Saturday, 23 July 2011

Financial Investment – Art, Science or Gambling?

In principle, everything we buy can be treated as an investment and therefore to a large extent investment is like breathing, something that everybody knows about. However when dealing in financial assets we should avoid the traditional statement that investment is the commitment of funds with the hope of gain, or a process of buying and selling securities with a view to get the greatest possible return, or, more plainly, the art of buying low and selling high.

This is so because the services provided by financial assets (money, securities, contracts or hybrids) include the protection and transfer of wealth, the facilitation of partial ownership and the provision of liquidity. That is the utility we derive from them depends primarily not on its material use but on rotating our exposure to them so that we may profit from distributions and changes in their market value (mostly in secondary markets).

Thus, we define financial investment as “a process of rotation between financial exposures which at the time of our choosing will allow us to attain the highest possible net liquidation value above that achievable without rotation and risk”. This means that at any given moment in time we may compare the valuation of our holdings in long, short and hedged positions in financial instruments with the valuation of such portfolio in a previous date.

The success of exposure rotation is the result of skill and luck. The skills required depend on the investment approach chosen (day-trading, event-trading or portfolio management) as well as on the strategies pursued. The net returns achieved may be amplified or reduced through taxation and leverage which also require specific skills.

Like in many activities the skills are both innate and nurtured through practice and education. Thus skills must necessarily be a combination of art, science and gambling. And, specific strategies and instruments require different combinations. For instance, investing in derivatives is closer to gambling while investment in fixed-income securities is more reliant on science.

In terms of science we could look at investment as an optimization problem defined as the maximization of total return over a given time horizon subject to a number of risk constraints. However, because of the uncertain nature of the investment outcomes, this mathematical formulation of investment is not feasible.

Alternatively we may look at investing as a form of gambling. To draw analogies with gambling we must distinguish games that combine luck and skill, like poker and football, from those that are purely games of chance like the roulette or the lottery. This distinction is fundamental because investment can clearly be considered as a game of the first kind, a game that mixes skills with luck but not a game based on pure luck or randomness.

Finally, we may define the investment activity as an art, an art not only in buying and selling but an art in forecasting prices and in undertaking calculated risks. What distinguishes science from art is not the degree of science and technique used in a particular activity but rather the creative and aesthetic nature of the activity. This is crucial to spot short-lived market imperfections and in this regard some view investment as a craft while others consider it to be the last liberal art.

Our preference goes to classify investment as a liberal art, defined as an activity based on worldly wisdom achieved by developing mental models enabling investors to extract knowledge acquired through multidisciplinary approaches (including the traditional disciplines of accounting, economics and finance, but also physics, biology, philosophy, psychology and literature). To a large extent, such an art form must be developed on an individual basis and as a self-satisfying activity.

Unfortunately not everyone can be an artist. However, the beauty of market capitalism is that not all investors need to pursue the art of investment. They may outsource it to honest professional investors.

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