Successful investing demands a subtle blend of science and art, according to Russell Investments NZ institutional director, Noah Schiltknecht.
Investors who neglect either element, or lay them on too thick, could end up facing an ugly shock, Schiltknecht told the Russell Investments NZ annual conference last month.
“Both art and science have a positive effect on investment,” he said. “But both can also lead investors off-track.”
Science has provided most of the tools that underpin modern investment practice, Schiltknecht said, citing concepts such as diversification, the link between risk and return, and the “consistent” asset valuation method of the discounted cash-flow.
“But science has limitations,” he said. Statistical analysis – no matter how sophisticated – has not yet fenced in the complexity of the entire financial system into a unified field.
“For example, we still don’t know how to accurately forecast a recession,” Schiltknecht said. “There is always some uncertainty.”
Quoting the French godfather of chaos theory, Benoit Mandelbrot, he noted: “Unfortunately, the world has not been designed for the convenience of mathematicians.”
While science has branched out beyond analysis of pure market numbers to quantifying investor behavioural quirks, Schiltknecht said tools such as risk tolerance measures remained rudimentary.
“If investors don’t appreciate the limits of science it can end in disaster,” he said.
Typically, investors make mistakes by relying on science that falls into two categories: shaky, and irrelevant.
For instance, Schiltknecht said the underlying technology of blockchain is irrelevant to any decision to invest in bitcoin.
“You are not compensated for the risks of blockchain by investing in bitcoin,” he said.
‘Shaky science’ includes the familiar textbook tool for measuring investment risk: the portfolio variance formula.
A standard application of the formula suggests a balanced portfolio (50/50 split between shares and bonds) would lose 20 per cent in value once every 4,000 years, Schiltknecht said.
“But it has actually happened once every 20 years,” he said. “How can a textbook formula be so wrong?”
Of course, the textbook mistake lies in smoothing over inconvenient data, which makes the all-too-real ‘tail risk’ disappear. The invisible tail risk has tripped up many over-confident investors, he said, such as Long Term Capital Management, the infamous hedge fund featuring Nobel laureates Myron Scholes and Robert Merton among its founders.
Similar factors were at play among the notorious collateralised debt obligation (CDO) instruments that triggered the GFC, Schiltknecht said.
He also used the example of the mandatory NZ fund ‘risk indicator’ model, which attempts to establish an easy point of comparison for retail investors.
Using the five-year pricing data required to set the dial, Schiltknecht said would yield the same risk measure for holding a portfolio of Warehouse shares, a fund comprising 25-35 Australasian shares, or an exchange-traded fund tracking the MSCI Europe with 500 plus underlying companies.
“You can’t rely on a single formula to assess risk,” he said.
If science has its pitfalls for investors, art can be equally, or more, dangerous, Schiltknecht told the Russell audience.
The artistic side of investment is largely about understanding human behaviour and gaining trust. However, humans generally have poor criteria for judging trustworthiness.
For example, he said research has consistently shown people will trust friends over experts for investment advice; and a recent study found people would rather trust a complete stranger than a computer for investing tips.
“If that’s right then good luck with robo-advice,” Schiltknecht said.
The most powerful investment art hinges on good story-telling, he said, which can cut both ways.
Fund managers talking about their recent trip to China, for instance, would tend to excite more interest from an audience than those who extol the virtues of a 300-stock portfolio.
Skilled story-telling, though, can swing the argument in favour of logic and investors’ best interests. Schiltknecht used a video showing a noted economics professor unraveling an MBA student assertion that Netflix could achieve revenue of $600 billion.
By pointing out that the MBA student revenue estimate would require almost the entire world to subscribe to Netflix at $100 each per year, Schiltknecht said the professor used story-telling to reveal an investment fairytale.
“Valuation is not just about numbers,” he said. “It’s a bridge between story-telling and numbers.”
Overall, Schiltknecht said investors should use ‘art’ to “sense check the science”.