Have a look at a company’s cash flow statement (you don’t have to be an accountant to do that), you will notice that there are three categories: Operating, Investing and Financing. A closer look at Investing activities will give you an idea of where a business is putting their money. This could be buying a new building, machinery, marketable securities and even another business.
For a company, investing activities consist of broadly (i) replacing ‘old’ assets; and (ii) buying new assets for growth. As an individual, we too ‘invest’ in ourselves. This includes further education, professional qualifications, specialised skill set to ultimately get us to the next promotion or new job.
But when a company buys another company, the thought process behind whether it is a good decision or not is not so easy. We faced similar challenges when you or your friends come across various investment strategies that you are apprehensive about it as to whether it's a good idea.
Regardless of whether you are an individual or a company, each investment has its own risk and return. One approach when considering whether an investment is a ‘good’ investment is to ask yourself these questions:
(i) How much can I earn (
return)?
(ii) What’s the maximum amount I will lose (
risk)?
(iii) How much do I need to start (
initial capital outlay)?
(iv) When should I get my money back (
investment horizon)?
This approach is a good start when thinking about any investment strategy. The next section of this post will focus on providing different perspectives of these concepts which may be contrary to what we know.
In finance, modern portfolio theory suggests that risk and return goes hand in hand. That is, the more risk you take, the more return you should expect. This is based on the fundamental assumption that market is efficient. Let us think consider these theories as an individual investor.
Risk vs Return
Let’s start by examining the notion of more risk = more return.
I will start by comparing three types of investments: (1) a term deposits which earns 6% p.a. ; (2) an investment property which (simplistically) also earns 6% p.a. ; and (3) a share that has a dividend yield of 6% p.a. These investments earn (
yield) the same return, but do you think it bears the same risk? You may think I am not being ‘fair’ with my comparison, as that there’s always a chance property prices or share prices appreciates. But what if it doesn’t?
Now, let’s consider another example. A listed company whose share prices was rising for the past 12 months but has recently fallen significantly in the last 3 months. If modern portfolio theory suggests that because the share price has been volatile (i.e. riskier), the expected return should be high. Would you buy the shares without considering what is actually happening within the business?
I was once told that we (humans) are very good at self justification. We can justify the share price is cheap when it is $40, and we can still justify the share price will rebound when it is $0.01.
Share price is a function of demand and supply. It’s the price people are willing to buy and sell equity securities. People in the share market are typically driven by two emotions: Greed and Fear.
Putting that together, does more risk really = more return?
Market Hypothesis in Share Market
Focusing more on share market and apply modern portfolio theory that the market is efficient. The share market has to be a ‘super-sized computer’ (because I buy my shares online) that is the smartest and most complex machine that updates all share prices using the latest information from all parts of the world. A believer of this theory would conclude that the price you buy and sell any shares is always the “right” price and there’s no chance you will get a bargain.
If you read the business sections of newspaper or news from the radio, it always reports on whether share prices has risen or fallen and there’s always a reason why. “Share prices has fallen because there’s uncertainty over Europe.... Share price has risen because there's confirmation over Europe has hit its worse.” Does this information really impact how Woolies does its business and therefore its share price?
If the share market is truly efficient, would it keep changing its mind about what it thinks is the ‘right’ price?
As explained before, shares price is a function of demand and supply. Market is made up of people. My view is that financial institutions (I loosely term ‘banks’) are the ones that make most money out of any market. As a middleman, they earn money every time you buy and sell; they make money through price fluctuations (speculations); and they even sell information (stock analysis report) on when to buy and sell. Hence, the efficient market hypothesis is a theory the finance community wants you to believe.
When share prices fall because banks want to take profit, everyone will follow and start selling their shares, thinking that the market is efficient and there’s something the banks know that individual investors don’t. But in actual fact, there are no new information of the underlying business. Similarly, when share falls low enough then the banks begin buying, others follow, thinking that there must be some new information. Such herd mentality results in one thing: the banks will always be first to maximise their earnings.
If you and I lost money in the share market, we may think that we are not getting up-to-date information to keep up with the banks and therefore pay them more money to subscribe to their share reports.
I am not here to deter you from investing in shares. However, I am suggesting that you need a structured and disciplined method if you are considering putting money in the share market. Otherwise, you will lose your initial capital very quickly.
