Source: Red and Green, “Investment Principles: 30 Years of Investment Experience and Lessons”
Author: Hilda Ochoa-Blemberg

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1. Price is not value

For a particular investor, the value of an asset may be lower or higher than the price of the asset in the market. This depends on the asset and the investor's legacy (existing).

The relevance of the portfolio and its needs. This is true even when investors agree with market predictions. Many portfolios include legacy assets or structures (reflecting clients' needs) that cannot be easily changed or at a low cost. Financial theory is insufficient to explain the relationship between market prices and the investor utility curve. This relationship allows the same asset to have different “fair values” (multiple equilibrium pricing) for different investors. There will be a market price for the asset for all buyers. However, for different buyers, the relative value of this asset is different. The first part of this book provides a quick formula that I think is useful for figuring out which assets are a better fit for your legacy portfolio.

Oscar Wilde has a brilliant moral judgment on cynics, and he criticized these people for “knowing the price of everything but not the value of anything.” Investing is like life. Theory can teach you how the market determines the price of an asset, but it's absolutely impossible to tell you whether the price of this asset matches its value when you put it in your portfolio. In the eyes of proponents of effective market theory, the first lesson is probably the most controversial of all my lessons, or probably the most relevant. The difference between market value and value to investors helps explain the gap between multiple balanced allocations in effective markets and inefficient markets, which determines that different investors are willing to pay different prices for the same assets.

For a given buyer, the value of an investment depends on the market price, expected return and risk, and the correlation of marginal investments in traditional portfolios. Institutional portfolios rarely start with cash. Once someone establishes an optimal portfolio structure through cash, traditional portfolios will compete with it. Any new asset entering a traditional portfolio is likely to bring a different value to your portfolio than to other market players. In addition to market price, expected return, and risk, the most important factor affecting the value of an asset is its correlation with other assets in the portfolio. When specific investors (such as institutional buyers) pour into a certain type of asset in droves, and the price of that type of asset is pushed too high for other investors (such as donation funds), then investors who have no strategic purpose for that asset should forego acquiring such assets.

2. Pay attention to the price

The price at which you are willing to buy an asset is one of the deciding factors for how much risk you face in owning that asset.We can never know the best price for an asset, but we can know if the price of that asset is overvalued, and we can also know that if an asset's valuation is at an all-time high or deviates from historical fair value by more than two standard deviations, then the risk will be higher than average. If you have enough time, then waiting for an asset price pullback is a safe bet. Unless you're in the middle of a war or when the market is closed for a long time. Post-modern financial theory argues that the value of the market is not always fair, because behavioral biases influence investors' rational choices and divert the market from fair value. Almost any investment management style can work if it takes long enough, or if you strictly follow the established strategy, or if the timing to act isn't that bad. Simply put, almost any investment management style can work as long as you buy it at a reasonable price and give it enough time to get it back to its proper value.

There are, of course, exceptions. Over time, asset prices tend to fall back to the overall average. Based on this empirical judgment, we found that over time, a simple momentum style results in more losses than gains. Momentum style refers to an investment method where investors increase positions and buy when securities prices are stable or rising at an accelerated pace, and at the same time withdraw funds in a timely manner when they detect a reversal of the upward trend. The momentum style is commonly used for commodity investments with high price fluctuations. This type of investment is not suitable for basic price analysis (cash flow discounting) because it has no cash flow and therefore cannot be discounted. If we can combine this with the price sensitivity style, then we can actually use the momentum style. In this case, momentum becomes a second effective filter.

If you pay a reasonable price, your investment will always be relatively safe over time; if you pay too much, then you may never fully recoup your investment.But the best thing to do at this point might be to keep those investments, unless they're still grossly overvalued. Your future decisions should refer to relative valuations. Many academic theories have attempted to prove that price-sensitive (“value”) -sensitive investments will be more likely to yield returns than momentum-style investments, as momentum style investors often pay too much for the assets they buy. But sometimes cheap assets stay low for a long period of time (value trap), and being able to find new momentum outside of the value trap is very important to avoid being stuck in hopelessly cheap assets for a long time.

According to Robert Shearer's analysis, cyclically adjusted price-earnings ratios (based on normal 10-year real earnings) help estimate the range of future long-term earnings. 7 Starting with a relatively low price-earnings ratio of 8 times, the expected annualized yield for the next 10 to 15 years should hover around 8% to 18%, with an average annualized yield of 15%. If the price-earnings ratio is adjusted from 8 times to 20 times, then the annualized yield is expected to decrease by 0-12%, and the average reduction will be higher than 5%. If the price-earnings ratio is 30 to 40 times, then it is difficult to determine whether positive returns will be obtained in the next 10 to 15 years. In addition to stocks, the risk faced by other asset classes also depends on whether the price at which they are bought is overvalued or undervalued.

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3. Don't bet on all your chips

Even with strong evidence, it's impossible for us to be 100% certain about something. Our experience with some low-probability events (extreme and unexpected events) validates the academic uncertainty theory.The probability of such an event happening is very low, but if your portfolio isn't fully prepared to respond, the results can be devastating. Of course, portfolios should not be managed with low-probability events as the core of management, since low-probability events are not the most likely outcomes.

We should manage our investment portfolios well so that the risks we need to face in extreme situations are not too serious. We have to be prepared for what might happen, but make sure that low-probability events don't disrupt our ability to reinvest in what might happen. To this end, I have added to this book the academic community's understanding of the limits of risk management and optimal coping methods, as well as understanding of liquidity management. Liquidity is either vastly overestimated or vastly underestimated. Properly evaluating it is critical to properly handle uncertainty.

