In the latest in our series ‘all you needed to know but were to afraid to ask’, John Kattar dispels some of the myths surrounding the investment community
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This article was first published in the February 2018 UK edition of Accounting and Business magazine.
Investment professionals come in for bit of stick, but this might be due to a lack of understanding of some areas.
As a life-long investor myself, I’m going to try to set the record straight. Here is some clarification on a few of the fundamentals.
- Myth 1: All investors are equal. The term ‘investor’ is used as a catch-all term for anyone who puts money to work. However, they are not a homogenous group – far from it. The term ‘investor’ covers a wide spectrum of activity, from those who try to outperform an index (active managers) to those who invest in line with particular stock indices (the passive crowd); from those who create algorithms to identify stocks that share particular characteristics (the algos) to those who devour annual reports, industry reviews, macro data – anything that will allow them to predict with some degree of confidence the future performance of an entity (the fundamental bunch).
- Myth 2: Investors are only interested in making money. This is only partly true. Most investors are certainly primarily interested in making money, but there is an increasingly significant group that has other goals, such as those who invest in companies that are environmentally or socially aware. But even those not within that tranche serve a valuable purpose: through price discovery, investors are a key link in allocating capital to the most promising companies in the economy. Stock prices are important signals that affect everything a company does, from raising capital to attracting talent.
- Myth 3: Short-selling is evil. Shorting is the practice of borrowing and then selling a stock in the hope that it can be bought back again at a lower price. Many people think it leads to higher volatility and crashing prices, so much so that it was partially and temporarily banned in the US and UK during the last financial crisis. However, most studies concluded that this only made matters worse, by restricting liquidity and price discovery. There is little difference between short and traditional sellers. Indeed, shorts probably reduce market volatility because they tend to be contrarians who buy at the bottom and sell into stock market bubbles.
- Myth 4: Markets are not efficient. The efficient market hypothesis (EMH) has been heavily criticised recently, mainly by those who think there is little rhyme or reason in markets. But EMH does not say that markets are fair, merely that they are really good at absorbing information. This means that the better the information provided by management and the accounting community, the more prices will reflect the underlying reality of the situation.
- Myth 5: Active investors always underperform. Well, sort of. Nobel laureate William Sharpe provided a simple rationale for this when he said that active investors in the aggregate cannot outperform the market because they are the market. However, what is true in the aggregate is not necessarily true in the particular. The evidence is mixed whether an individual investor – even one operating in less well-researched areas such as small cap – can consistently beat the market.
- Myth 6: High-frequency trading (HFT) is a bad thing. HFT is investing for very short holding periods, measured in seconds or minutes, and often without human intervention. As with short-selling, critics claim it restricts liquidity and price discovery; they also say it provides an unfair advantage. But I say that by itself HFT merely speeds up price discovery and enhances liquidity, which theoretically helps all market participants. The problem is that some exchanges have sanctioned rules that benefit HFT at the expense of everyone else. This undermines investor confidence in markets, which is very bad.
- Myth 7: Investors know about accounting: There are investors who are trained accountants; but they are in the minority. The rest of us are at best gifted amateurs, trained to strip down balance sheets and build up income statements, but far from being technical experts. In our defence, I would argue that we shouldn’t have to be as familiar with the minutiae of accounting as a professional. Being able to use accounts is not the same as being able to create a set of financials. I drive a car. I cannot build an engine.
- Myth 8: Investors don’t read annual reports: Investors are bombarded with information. For many, the release of the annual report is not as big a milestone in the financial calendar as it once was. That doesn’t mean that we don’t value both audited financial statements and narrative reports. Both are key to making informed decisions about a company’s value, and hence its stock price. It is true that many investors use data intermediaries (such as FactSet and Capital IQ) to access companies’ financial data. They provide a one-stop-shop for accessing corporate data and normalise financials to make them easier to compare. But there is a limit to the amount of insight that can be gleaned. To really get behind the numbers, you need to go to the source: to the annual report.
John Kattar is a professional investor
CPD technical article
"Using accounts is not the same as being able to create a set of financials. I drive a car. I cannot build an engine"