An understanding of what speculation is, will allow a better understanding of the essence of the investments and strategies we carry out
An understanding of what speculation is, will allow a better understanding of the essence of the investments and strategies we carry out. The people who show the deepest understanding of the risks and investments of money are those who have made many investments of money during their years and not university professors or other theorists. Just as it is not possible to learn how to shoot a rifle theoretically, so it is also not possible to truly understand the essence of speculative activity without investing your own money or that of others. At the same time, the word speculation can be given a somewhat extreme interpretation: anything that differs from the ability to invest in a channel that guarantees a risk-free return. After we clarify what a risk-free investment is, we will also know that we all engage in speculation to one extent or another. Even investing in a bank deposit is a speculation that very few are aware of. The essence of speculation is our assessment that the bank will not go bankrupt and that the day comes when we need our money we will be able to get it.
A risk-free investment
A few years ago I received a strange cell phone call. The person on the other end refused to identify himself, but wanted to receive my consulting services. I explained to him that this is an expensive service, but he immediately interrupted me that money is not the problem. What is it about I asked. His answer surprised me - it turned out that he invests all his money in US government bonds - Treasuries. Well what's the problem I asked. Is this a safe enough investment channel? was his answer.
The very question made it clear to me that this is a person with a huge fortune. An Israeli or any other person in the world, who invests all his wealth in Treasuries is a person who has so much of the product called money that he can afford to give up higher interest rates in bank deposits.
After I met with him, it became clear to me that he is one of the richest Israelis, a man who made his entire fortune from high-tech and founded one of the largest and most successful high-tech companies in Israel. The bank statements he showed me made it clear that his fortune at the time was about 250 million dollars in cash, registered in his name in banks in Switzerland and the USA, with all the money being invested through them in a small number of Treasuries.
During the three meetings we conducted, I explained to him why US government bonds are the investment that is considered the safest in the world, the anchor, the benchmark of all investments. And if something happens to the US and she can't return the money? he asked in one of the meetings. If the US government can't return the money it owes investors, then the situation in the world will probably be so bad that it won't be our main concern, I answered him, and he laughed.
Nevertheless, from this wish I developed thoughts about a number of additional investment avenues that are considered very safe, in case the USA decides to go bankrupt, for example. I recommended that one of these investments be in gold, an investment product that has become less popular than in the past, does not pay interest but its price increases especially in situations where the world enters wars or other catastrophes occur.
But gold is a dangerous product in other ways because its value can fall and even fall a lot. This investment was suitable for the high-tech man who was afraid of global risks, but this investment is not recommended for a person who wants to guarantee a certain interest rate on his investments.
So what is a risk-free investment?
For investors around the world, a risk-free dollar interest rate is the yield on US government Treasuries. In Israel, the risk-free interest rate is the interest rate that can be received on Israeli government bonds (or Bank of Israel MCM). A Dutch citizen will see the bonds of the Dutch government as an investment with a risk-free interest rate and so will any citizen of a western country. We will add to this rule only the distinction that such an investment must be in a short-term government bond of up to one year, because of the leverage risk found in investing in longer-term bonds (including government bonds), but we will limit ourselves to this without expanding.
Hence, when an Israeli investor compares the annual return he receives on his investment, he must examine what is the return he could have received if he had invested his money in government bonds of the Shahar or Galil type, with a one-year term to maturity, or alternatively to the annual MCM return, of the Bank of Israel.
Is the interest you get on a one-year deposit in the bank also a risk-free interest?
No! Investing money in a bank deposit has risk. The risk is bankruptcy of the bank. So why do people deposit their money in the bank? Because this risk is very low. The banks are continuously supervised by the Banking Supervision Department of the Bank of Israel. Also, banks have very large equity capital and many control systems aimed at preventing risks from the bank. But in any case the bank is less safe than investing in government bonds. What would happen if you invested in government bonds and the bank through which you invested went bankrupt? The state in any case owes you the money even if the bank cannot return it.
If we summarize things up to this point, we can conclude that any investment that is not in government bonds issued by the country where the investor lives, is a more or less risky investment. ZA, any investment that goes beyond investing in short-term government bonds has speculative characteristics. Since almost all of us are interested in receiving a higher return or interest rate than the government interest rate yields us, we all engage in speculation to one extent or another, but what is a return that may be considered adequate for us as investors?
What is an adequate return?
Adequate yield is in the eye of the beholder. From a subjective point of view, it would be difficult to find two people in a room who would completely agree on the nature of a "good" return on an investment portfolio, how good it really is or whether it is not good enough. The answer to what is an adequate return is really complex, and it is often related to the way we analyze the information of the performance results of the capital markets at that time.
For example, in a world where investments in stock markets yielded 30% in a certain year, if a private stock investment portfolio yielded 20% at the same time, in the eyes of many this could be a poor return. In another year where the return from stock markets is zero, a 20% return is amazing. As with a risk-free investment, we look for an answer that is related to the "anchor" Benchmark on which we decide.
The world of returns is relative in the eyes of investors and it really depends on the degree they apply to measuring their personal return. Each investor makes a subjective decision about what is the appropriate return on his investment portfolio, by being exposed to different sources of information and different "stories" about returns that can be obtained in the market. He can receive true or false information from his neighbor, for example, who has an investment portfolio with similar characteristics to his and decide that if the neighbor "made" 8% in 2005, and he made 10%, then he did well. This is possible regardless of the fact that an average investment portfolio similar in characteristics to those of both of them made 12% that year, thus both his portfolio and the neighbor's portfolio "didn't make enough" in 2005.
For psychological reasons, most investors would prefer not to get a better return than their friends if they have to risk receiving a lower return than their friends, God forbid. Studies show that the "caress" that the investor receives from knowing that he obtained a higher return than most of his friends, does not compensate at all for the "slap on the cheek" that he receives if he received a lower return than most of his friends. ZA, most investors would prefer not to take a risk and settle for the average.
Even professional players often prefer the "good place in the middle" method. Most institutional investment managers prefer to generate a return very close to the average level of returns of their rivals. They prefer not to take risks in order to obtain a higher return than their competitors and this is to avoid an embarrassing situation in which the return they provided is lower than that of the competitors and customers will leave them, or in a worse case personally - they will be fired. Being in a good place in the middle is an important rule among managers of large brokerage firms, although they will never admit it.
Well, we have explained the issue from a psychological point of view, but we have not yet determined what an adequate return is. The accepted way to understand what is an adequate return of an investment portfolio is to divide the portfolio into channels according to stocks, bonds and foreign exchange and to examine the weight of each channel in the investment portfolio. After that, it is necessary to examine what each such channel has done since the beginning of the year, how much return the channel has generated and weight the results according to the weight of each channel in the portfolio. If the private investment portfolio yielded a higher return than the market yield, the portfolio was successful, if it yielded less than the market, the portfolio was not successful. It is advisable to examine this parameter patiently over a long period of time, i.e. start the measurement at least half a year after the initial investment phase and not reach hasty conclusions before at least a year has passed since the beginning of the measurement.
Adequate return - the academic way
The accepted and popular academic way of examining an adequate return is the "Sharpe index". This is an index that measures not only the return but also the risk inherent in achieving this return. William f. Sharpe calculated an index that became a global standard. Method of calculation: measure the monthly yield generated by the asset/investment minus the risk-free monthly interest rate and divide the result by the monthly standard deviation of the asset/investment yield. The higher the Sharpe index, the better the result.
The Sharpe index of a specific investment is measured against the Sharpe indices of investments with the same characteristics, but can also be measured absolutely against any investment.
