Entrepreneurs make important decisions about the further development of their company on a daily basis. The basis is their practical knowledge, experience and a detailed insight into relevant information. How useful are these for capital market decisions?
Successful entrepreneurs often transfer their approach to business decisions to their actions on the capital market. They tend to overlook the fact that the latter are subject to different laws than the corporate world. Above all, emotional factors play a greater role on the capital markets, which significantly influence success. Fear and greed counteract objective investment decisions. At the same time, all investors are under the illusion of being able to achieve above-average investment results. Similar phenomena can be observed from the survey of car drivers, who also consider themselves to be exceptionally talented. This “overconfidence” often promotes risky decisions, for example selling securities on a large scale after significant price declines, assuming that further declines are inevitable. Firm intentions are often revised for emotional reasons. Portfolios are also becoming reservoirs for future values, as they are touted in publications. As entrepreneurs, the same people make completely different decisions when it comes to investing in business and solving problems.
Research in the field of behavioral finance deals intensively with behavioral capital market decisions, which we will discuss later. Because first of all we want to deal with the question of whether active portfolio management can deliver any added value at all? One of the most important scientific approaches, the random walk theory, challenges this. The reason for this is the market efficiency hypothesis, according to which all price-relevant information is already contained in the current price determination. And without an information advantage, nobody can achieve an advantage that goes beyond the usual capital market return. Who has not experienced this, that a course development took a completely different course, although one was sure what had to happen. In 1988, The Wall Street Journal put the random walk theory to the test, pitting financial professionals against dart throwers who chose random stocks. Although the financial professionals won the competition, they could not significantly outperform the Dow Jones Industrial Average as a benchmark. Accordingly, one can also rely on market indices at low cost, for example using ETFs.
That’s the theory. Practice has shown that there are different approaches among professional investors and that their average results are based on a wide spread. One way to approach problem solving is to use scientific knowledge. The aim is to identify anomalies in the markets, i.e. deviations from the theoretically perfect market, as described by the random walk hypothesis. It is equally important to explain the cause of such deviations. Because naturally there is a risk that the anomalies are merely coincidences that do not show any continuity. Intensive investigations are therefore essential.
Capital market: Facts and figures instead of opinions
If the capital market decision-maker wants to avoid gut decisions and act objectively and rationally, it makes sense to focus on numbers and data instead of opinions. Figures are easy to analyze, and shares can be better classified into categories based on quantitative characteristics than based on qualitative factors. Especially in times when companies are expanding or changing their business models, it is difficult to classify companies based on their industry or regional focus. On the one hand, this can be done on the basis of fundamental valuation parameters – such as the price-earnings ratio, price-book value ratio or earnings growth. On the other hand, technical market indicators can be used, such as price volatility.
In addition to the measurable risk of insolvency, volatility is the most important risk indicator. Since studies have shown that there is a significant connection between the valuation level of a company on the one hand and the risk and historical price development on the other hand, conclusions for portfolio construction can be drawn from the data. For example, value stocks with particularly low valuations are unattractive in normal capital market phases, which can be seen from the index volatility. These stocks do not offer a reasonable yield and are considered a value trap. Their rating isn’t “cheap,” but signals that the company has a problem. Nevertheless, after the onset of stress phases, which can be identified using indicators, such companies show such high returns in the subsequent recovery phases that they overcompensate for the increased risk and can therefore be worth investing in.
It is important that these findings are not related to individual cases, but are applied consistently and with broad diversification in order to limit the effect of outliers. Diversification helps to avoid company-specific risks, while the capital market risk can at best be reduced by adding low-correlated investments such as gold. There are also studies on how much diversification makes sense. While investors who forecast corporate developments or are even active as activists usually choose very high and concentrated weightings, quantitative models tend towards broader diversification. The special risks – but also opportunities – from the first strategy are known from many prominent cases. Anyone who prefers smaller target deviations, i.e. who wants to invest risk-aversely, should diversify broadly. Entrepreneurs in particular who are already taking entrepreneurial risks should not overstrain their risk budget with additional risks on the capital markets.
Limits of broad diversification
However, the well-known wisdom of not putting all your eggs in one basket doesn’t help if all the baskets are transported in the same car. Unexpectedly high correlations are often hidden behind various securities, which only arise as a result of a new event. As an example, the Fukushima nuclear reactor accident caused a sharp shift in the correlation between reinsurance and utility stocks. The current military events in Ukraine are also changing historical correlations. This is where the limits of scientific knowledge lie. When so-called black swans occur, as Nassim Nicholas Taleb has dubbed unprecedented events, the benefits of any portfolio strategy can erode.
Nevertheless, it can be said that scientific studies can be used to derive methods for constructing portfolios with a favorable risk/reward ratio. Mistakes caused by gut decisions are avoided and investment decisions are objectified, because capital markets work differently than entrepreneurship.
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