Two General Premises and a Criterion

How plausible is the increasingly-cheery consensus described in Part I? How to reconcile the disparity between this consensus and our dour background themes? To answer these questions, consider a subversive first premise: only a very small group of Australian market participants – Brian McNiven reckons perhaps as small as 2% of the total – invests. The remainder either dedicate themselves consciously to speculation or believe that they are investing whilst actually speculating (the distinction is set out in Why Speculation Inevitably Ends in Tears). 

This premise draws attention to a fundamental point: to invest, one cannot over-emphasise, is to assemble incomplete and imperfect information about the past and present; to analyse this information in order to make cautious and fallible assumptions about an inherently uncertain (and hence risky) future; and to draw inferences from these assumptions. These inferences, it is important to realise, will at best be logically valid but invariably erroneous to various degrees. To invest is to take decisions, each of which is susceptible to error, whose effect is to constrain consumption in the present and whose purpose is to enable consumption to continue indefinitely into the future. Clearly, then, to invest successfully is to assemble a portfolio of assets reasonably capable of generating a tangible and sustainable stream of earnings – as distinct from unrealized and often transitory ‘capital gains’ – whose magnitude is sufficient to support one’s desired standard of living. To invest successfully, it therefore bears repeating, is not to ‘beat the market’; still less is it to obsess about market prices’ daily fluctuations. 

A second premise: any earnings which a financial asset generates, if they are not first consumed or destroyed by their producer, must eventually return to their owners. Some earnings, such as stocks’ dividends and bonds’ interest payments, are not retained but rather returned immediately. Others, such as companies’ retained earnings, may ‘return’ at some point in the future. Importantly, however, retained earnings need not necessarily return to their owners. Indeed, often they do not: perhaps (as occurred between the mid-1960s and early 1980s in most Anglo-American countries) the market prices of shareholders’ equity, of which retained earnings comprise a significant proportion, stagnate or become depressed; perhaps (as Berkshire Hathaway demonstrated between 1955 and 1965, BHP Co. Ltd demonstrated during the 1990s and countless failed mergers, restructures and instances of profligacy have demonstrated since time immemorial) poor decisions by directors destroy large amounts of retained earnings and shareholders’ equity; and perhaps (as HIH Insurance demonstrated earlier this year and several Australian reinsurers demonstrated during the late 1990s) systematically and diabolically poor decisions can destroy a company.

These two premises provide a basis which investors (properly defined) can use to compare the attractions not just of one class of asset relative to another – but also of individual candidates for incorporation into one’s portfolio. Most notably, a Commonwealth Government bond is ‘risk-free’ in three senses: the interest payments which it generates over time are fixed; they are virtually perfectly predictable; and the likelihood of default is extremely small. Another class of asset, real estate, is riskier because rental income is more variable and less predictable and because the likelihood of bankruptcy is greater. Unlike governments, owners of real estate cannot confiscate others’ money in order to repay debts. Two other classes of asset, stocks and corporate bonds, tend to be riskiest because their earnings and ability to make interest payments, respectively, are most variable and least predictable (indeed, some studies imply and others conclude that they are virtually unpredictable) and because the possibility that one’s capital is destroyed is not negligible. 

Notice that this conception of risk (i.e., the likelihood that the asset does not generate the earnings which its owner imputes to it), echoes that of Benjamin Graham and other value investors. It thereby differs diametrically from the conception underlying mainstream contemporary finance, i.e., the short-term volatility of the asset’s market price. (Details are set out in Value Investing, Risk and Risk Management).