I was interested to read a recent interview with a local financial adviser who was using food as an analogy to help educate clients about financial concepts.
In a world where many investors feel disempowered by investment jargon, I thought it was an innovative approach.
This got me thinking about the power of analogies and stories to help build knowledge and self-understanding.
The marshmallow test: In the early 1970s a psychology professor at Stanford University conducted a series of experiments with young children.
The experiment involved the offer of an immediate reward (a choice between a marshmallow or pretzel) or the prospect of a greater reward (two of the same treat) if they were willing to wait 15 minutes.
The findings suggested those children who had sufficient self-control to wait 15 minutes and receive the greater reward tended to have better outcomes in later life and not just in financial terms.
From my experience, this capacity for delayed gratification is one of the key indicators of an individual’s likely success as an investor, but it is not just about self-control.
Self-awareness allows people to build in processes that will reduce the level of temptation. Some simple examples are:
- Ensuring your savings are deducted from your income before it hits your transactional account. You are less likely to spend it if you never see it.
- Separating your savings into short, medium and long-term categories and using investments where different access criteria apply. This reduces the chances your annual travel fund could morph into Friday night drinks.
In investment terms, the marshmallow test is even harder because, as a long-term investor, you sometimes need to be able to cope with the emotion of watching your marshmallow shrink to half of its original size (i.e. experience a short-term market contraction) before rebounding and becoming four times larger.
Four coloured crayons and a sheet of A3 paper: Many years ago I was inspired by Prof John Leader at the University of Otago.
John was able to explain the most complicated matters in the simplest of terms.
This has led me to the belief that, if I can’t explain what I do and how I do it using nothing more than four coloured crayons and a piece of A3 paper, then I probably don’t understand it as well as I should. In my view, jargon and complicated explanations can be a front for a lack of understanding.
The voting machine & the weighing machine: The apparent irrationality of markets is something that many investors find baffling.
The father of a technique called value investing, Benjamin Graham, likened investment markets to being both a voting machine and a weighing machine.
His analogy suggests that for periods of time the shares for companies often become valued on their popularity alone (or voting as he puts it). During these periods, the value of a share may have little to do with the company’s intrinsic profitability.
With shares this can happen for an extended period, so it is dangerous to be completely out of the market at these times. However, over longer timeframes the market transforms from a voting machine back to a weighing machine.
When this happens the profitability of each company comes to the fore, or as Graham puts it, its true weight is uncovered. When this happens some previously highly valued companies become revealed as lightweight and the value of their shares can fall sharply. A general increase in the cost of money (i.e., increasing interest rates) can often be a trigger for this change.
For an investment manager, the challenge is to maintain focus on the matter that ultimately drives the long-term value of a company, business profitability; while at the same time keeping a weather eye, for the pure voting machine, which will periodically create surges in share prices.
For now, it looks like the weighing machine is more in vogue.
As a financial adviser, my role is quite different from that of the investment manager.
One of my most important roles is to help my clients not to despair when they see their marshmallows shrinking.
And to inspire confidence that the marshmallows will not just recover but will be even larger and tastier in the future. It turns out you can only eat your marshmallows once!
- Peter Ashworth is a principal of New Zealand Funds Management Ltd and is a Dunedin-based financial adviser. The opinions expressed in this column are his own and not necessarily that of his employer. His disclosure statements are available on request and free of charge.
