Everything You Wanted to Know About Investing (but were afraid to ask)

I’m new to the crew here, but I’d like to introduce myself. My name is Gabe Kates and I’m currently a student at Haverford College, which is a small liberal arts school located in the Philadelphia suburbs. I’ve recently been hanging out with Wes and the team and I quickly realized that Haverford–while outstanding–wasn’t giving me a lot of hand’s on experience and practical knowledge for the field of finance. Wes suggested that I write blog posts that summarize the projects he’s had me investigating. I hope my unique and uninhibited perspective–young, fresh to finance, etc.–will add a new complementary element to the content that flows through the TurnkeyAnalyst veins. I hope you enjoy learning about finance as much as I have–challenging, but well worth the efforts!

My first assignment from Wes was to investigate the basics. As a point of reference, I just learned what an income statement was a couple of weeks ago from David.

What is Active Management? 

Essentially, active managers are people who believe they can identify securities that are currently valued at less than what they’re actually worth, and then profit when those securities ultimately reach their potential. Active managers try to find what Warren Buffett (a.k.a the Bill Belichick of the investment world) calls “value stocks.”

What are value stocks again?

Think of it like this: a value stock is a security that the market currently values at less than its fundamental worth. This undervaluation can be caused by any number of reasons (see cognitive biases), but the general concept is that stock X is worth some amount of money today, but–based on the quality of stock X’s business–will be worth some larger amount tomorrow.

Here’s an example:

Bill Belichick (a.k.a the Warren Buffett of the NFL) routinely picks up veteran players at bargain prices, because other NFL teams have overlooked their abilities. The player in this scenario–let’s just call him Randy Moss–represents the undervalued stock. Belichick then incorporates the undervalued, yet talented player into his offensive/defensive scheme, and reaps the benefits of their talent when it manifests itself (which he recognized from the start*). The offensive/defensive scheme in this example represents the active manager’s portfolio–when the undervalued stock (Randy Moss) exceeds its cost basis, the whole portfolio benefits.

Now, based on the previous example, one might assume that finding and investing in value stocks is a simple strategy: find an undervalued security, buy it, and benefit when it reaches its potential. The reality, however, is different. It is well documented [French (2008)] that, in aggregate, active investors are unable to produce positive alpha. In other words, there is little evidence that managers produce net returns that compensate investors for the risk involved in a given investment.

To put that back into a sports perspective, most coaches who fancy themselves as having comparable ability to Bill Belichick in identifying undervalued players, in fact, are unable to make such identifications. Most coaches pick guys like Donovan and Dwight–or what the majority of value investors would call “growth investments.”

Only a select few active investors are actually recognized as having sufficient skill to create positive alpha. This means that there is only a small minority of active investors with enough skill to cover their investment costs.

Why Do Investors Invest with Active Managers?

Meir Statman provides a compelling answer, which Kenneth French (2008) summarizes for us below:

“Statman (2004) offers another behavioral explanation for active investing. He suggests that, in addition to expected return and risk, investors are concerned with what he calls the expressive characteristics of their portfolios. Thus, some investors may accept a lower expected return in exchange for the bragging rights that come with a fund that has performed well.”

Knowing that other investors are overconfident of their ability to choose value stocks, it will be interesting to see if someone eventually decides to take advantage of such behavioral biases.

I guess we’ll just have to wait and see…

*Now some people may say that Randy Moss only succeeded in New England because Belichick and Brady are the best coach-QB tandem to play the game of football, which would have allowed Moss to succeed regardless of his ability. I–this finance-specialist in training–would have no response to such statements. In fact, I agree with them.