The science of investing
Investing involves making assumptions about the future. What are researchers in Finance contributing to in a world full of uncertainties?
Finance and Investments:
Even though complicated at times, Finance research provide plenty of ground rules for how governments, companies, and even you, should and should not invest.
Knowledge of finance enables you to evaluate which investments can be profitable. Does that mean that finance researchers are fit to tell you how to make the most money by investing?
The short answer is yes. Before we look at some examples, let's quickly review what this fascinating and confusing field is all about.
Investment is about risk and return
Many may still associate the word finance with the stereotypical Wall Street broker, but the truth is that this is a pretty small part of what this field is about. The scope of finance is broad, not least regarding its subset investment.
An investment can be as simple as saving an amount of money each month but instead of depositing it to your savings account, you place it in an index fund. The bank will place the money in funds they consider safe, but with a bit more risk than if you had opted for keeping the money in your account. In return, you can get higher returns for what you invested.
What is the best strategy?
As we have seen, investment is about risk and return. However, the key is knowing how to best manage the capital you have available, and the more money at stake, the more critical it becomes to apply the science behind it all. Therefore, researchers are studying the advantages and disadvantages of various investment strategies.
In contrast to investing in index funds, an active investment strategy is about beating reference indexes over time using your own analyzes. At the very extreme of this scale, we have investors who go to even greater lengths to make sure their investments will be in good hands in the future. These investors buy shares in a company with the intent to gain control and influence its management's decisions.
Researchers Øyvind Norli, Charlotte Østergård and Ibolya Schindele have studied this group. The findings were that these investors usually single out companies where it's easy to buy shares. On average, they bought nine percent of the shares in the companies before they used their ownership to exert influence and earned an average of 8.5 percent in return on the capital they had invested.
In short, active investment can potentially achieve higher returns, but demands more resources and is therefore more costly.
Citizens are investors too
The Government Pension Fund of Norway, or the Norwegian oil fund, manages the of revenue from Norway’s oil and gas resources so that this wealth benefits current and future generations. It is not uncommon for governments to make various investments to ensure future growth, but the fact that the fund is the largest of its sort in the world, creates a need for especially strict supervision.
In this regard, financial researchers play an important role in the scrutinization of decisions that are made on behalf of Norwegian citizens, but that most people don't understand. The name of the organization that makes these decisions is Norges Bank Investment Management (NBIM). In 2015, Professor Richard Priestley criticized NBIM's management and their investment strategies for taking too much risk.
After a thorough examination Priestley and other researchers concluded that a practice described as "betting" was leading to an annual loss of 9 billion NOK. With updated data in 2017 and 2019, the researchers were still not happy with what they found. After costs had been deducted, fund was still losing billions from its active investment strategy compared to what it would have earned by investing in index funds.
At the crossroads
Associate Professor Espen Henriksen has also been following the Oil Fund's strategy in closely. When a committee appointed by the Norwegian Ministry of Finance in 2017 recommended separating the oil fund from the central bank of Norway, he expressed his concerns. The professor worried that the new organization would lead to more focus on business practices involving more risk taking. When the government considered whether the fund should invest in unlisted shares in 2018, he was equally critical for the same reasons.
The question Henriksen raised was whether the fund was suited for these types of operations. According to the researcher, the Oil fund had until then had been following a specific formula of success: It had made its profits by sharing global risk through investments spread out in various index funds. One of his main arguments against more active investment was that privately owned companies would be better equipped to compete in the market. Hence, Norway would lose money on such a strategy in the long run.
Investment in times of crises
One thing is how to invest, but when should you buy and when should you sell stocks? The perfect answer does not exist unless you can predict the future. However, financial theory still can teach you a great deal about what you should do in particularly uncertain times.
Henriksen explains that the question you should ask yourself is what happens to your values if the news in the next few weeks is worse than expected? Could your finances carry more bad news?
If you think bad news will weaken your ability to bear risk, and that you could easily be worse off than with others, the answer is most likely that you should sell the stocks you're sitting on. If the shares plummet, it is best that the value of the rest of your savings doesn't drop at the same time.
On the other hand, if you think that more bad news won't have much of an impact on your earnings, and that you are better off carrying an increased risk than the average investor, you may want to consider holding the stocks or buying more. At best, you can reap rewards because the premium for risk taking in the stock market has increased. If you lose money in the short term, you will at least be able to withstand it. A third alternative is to follow the evergreen advice to sit quietly in the boat.