an industrial world that was rapidly changing and merging, the most potent hook to this new market was the promise of capital gains.

The structure of costs

The profitability of investment management today is based on AUM, that is the volume of money being managed, and not successful investment itself. The only importance of that is the public’s belief that any particular management house knows what it is doing, and so adds new funds to those already being managed. To be successful these need to catch the public’s current fad, such as technology, emerging markets or higher than average income.

Such fads have unexpected consequences. Bric (Brazil, Russia, India and China) sounded good, as developed by Goldman Sachs, but now looks bad: Brazil is steeped in corruption, Russia in military posturing, India still hog-tied by regulations, and China desperately trying to manage a transition from investment driven exporting to consumer spending.

Nothing in that is surprising, since both the UK and the USA spent years cleaning up their game, and the Bric countries will have to do the same, assuming that they do ultimately succeed. Reform will certainly not be quick, and probably harder than it might have been.

Short-termism and business decisions

Despite ultra-low interest rates, business investment has not recovered since the 2008 crash. Commodity prices are falling, because world demand is low, and business is not investing because, without demand, CEOs threaten themselves if they invest for the future, and disappoint shareholders this quarter with their profits.

Presidential hopeful Hillary Clinton is concerned with this ‘quarterly capitalism’, a concentration by companies on short-term result over long-term growth. Research co-authored by Andrew Haldane, chief economist of the Bank of England, suggests that most shareholders today are seeking instant gratification in the shape of buy-backs or increased dividends.

In 1950 investors held their shares for an average of six years, but now do so for less than six months. CEOs who disappoint pension fund trustees and investment company managers don’t last long, but transfer that bitter experience to their next job. This flightiness appears to influence boards of directors. It seems that quoted companies invest less than privately held companies of similar size.

The purpose of investment

There have always been people with money and the need for an annual income, but no desire or ability to manage assets. Once money was land, then later housing, then the availability of mortgages on both. Finally, in about 1600, shares in the Dutch East India Company could be purchased together with the speculative gamble on the value of the cargoes of its trading vessels – or at least those that made it safely to Amsterdam from Indonesia and China.

But whether farmland, mortgages or shares, the purpose was an income, from your capital and someone else’s work and imagination. To them went the capital value of a successful business, to you a rent on your money – fixed if it was a mortgage or government loan, varying upwards and downwards if it was a share in another’s business.

And that has not changed, despite computer technology, global communications, derivative markets and, soon to come, robot traders and managers. Nor has reality; you have money and need an income, and for that you need a good adviser. Although the family stockbroker has disappeared, and the private banker has morphed into something that you really do not want to be involved with, you do need a manager that is concerned with your money, and that of your fellow clients.

The nature of the unit trust business makes this a difficult task. As a manager it is much easier to go with the swim, unless either you make a name for yourself like Anthony Bolton at Fidelity, or like Terry Smith set up your own financial management company. Even exceptional managers need support, since markets are lonely places and, as many have found, markets can stay irrational for longer than most of remain solvent, or trusted.

This is why that 19th century innovation is the answer for today. Boards of directors set strategy, and managers identify the tactics of day-to-day investment. With both elements committed in advance, both need to hang together to survive and accountability is clear.

Investment trusts managers last for years – if not decades – and although not every one is a genius, the support structure and process of an investment trust makes them adequate. And it helps to meet the amateur requirements.