4. Getting into trouble is inevitable

Although diversification makes it easier to get into trouble, smart diversification is still the best way to manage risk.This mistake should have only a small impact on your portfolio, but it can embarrass and shame decision makers. In recent years, theories about fragile structures and stable structures (elastic structures) developed through observation of biological evolution have solved this problem well. We need to focus on manageable weaknesses within a solid structure. Focusing on the diversity and diversity of risks is central. Although Warren Buffett may disagree, for portfolio managers, many small but good investment opportunities are an important source of high returns and portfolio stability. Diversified investing allows you to add new asset classes, new investment styles, and volatile but diversified risks without exposing your portfolio to excessive fluctuations or volatile (highly uncertain) results. For over 60 years, Buffett's unique investment techniques have been based on being able to use his brand effect to obtain better transaction prices when buying assets. Sometimes investors may have the opportunity to invest more in less valued assets (large profit-seeking games) or stay away from overpriced assets, but these large transactions (usually involving 5% to 10% of the total asset class assets in a single transaction) should have a particularly high degree of certainty. This certainty can be determined by deviating from the standard of more than 2 times fair value.

5. Fraud is also inevitable

Fraud is less likely to occur in the US capital market, but it is impossible for fraud to completely disappear, so any market is dangerous.You must guard against fraud. The best precautions are due diligence and risk diversification to limit it to the level of risk faced by a particular asset class (stocks or bonds) or specific managers.

6. We need to prevent volatility

The impact of annual volatility on investment portfolios has grown exponentially over time, and the average investor often grossly underestimates this impact.The volatility of an investment portfolio can be measured by calculating the deviation value of the annual rate of return. Volatility is caused by frequently fluctuating market prices. At the same time, losses were caused by valid transactions or irrecoverable impairment of capital. Failure to understand compound interest and how to adjust yearly volatility is probably the biggest cause of loss of principal. Managing volatility requires distinguishing between expected market returns and risks (beta returns), which stem from excessive activity between benefits and risks (alpha returns).

7. Adversity may be a gift

Effective recovery from loss requires as much effort as effective risk management.Many senior decision makers may stand still for a long time after suffering losses, which often exceeds the necessary recovery time. Worse still, they may have broken away from the investment beliefs they had held to, but are now being challenged, and missed their chance to make a comeback. Our experience confirms behavioral finance's early findings on “interrupting rationality” and rational decision-making, as well as behavioral finance's findings on the relevance of governance structures in maintaining discipline. Recovering from losses by rebalancing portfolios to maintain established investment strategies is critical to ultimately superior performance.

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8. It's hard for ordinary people to beat the market, but experts may be able to

Under expert guidance, active management works better than passive management. The passive way to manage market assets is suitable for inexperienced ordinary investors.When formulating passive investment strategies, investors should pay attention to valuation to avoid taking over at a high level. If you're facing a market segment and competition is limited by regulation or other factors, an active management approach may benefit you even more. In some markets, long periods of apparent market fragmentation create pricing anomalies, and experienced, non-dogmatic investors who are not bound by rigid rules of governance or other restrictions (some self-imposed) can take advantage of this.

The high-yield bond market is one example, but other markets also face the problem of supply and demand being split, making it impossible to bring prices to an equilibrium level. The M&A market has experienced continued fragmentation, as has the emerging technology market. Since unrestricted investors or “preferred” intermediaries can buy these assets at relatively low discounts, these assets can provide them with a medium- to long-term asset advantage. The “preferred” intermediaries referred to here are those that can provide a competitive advantage for the future of assets (able to provide communication, coordination, or management expertise for asset management). In addition to high-yield bonds and hedge funds, private equity and venture capital are also quite divided markets. In such a market, many “preferred” intermediaries can have a price advantage.

9. Alpha is hidden in the details

“Sorting out” the risks you face is another simple method that can increase your alpha.For example, a manager's ability to pick stocks may be overshadowed by the large amount of cash he holds (he should have taken the opportunity to temporarily invest that cash). Without limiting managers' trading authority, hedging cash risk exposure using stock futures would increase market risk exposure. Some investors may mistakenly abandon such a manager unless that manager no longer continues to hold large amounts of cash, as this would impair its ability to make decisive transactions.

10. Beware of bad apples

Too often, bad governance does more damage to portfolios than bad managers.Markets and managers can recover from cyclical losses (return to average), but recovering from losses that have been damaged by poor governance decision-making processes is not easy. A poor governance structure within a board or investment committee usually shows the following:

• Managers are changed frequently.

• Frequent changes of committees or staff.

• Keep an eye on practices that have seemed useful over the past 3 to 5 years.

• Negative or zero growth has continued over the past 7 years.

• The manager was fired for poor performance in a short period of time.

• The conditions for hiring and firing managers are too simple.

• The process of hiring managers is similar to a continuous beauty pageant process.

• Sorting asset classes into separate categories in a vertical manner ignores intersecting investment opportunities between asset classes. The way a basket is arranged may be a good choice, but it is important to focus on investment opportunities that exist between baskets (some investment opportunities do not belong to a specific basket) or within different baskets. The basket here means that factors such as value, growth, and small-cap stocks are all included in it.

• Management costs are too high compared to asset appreciation.

• There is a conflict of interest between the trustees.

Editor/jayden