Portfolio Management 101: Our Fundamental Philosophies

INTRODUCTION

The foundation of the Fisher Investments investment philosophy lies in the inherent belief in capitalism in free markets. Driving that belief are basic economic principles you may be familiar with, but may not have thought of in the following regard.

Supply and Demand

First is the law of supply and demand, a commonly known concept, but rarely applied to securities pricing. Supply and demand for securities are not reflections of contemporaneous events. The supply of securities is almost completely fixed in the short run, as it takes time and effort to create new shares. Therefore, demand is a more indicative variable of short-term market pricing. By monitoring the demand for securities, we can forecast market expectations. In the short-term, demand, measured by investor sentiment, has the most influence on pricing, while over the long-term, pricing is almost completely a function of supply.

In the long run, supply is the dominant determinant of securities pricing since their supply is nearly completely variable. There is no limit to how many shares may be issued or retired. When the price of securities is low enough, demand becomes infinite for securities. At a certain price level, supply becomes virtually infinite, as investment bankers have incentive to create as much new supply of securities as possible. An excellent proxy for securities demand is investor sentiment. Sentiment oscillates constantly, but it usually varies within a fixed bandwidth. When people anticipate losses, they instinctively sell and park the proceeds in cash until they feel confident enough to invest again. When investors are most pessimistic, they will have already sold, and the next shift in sentiment by default, is up. Once their selling pressure is exhausted, a springboard effect takes place when, at marginal prices, there is suddenly greater pressure to buy than pressure to sell. Prices can then rise quickly as the previous selling pressure dissipates. As demand increases, prices rise. On the way up, those who were most worried and sold their stocks low gradually regain confidence and begin buying as prices rise. This is the proverbial "wall of worry" bull markets climb.

Efficient Markets

In conjunction with supply and demand is the theory that markets are efficient—that capital markets discount, or reflect, all widely known information. Pertinent information about public companies is public information. News travels fast, and the knowledge and expectations of investors are absorbed by the market as quickly as they are acknowledged. Those seeking to profit act on every bit of news, rumor, and speculation that is available, such that any obvious opportunities vanish before they can be seized. Therefore, one must have new or different information than all others to achieve excess returns.

Capital Markets Technology

Some of those who believe markets are efficient conclude that attempting to beat the market is futile. However we think it's possible to add value by interpreting popular information differently yet correctly, by developing tools to extract new understandings from this information. About twenty years ago, Ken Fisher pioneered the Price to Sales Ratio for investment analysis. We have continuously sought to innovate capital markets science and technology for the benefit of our clients.

Benchmarks and Relative Return

A common objective of investors is to beat the market, but few identify a market to beat. Broad equity indexes like the S&P 500 or MSCI World make good proxies for market performance and hence, a benchmark against which to measure success. However even when measuring success against a benchmark, some forget the importance of relative return versus absolute return. Relative return is the return realized relative to your chosen benchmark. For instance, 5% may not seem like much in absolute terms, but if you achieve 5% return on your portfolio when the market is down 15%, you've beaten the market by 20%. Likewise, a 10% absolute return might sound better, but if the market returns 20%, you'd be disappointed for having lagged your benchmark by 10% in relative terms. We discuss how to choose a benchmark, and why to use one, in the pages that follow.

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