How much is it worth? Thats a question relevant to
any asset you own. The worth of that asset will provide
you with either a sense of joy or sorrow, satisfaction or
disappointment. There are two key assets in your portfolio
where valuation (sense of worth) is key. They are property
and stocks. The latter is topical because of the debate
surrounding the RBTT transaction and the former is topical
because of the extremely high valuations currently attached
to local real estate.
In assessing the value of an investment an important factor
is its liquidity. If you believe an investment to be worth
$100 but there are no buyers on the market willing to pay
such a price then all you really have at that particular
point in time is a theory. The real value of the asset at
that particular point is the price at which someone is willing
to purchase that asset.
The more persons willing to purchase an asset at a particular
price the more realistic is the price being quoted. This
is exactly what liquidity is all about and its existence
is an effective pricing mechanism. There are many classes
of investment assets competing for your money. The ones
that are more liquid are generally the ones that are more
A liquid stock may be much more attractive to hold than
say land, jewelry, or art since it should be easier to sell
if needed. Similarly, a liquid stock may also be more attractive
than a fixed deposit or other term products since these
often carry a penalty for early withdrawal.
In addition, understanding the role of liquidity in classifying
an asset as an investment is crucial if you are to make
the right choices with your money.
Take for example, the run up in property prices in the US
(something which we are currently experiencing here in T&T).
Many in the US viewed their house as an investment so when
the value of the property went up they began to feel wealthier
and began to consume more. Some even went to borrow against
the increased value and used the funds to fuel further consumption.
The reality is that these people were misguided in their
actions and may even have been mislead by those who are
supposed to know better. Your house does not qualify as
an investment. It is an asset, yes, but not an investment.
Your house is your home, the place where you live.
An investments value is determined by the price at
which it can be sold. If you sell your house then you have
no place to live. If the value of your home increases then
it is likely that the value of other properties are increasing
as well so unless you plan to take a step down in your standard
of living, selling your home usually means utilising most
if not all of the proceeds to acquire another place to live.
If you consumed more based on the value of your home but
you are not in a position to sell at the high valuations
then when the market adjusts, as it must, you can very likely
find yourself in financial difficulty. This is exactly what
has happened in the US leading to the subprime issue in
particular and a high level of default on mortgages in general.
The bottom line is that the house you live in is never an
investment, never was and never will be. Any suggestion
to the contrary should be viewed with caution.
Boom and bust
The lesson here is that you really need to understand the
asset that you own before you can attach an investment value
to that asset and further, you need to understand where
that value lies in the cycle associated with that asset.
An observer of a market would realise that prices move from
boom to bust and then back to boom again.
Even though there is always a fundamental or intrinsic value,
human nature being what it is tends to extrapolate from
a particular point so that good news leads to a feeling
that more good news will follow causing prices to rise above
the fundamental value and bad news leads to the same process
causing prices to fall below their fundamental value.
This is the reason why you will buy a stock and be unwilling
to sell it when the price goes higher or sell a stock after
it has already fallen by a significant amount. Investors
should juxtapose this insight against the movement of the
RBTT share price over the past couple years to see if the
theory matches their actions.
How many investors actually sold RBTT at around $45 a few
years back? Not many, since there was the expectation that
the price would go higher. This view was not based on expected
earnings but rather simply because the price had moved rapidly
upwards in the past and we expected it to continue this
trend into the future.
Similarly, how many investors sold at prices lower than
$40 to 45 based on the expectation that the price was falling
and would therefore continue to fall.
It is important that you appreciate whether the purchase
of a stock at a particular price was based on an understanding
of its intrinsic value or based on an emotive response to
price movements. These two contrasting ideals highlight
the difference between risk and uncertainty.
According to one school of economic theory, risk occurs
where the probabilities can be assigned with confidence.
In this context we know that valuations are subjective and
different methods give rise to different valuations. The
best we can hope for is to establish a range of values.
Risk in this instance means that the price of a stock should
reflect the range of reasonable valuations available so
that while the stock price may be variable the variation
is based on the underlying valuation range; the possible
prices can be assigned with confidence.
If stock prices are instead based on an emotional reaction
to past price movements then there are no precise probabilities
to rely on in assessing the future.
In such instances the stock price is subject to sudden and
rapid changes causing investors great discomfort in the
If you understand the concept as it relates to a particular
stock, then it becomes easy to translate this insight to
the wider economy. As an economy continues to grow and prosper
(take T&T or the US over the past few years as examples)
people begin to expect that the economic growth will continue;
the future will be similar to the present.
Companies in various sectors in the economy that are most
profitable will be rewarded very well for taking on higher
levels of risk. Success from this type of behaviour will
see similar actions being taken by others in the same sector
or by companies in different sectors. If a bank takes on
additional leverage and is rewarded by increased profits,
other banks may follow suit or risk incurring the wrath
Companies in other sectors may increase their level of borrowings
as well or take on other types of risks. The growing economy
means that these actions will produce profits easing any
fears that the increased borrowings may go unpaid.
In addition, economic growth is usually associated with
low levels of interest rates further encouraging companies
to take on leverage. Low interest rates means that the risk
free rate (Treasury bills) is also at low levels. The longer
this environment spans the more risk that a financial institution
will have to undertake in order to maintain or enhance its
rate of profit growth.
The combination of home owners mistaking their homes for
an investment and the need for ever increasing levels of
risky assets in order to fuel bottom line growth offers
a potent mix that has lead to the type of write downs that
we have seen from financial institutions around the world.
Stocks of companies in the financial services sector have
declined as much as 50 per cent over the past few months.
Investors now need to do some homework to determine how
much of those declines are due to a change in fundamental
value and how much is attributable to a negative market
sentiment. The answer will determine what you buy and when.
Ian Narine is a stockbroker registered by the
Securities Exchange Commission.
Todays article marks four consecutive years of writing
in the Business Guardian.
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