3 keys to understanding investing

As my colleague Andrew Pease pointed out in a recent blog, there’s much to be said for an investing style that combines quantitative (deep computer scrutiny) and qualitative (human judgment) approaches.

We see an analog for this in “freestyle chess,” in which a human and a computer join forces to compete against a computer. A computer can defeat a person, or another computer. But a team composed of a human and a computer is unbeatable. Machines can process huge amounts of information, while people offer insight, experience and judgment.

Just as important as the methods we use to analyze the world of investing are the building blocks we used to construct our investing models.

I’m writing today to explain three key components of our own investing framework that may help many in understanding investing better: cycle, valuation, and sentiment. They’re tools every investor needs to understand in order to help gain insight into how markets work – and to help avoid being part of the investing herd.

    • Cycle. There are patterns everywhere in the world—seasonal rainfall, tides coming in and out, trees leafing out then dropping those leaves. Patterns also exist in what we call the business or market cycle.

Almost invariably, a peak in the economy leads to a recession. Then comes recovery as an economy climbs back towards its previous high, then expansion as it surpasses that former high-water mark. This is what we mean by the term, “market cycle.”

Where we are in this cycle matters deeply to investors, who may want one basket of assets when an economy is heading for recession and an entirely different one when the economy is expanding.

Last August, when investors feared a global slowdown, gave us a good example of this in action. Equities, credit, currencies all performed poorly because investors feared they would lose value. “Safe” assets such as U.S. treasury bills, or defensive equities did well.

As noted in that year’s September post, like many other investors who understand this key, we monitor the business cycle constantly, taking into account central bank actions and other measures to put forth our best effort to plot where we are in any given cycle.

      • Valuation. You go to a restaurant and order a meal. It’s good, but very expensive. Would you go back? Well, maybe. The concept of valuation in the investing arena is similar.

For example, in a particular scenario, some assets might be attractive, but because they’re well known and have a good track record they could also be expensive. In that case, an investor might do well buying some of that asset, but chances are other investors have already bid up the price as far as it can reasonably go. In this example, one might run the risk of paying $120 today, and getting $100 back tomorrow. It’s obviously much better to pay $80 today, if possible. The price you pay for an asset is an important driver of future returns.

As we noted in the Valuation section of our recent update to Global Market Outlook, right now we see U.S. equities as very expensive, while those in Europe and emerging markets offer the potential of moderately better value and hence a better potential hope of returns.

Value is another issue we keep a careful eye on, looking for bargains and overlooked assets that have upside. We also watch for times when people become fearful and sell off assets over-aggressively, creating buying opportunities. And that point leads naturally to our third building block:

      • Sentiment. We’re human. So we make decisions that aren’t always rational. In investing, it’s common for people to panic when equity prices start to tumble. In such a scenario, nearly everyone may start selling, accelerating the drop. That’s when cooler heads can step in and potentially make money.

But there’s another aspect of this that behavioral research has uncovered. Put simply, people are slow to overreact. They’ll hear bad news – or good news – about the markets, and discount that information. Then they’ll read that people are selling some asset, or buying another. Not long after that, nearly everyone is selling or buying that asset, and it becomes either over-sold or over-bought.

Understanding how behavior moves markets can help smart investors to react in a way that may better benefit them than reacting with the “herd”.

Investing is a complex business. The better framework an investor has for understanding and monitoring markets rationally and consistently, with a model framework like what I’ve outlined here, the better his or her chances of helping to achieve a desired investing outcome. Understanding cycle, value, and sentiment gives investors tools that can help guide better investment decisions.

For more on other key tenets of our investment beliefs, see this video by our Global CIO, Jeff Hussey.