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Which type of investor are you?

BY JOE WIGGINS

Republished from firstlinks.com.au


It is so tempting to get lost in the noise and intrigue of financial markets that we can easily forget what type of investor we are. Although the investing community can at times appear something of an amorphous blob attached to the latest in-vogue topic; groups of participants are engaged in wildly different activities that – at anything but a cursory level – are barely related. To have any chance of success it is critical to understand the realities of our own approach and avoid playing somebody else’s game


In broad terms, I think there are four investor types:


Trader


A trader operates with ultra-short time horizons (intra-day to weeks) and is typically engaged in the prediction of price movements based on historic patterns or the expected market reactions to certain events (if X happens, prices will do Y). Asset class valuations and fundamentals are largely irrelevant, and the focus is on forecasting the response function of other investors.


This is staggeringly difficult to do consistently well, which is why profits often seem to accrue to the people who teach trading to others rather than do it themselves.

Price-based investor


Almost certainly the most common active investment approach. Price-based investors have short time horizons (ranging from three months to perhaps three years) and tend to engage in one of two related activities:


1. Predicting future market / macro factors and how other investors will respond to them. “We believe that the Fed will be more accommodative than the market expects, which will support US equities.”


or


2. Predicting how other investors will react to realised market / macro factors. “The Fed is far more dovish than the market expected, therefore we have increased our exposure to US equities.”


The common factor in both of these closely related methods is that investors are guessing how other investors will behave. This is similar to trading, but the horizons are extended (though still what I would class as short-term). In essence it is an attempt to capture anticipated price trends.


Valuations and fundamentals matter somewhat for this group, but only insofar as they are useful for understanding the positioning and future decisions of other people like them.


This is probably the most comfortable style of investing from a behavioural perspective as it caters to plenty of our biases – our desire to be active, to be part of the herd, to tell stories. For similar reasons, it is also likely to prove the most prudent survival strategy for professional investors.


The problem is that it is incredibly challenging to get these types of calls right (or even more right than not).


Valuation-based investor


This type of investor is focused on the fundamental attributes of an asset and will look to make some assessment of expected return or fair value based on analysis of starting price and future cash flows. Given that price fluctuations dominate short-term asset class performance, a long view is essential.


It is important not to confuse a valuation-based approach with value investing, which is only a subset of it. Valuation based investors are seeking to identify asset mispricings – these might occur because the level of growth is underappreciated, or high returns on capital will persist. The key distinction is that the focus is on the returns produced by the asset rather than how other investors might trade it.


Given that market movements over short and medium horizons often bear little relationship with the fundamental features of an asset class, a valuation-led approach is undoubtedly the most behaviourally taxing. This group will inevitably spend a great deal of time appearing out of touch and idiotic, even if they are right, and they might end up waiting years for validation that never arrives (taking a valuation-led approach doesn’t mean that you will necessarily be correct in the end).


Relative to a price-based investor they are more likely to be successful in their investment decision making, but also more likely to lose their job.


Passive investor


Although there is no purely passive portfolio, this group seeks to invest in a fashion that can be considered a broadly neutral representation of the relevant asset class opportunity set (by size). While passive investors are inherently agnostic on valuation, they do care about the fundamental features of the assets in which they invest, but specifically in regard to the ultra-long run, or structural, expected risk and return.

A passive investor may not believe that markets are efficiently priced, but simply there is no reasonable and consistent way of capturing any inefficiencies (certainly relative to the effort or behavioural stress required), particularly after costs.


Although a long-term, passive approach appears simple it is not without behavioural challenges – doing nothing is tough and rarely lucrative. There will also be incessant speculation around how some profound change in asset class behaviour will soon render a passive approach defunct.


But perhaps a more credible problem is that a purely passive style requires investors to be ambivalent about extreme asset class overvaluation – passive investors are fully / increasingly exposed to equities trading at 100x PE or bonds yielding zero – even if the evidence suggests this will lead to derisory future returns. It is reasonable to suggest that this is a known cost and one which still leaves it superior to other strategies. It should not, however, be ignored.

Which one are you?


These categories are not quite as discrete as I have made out, but the overall point holds. Defining our own approach and understanding its realities and limitations is absolutely critical for any investor. This requires setting realistic expectations, knowing the information that matters and what should be ignored, and preparing for the specific behavioural issues we will encounter. Failure to do this will mean we will inevitably become part of that amorphous blob.


All investors should be asking who they are and what it means.


 

Firstlinks is a publishing service providing content written by financial market professionals with experience in wealth management, superannuation, banking, academia and financial advice.



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