What Drives Investment Returns?

Investment practice is about maximizing rate of change. But we don’t understand the variables that produce rate of change. We understand that fundamental factors seem to affect change over the “long-term” and that emotions play a large role in the “short term.” The rate also changes over time, depending on geopolitical events, vacations, even weather.

Technical analysis.  Seeing patterns in the stock market is used by technical analysts as a way to predict the future. Our brains are wired as pattern-sensing machines, and they will even find patterns where none exist (as in the movie A Beautiful Mind). They sometimes play tricks on us, and we are predisposed to believe in order and predictability. But isn’t this how oracles and fortune tellers operated in the past? In hindsight, technical analysis appears to work. Looking forward, however, it may simply be another way to view momentum.

Fundamental analysis. Researching companies and economies is how most investment analysts find the “true” value or the likely future value of market-based investments. There are a huge number of variables that will affect the future value of a stock, so many analysts will focus solely on one family of variables. This translates into different investment styles.

  • Value is a style that looks at business valuation, comparing the shareholders’  equity, past earnings and likely future earnings with the market price. It also prefers low leverage (debt to equity).
  • Growth is a style that looks at business growth, comparing current earnings to past earnings and buying the fastest growing companies (sometimes regardless of price).
  • Momentum ignores company characteristics and looks only at recent (2-12 months) changes in price. Equity prices are assumed that they will continue to move in the same direction over the near term.
  • Sector rotation looks at economic conditions to predict at what point in the business cycle we are, then determines which sector is known to benefit most from the current environment.

Cash flows or supply and demand. Like any market-traded commodity, investments traded in the market respond to supply and demand. Imbalances are perceived as bull and bear markets: when more people want to buy than sell stocks, a bull market (or bubble) develops; when more people want to sell than buy, a bear market results in rapidly falling prices. This tends to affect entire sectors and likely the entire market.

The rate of change in price means the change in price over time. But even time isn’t consistent, as it relates to trading. Some days, weeks or months have much higher volume, while others have lower volume. This has been referred to as “trading time”, where not every minute has the same weight. With the advent of high frequency trading (in nanoseconds), it’s apparent that trading time is inconsistent.

We can say that the rate of return of a market-traded investment is a function of fundamentals, public opinion, supply and demand over trading time. We do not know what the function is, or the way in which each variable affects the result. Neither do we know if the list of variables is incomplete or if it includes variables that don’t really affect the outcome. What most traders and investors do, to cope, is to choose one family of variables (an investment style) and focus exclusively on those, ignoring all other information.

Ideally, we want find a (theoretical) relationship between the each of the various families of variables that produce the rate of investment return. However, due to errors of induction (as explained in The Black Swan, by Taleb), with wild randomness it’s very difficult to tell which system of the set of all possible systems that could produce the experienced outcome is the closest to reality. Until then, the unknown is what we call risk, and it includes everything we don’t know and everything we choose to ignore. It’s the price we pay for investing in the market.