Opinion piece: The Art and Science of Investing  

As a recent graduate starting out in the working world, the term “investment” doesn’t mean much to me, I’ll be honest. Apart from putting away a couple of hundred rands a month into a savings account, that’s about as responsible as I am with my money at this stage in my life. But in working for BizNews and dealing with numerous financial articles weekly, I am learning more and more  about just how important it is to manage your money wisely. So for those of you who are big into investing, this following article is a definite must read. There is a definite art and science to investing and if you play your cards right, have patience, act responsibly and stop trying to predict the future too much, the rewards will be great. – Tracey Ruff

By Charl Botha*

Charl Botha offers his expertise on investing.

Investing is both an art and a science. It is an art because human behaviour is neither reducible to a recipe nor predictable by one – at present. It is a science because we do have general psychological, economic, and business models and principles that allow us to potentially make more informed business and investment decisions.

I hope that this article “Two things that we know…(part 1)” will be the first in a series of articles where the fascinating and financially fattening fundamental concepts of investing will be unpacked for the interest and decision-making benefit of those who take the time to reflect on them with me.

Two things that we know(part 1)

I was having a meal with my family at a restaurant a little while ago where my mom, whom I very much resemble in character, was sharing her latest story of misplacing her cell phone with all the discomforts accompanying such a temporary loss. All of us smiled knowingly – our mom is one of those people who misplaces most things, the car at the mall (all malls), the keys to everything, her cellphone of course, and many other more or less useful items. Her entertaining story reminded me of a common fetish that occupies many a philosophers’ mind and provides some useful advice to the prudent investor. The philosopher is not only worried about getting to know where his or her lost car keys are but some of them are also seriously worried that they cannot find the external world! I am not implying that we should all become solipsists – a difficult undertaking to accomplish communally if there ever was one- but that we should weigh the mountains of information that weigh down on us daily for the gold dust of real knowledge. If we are reasonably sure about what is true in the financial world, or even as close to certain as epistemically possible, then that surely improves our chances of making better investment decisions? In investment practice you are not paid for being busy, but for being right more often than not, or being right in a bigger way than what you are wrong.

In this particular article, I want to discuss two investment ideas that we can be reasonably sure of. The first idea that we seem to know is that the purely economic value of any financial asset is all the cash flows that we can expect from that asset over its lifetime discounted back to the present at an acceptable discount rate. Secondly, we know from personal experience that people are emotional about most things, especially things financial. The total value of any financial asset thus consists of two components, a fundamental economic component, the rational-read-your-economic-textbook-variety of value, and an emotional value, which necessarily, if not sufficiently, depends on the interaction of a host of biological, psychological, and sociological factors. The emotional component of financial asset value will be discussed in a forthcoming article.

We can only ever know the fundamental value of many assets such as shares to a degree because we can only ever know many of the inputs to the calculation of the fundamental value to a degree. In other words, we know what the formula for calculating the fundamental value is, we are just not always sure what values for the variables to put into the formula, and because we are not sure of that, we are not sure if its going to lead to investment success or financial ruin.

There are three basic variables that are necessary components to a fundamental value calculation (aka “the inputs”), and they are:

  1. The number and size of the cash flows that will be generated by an asset, in the form of dividends, earnings, or cash flows.
  2. The timing of when the cash flows will be forthcoming from the asset. For example, will all the cash come in one big lump at the end of next year, will it be generated in drips and drabs over the next 10 years, or will it be steady as she goes until the end of the common era?
  3. Thirdly, and finally, the required rate of return (aka “the discount rate”) that should take account of the uncertainty in your estimates of the size and timing of the cash flows from the asset, as well as the opportunity cost of using your money to buy Facebook shares instead of possibly paying back part of your home loan.

I am not going to bore you with the mathematics of valuation; there are many valuation textbooks that will do the job very well. The nugget of possible value that I want you to mine from the preceding section is that if you are able to estimate the “inputs” to the valuation models, the size and timing of the cash flows, and the discount rate, more accurately than most, then your chances of investment success, keeping everything else equal, should be better than most. The devil is in the details, well most of the time, these days he seems to be pretty visible and busy on our streets. A small change in any of the inputs can have a major effect on the output to any of these fundamental value equations, which implies that it is all very well and good to know what these equations look like and how to do calculations with them, but it is the inputs to them that will make or break your piggy bank. A share paying out R10 per year for all eternity will be worth R100 today at a discount rate of 10% but only R80 at a discount rate of 8%.

In future articles I will discuss the “inputs” to the valuation models in much more depth as they are the causal factors driving fundamental value. What I will say now is that the “inputs” also have “inputs” and therefore the investor will always be faced with the problem of estimating some value for which no certainty seems possible. Those who consistently do this better than others are the investment artists.

There is another way to achieve investment success more often than not. If you know that you cannot consistently estimate the inputs to the valuation models better than the average investor, perhaps this knowledge that you don’t know opens the door to a way of acting in the markets that provides a way of generating above-average returns. In other words, if you know that human beings are generally terrible at making accurate predictions about the future, then invest against their predictions. If investors are seeing a future where everybody has a penthouse in New York, it could be prudent not to be invested in the New York property market. If investors think Facebook will last forever, ask them what ever does? If you are skeptical of your ability to know the future you will be wary of paying up for the privilege of owning a piece of it. As for me, I would like to own a piece of tomorrow’s economic pie for my clients and myself, I am just cognizant that today is real and tomorrow is still a maybe.

In summary, know that fundamental value is one of two essential components of financial value, and take note that the most important influence on the fundamental value of any financial asset is the size and timing of the cash flows generated by the asset, and the required rate of return necessary to discount the cash flows to the present. Finally, take note that estimating the future is something humanity has traditionally been less than successful at – the prudent investor will not pay too much for what the future might hold.

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