Avoid the fate of a deluded turkey

Many factors trick investors into bad calls

IN the world of money management there are two types of risk: business and investment risk. Company management deals with business risk and, as custodians of the company, management’s role is to grow its value by devising and executing a strategic plan.

While doing so, management has to deal with employees, suppliers, customers and products, as well as the economy and politics. Laws and regulations change and interest rates and exchange rates are volatile. It’s a tough job. Management’s actions are in the spotlight 24/7. Regular financial reporting for listed companies brings with it a flurry of analysis, commentating and opinions.

Unfortunately, in response to this overload of information, investors make predictable mistakes. They are called cognitive biases.

Chief among them is what is termed “availability bias”. If there is enough readily available information, we tend to believe that information without further thoughtful analysis. We also tend to seek out information that confirms our existing beliefs and are less inclined to seek out information that might contradict those beliefs.

In addition to this potential for misjudgment, there are events we cannot anticipate. Contract law has a term for this — force majeure — referring to chance occurrences or unavoidable accidents. When evaluating the investment merits of a particular business, any downside relating to force majeure is simply unknowable.

Furthermore, markets are complex environments, and complexity brings with it interdependency, whereby little things can have big consequences.

From Nicholas Taleb: “A complex domain is characterised by the following: there is a great degree of interdependence between its elements, both temporal (a variable depends on its past changes), horizontal (variables depend on one another), and diagonal (variable A depends on the history of variable B).

“As a result of this interdependence, mechanisms are subjected to positive, reinforcing feedback loops, which cause ‘fat tails’.”

For Taleb, this term has nothing to do with overindulging in KFC — it is shorthand for extreme outcomes with a higher than expected probability.

As an illustration of a fattailed event, he uses the

In response to this overload of information, investors make predictable mistakes

analogy of the turkey being fattened for Thanksgiving : “Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests’, as a politician would say.

“On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. The same hand that fed it will chop off its neck.”

Business risk falls in the domain of complexity and has resultant fat-tailed outcomes. Business managers are well equipped and remunerated to deal with them. Investors are less well equipped, because they are one step removed from the process and suffer from cognitive biases.

So, if you invest based on the superficial analysis in the commentary section of your favourite fund managers’ quarterly report, or on some adage such as “invest in bricks and mortar, it’s safe, you can touch and feel it”, be careful.

There is a lot going on out there that we cannot know about and will only find out too late. Worse still — we even tend to interpret things we have correct information on incorrectly. As Charlie Munger said, “the dawning of wisdom is when you realise you know nothing”.

So if we cannot expect investors to make consistently good investment decisions based on their analysis of business risk, what should they do?

Fortunately, there is another plane on which investors can operate — the plane called investment risk. Investment risk is simply encapsulated by the difference between the price one pays to acquire an investment and its underlying intrinsic value.

If the price is far enough below one’s estimate of intrinsic value, many bad things can happen to the business without having a negative effect on the investment.

For example, say one is lucky enough to acquire a share of a business for R10, although it has an estimated intrinsic value of R25. New competitors then unexpectedly enter the fray and reduce the earnings power and intrinsic value of the business 40%, to R15. Not having foreseen the new competitors’ effects on the business, our investor is still R5 in the money.

In short, it is easier to manage investment risk through the price mechanism than through reacting to — or even trying to anticipate — business risk.

Viljoen is the chairman of value asset manager RECM