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Edward Chancellor

Edward Chancellor is a financial journalist and author. After reading history at Cambridge and Oxford universities, he worked for Lazard Brothers in London. He has written freelance for a number of publications, including the Financial Times and The Economist, and is currently assistant editor at Breakingviews, the award-winning financial commentary service. He also writes for Fred Hickey's High Tech Strategist, Smithers & Co, and Grant's Interest-Rate Observer.

Books

Devil Take the Hindmost, MacMillan, 1999

Crunch Time for Credit?: An Inquiry into the State of the Credit System in the United States and Great Britain, Harriman House Publishing, 2005

Capital Account: Reports from a Contrarian Fund Manager, Texere Publishing,US, 2004

Lessons from history

1. ‘Put all your eggs in one basket and watch that basket!’

This saying comes from Mark Twain, but has been applied to stock market investment more or less verbatim by both John Maynard Keynes and Warren Buffett. Modern portfolio theory suggests that one can reduce risk by diversification. However, it also suggests that the index represents the optimal portfolio, in which case one might as well purchase a tracker fund. However, most active investors would do better to concentrate their shareholdings in a limited number of companies which they feel they understand. This can actually reduce risk.

2. ‘When the ducks quack, feed them.’

This is an old Wall Street adage relating to initial public offerings. Investment bankers are not driven by philanthropy or even by an intellectual motivation to understand the world of finance. They are out to make money and will sell the public anything within the bounds of the law. In recent years we have seen a flood of second-rate IPOs, most of which are now trading at below their offer price. Research suggests that, in general, IPOs rocket upwards on the first day’s trading but tend to underperform comparable companies over a three-year period. Since small investors don’t receive fair allocations of the best IPOs but are landed with the duds, they should avoid the new issue market entirely.

3. ‘Markets make opinions, not the other way round.’

This is another Wall Street saying, which has been revived by James Grant, editor of Grant’s Interest Rate Observer. When markets rise, commentators find a way of rationalising the gains. Take the recent bull market. We were told that the ‘valuation clocks’ were broken and that companies deserved to trade on a higher price-earnings ratio. We were also told that US productivity had risen and that the US would experience a higher growth rate in the past. We were also told that Greenspan et al would prevent another cyclical downturn. All these comments were spurious rationalisations of an ‘irrationally exuberant’ market.

4. ‘Buy low, sell high.’

This advice seems obvious, but investors always ignore it. The demand curve for investment assets is like that for a luxury good - the higher the price, the greater the demand. Hence we see turnover rising during a bull market (when assets are getting more expensive) and falling during a bear market (when they are getting cheaper). Investors should always be prepared to act contrary to the market, and should always be prepared to question both the optimism at the top and the pessimism at the bottom.

5. ‘When the rest of the world is mad, we must imitate them in some measure.’

This observation came from the mouth of an eighteenth-century banker, John Martin, during the South Sea Bubble of 1720. It is another expression of the ‘greater fool’ theory, namely that you can buy over-priced shares and sell them on at a profit to some sucker. This speculative attitude has been much in evidence in recent years in the form of momentum investing. Of course, you can make money if you find a greater fool, but you also will lose your money if you don’t. Would you put $10,000 into a chain-letter? If the answer is no, then avoid momentum investing. Incidentally, Martin lost all his money when the bubble collapsed and complained miserably of being ‘blinded by other people’s advice’.

6. ‘During a bull market nobody needs a broker. During a bear market nobody wants one.’

This is another Wall Street saying, cited recently by Alan Abelson in Barron’s. An unkind English version comes in the form of a question: ‘What’s the difference between a good broker and a bad one?’ Answer: ‘Not a lot.’ We are now more aware than ever that most brokerage research is generally of a low quality and that broker recommendations cannot be followed profitably. This has always been the case, but the problem is exacerbated by the conflicts created by uniting brokerage and corporate finance under the same investment bank roof. Investors should avoid reading research by brokers whose parent company provides financial services for the company concerned.

7. ‘Every man his own broker.’

This is, in fact, the title of the first investment book, written by Thomas Mortimer in the 1750s. It was republished several times. If you can’t trust brokers, you must replace them. The problem is that the private investor is not well-equipped to do so. He doesn’t have access to company management and probably can’t read financial accounts with any sophistication. As a result, he is likely to make decisions on whim, many of which will be regretted later at leisure. Bull markets are periods of ‘people’s capitalism’ when the private investor figures prominently. Inevitably, the private investor gets burnt after the market collapses and withdraws from the market, handing it back to the professionals.

8. ‘Markets can remain irrational longer than you can remain solvent.’

This saying comes from John Maynard Keynes, the great English economist. He was also an acute observer of markets and a speculator. Keynes held his stock-market investments on leverage and was an active player in the commodities market. It is sometimes said that he lost three fortunes, but made four. So he died rich. The point of Keynes’s comment is that your observation may be fundamentally correct but it can take the market a long time to catch up. For example, the dotcom bubble ran for almost five years from the flotation of Netscape in the summer of 1995 to the Nasdaq collapse in March 2000. Many people lost a lot of money shorting the likes of eToys and Amazon.com before the market woke up to its absurd overvaluation of the sector.

9. ‘A mine is a hole in the ground with a liar standing over it.’

This saying also comes from Mark Twain. It should remind investors to be wary of all projectors, whether they are promoting gold mines, biotech or some other new-fangled technology. In general, the promise of outsize profits are followed by the reality of painful losses. You will make more money in the long run by restraining your greed. Incidentally, Twain had a personal investment maxim: ‘I never spotted an opportunity until it ceased to be one.’

10. ‘Be diffident when others exalt, and with a secret joy buy when others think it in their interests to sell.’

This advice comes from the English writer, Sir Richard Steele, in an article for The Spectator in the early 1700s. To my knowledge it is the first expression of a contrarian investment philosophy. The art of investment lies in judiciously going against the crowd. It is both intellectually more fulfilling to refute the market consensus and in the long run should be more profitable. Academic research suggests that unloved ‘value shares’ tend to outperform so-called ‘growth stocks’ over the long run.