Lessons from existence of stock markets

Thursday October 11 2018


What do you think is the most important thing that investors in stock markets do? Keep their expenses low? Hire good fund managers? Avoid paying taxes? Have perfect investment timing? Well, these are all important, but arguably the very most important decision is choosing what kinds of things to invest in. In other words, a good selection of asset class to invest in.

The action of setting aside some money to invest in the first place is the absolute most essential step.

But then, if you don’t do that, you are not even an investor in the first place.

In the stock market, you can invest in popular growth stocks or the unloved value stocks – it depends. You can invest in big companies (commonly known as “large-cap”) with years of existence or small companies (“small-cap”).

You can invest in domestic listed stocks or in international stocks, and so forth.

According to the experts, more than 90 per cent of your ultimate investment return depends on your choices of asset classes.

But then, this assumes that you invest money and leave it invested.

If you move in and out of your investments, then your results are totally unpredictable. If one was observing stock performance for the DSE over a period of 10 years, by the way the reason I say 10 years is because of a famous maxim from Warren Buffett, who says: don’t buy something unless you would be willing to hold on to it if the market were shut down for 10 years.

So, the performance of DSE listed stocks for these past 10 years indicates there has been both significant growth in value and dividend elements.

On the other side of the coin, some people perceive and compare stock exchanges to casinos or betting joints or places to make quick money.

Some of these sentiments are partly informed by news report that show frantic traders speculating on where prices would go next, almost becoming euphoric if the shares have had a good run up (also called a bull market), or thoroughly depressed if the market is down (a bearish market).

The image portrayed by the media is somehow unfortunate because alongside speculative traders and investors are millions of value-based investors, representing retirements savers, pensions funds, insurance funds, who genuinely try to understand the long-term prospects for a company, calculate intrinsic values, deciding allocations of money to companies -- facilitating their growth and expansion, or building new factory, make new invents, go into new frontiers, etc.

Through the actions of these genuine investors, societies access new products, new industries, employments, wealth creation, economic empowerment, etc as money is taken from idle and inefficient activities and re-allocated to new frontiers and efficient use.

That way everyone benefits: from businesses ideas in need of funds, to those with savings in a pension schemes, to those with life insurance covers, to those with idle held cash, to those with investments in lower returns assets, etc.

As it is, economies need diversified investors and investment avenues to facilitate business growth, especially long-term enterprises and projects -- many investors would prefer the liquidity and vibrancy offered by stock markets compared to the difficulty of alternative avenues.

In the same vein, societies need people willing to take risks — either in establishing new business ventures, or expanding current businesses into other new territories, or innovations based on ideas or people with the willingness to provide risky funds to new ventures and ideas.

Some financial institutions, by their nature, or business model and mandates are not willing to accept such risks. Institutions, such as banks — would like to strike deals with companies whereby even if the profit is small or when the company makes losses, they are still paid their money in agreed terms.

Also, they usually require collateral so that if business plans turnout to be not as expected, the bank can recoup its money by selling off property or other assets under collateral.

Holders of other forms of debt capital such as bonds, take similar low-risk (but also low-returns) deals.

Imagine if debts were the only form of capital available for businesses. In such case, few businesses would be established or flourished, it would be rare for entrepreneurs and business managers to come-up with investment projects that would offer lenders the security they need or the certainty and predictable returns they require.

Part of the reason why businesses flourish in various uncertain environment, is because they are also financed by capital whose source recognize that uncertainty and risk taking is part of the business and investment environment.

Such fund providers factors-in such situations in their capital and investment pricing.

Now, consider a company whose business is continuously cyclical, or whose sustainability depends on its customers sentiments, or weather, or other external factors — can such a business be purely financed by debt? Probably no — such a business would require part of its finance be partly equity.

That way non-risk takers can finance part of the business and risk takers can finance it partly — naturally risk takers will want high reward for putting their hard-earned savings in such an exposure.

In exchange to such risk taking they would want to have their views on who should be on the board, they would want the power to vote down major moves proposed by the managers.

They would also want regular information on the progress of the company.