By Daniel Archibald | CFA
Let me begin this attempt at a metaphor by confessing that I am hopeless at surfing and couldn't catch a wave if my life depended upon it. Nevertheless, I do think that the concepts I will look to represent below should still be valid.
Imagine that you are sitting on your board, out beyond the break, taking in the fresh salty air and enjoying the early light of a new day. Around you are a host of other surfers, many of which you see on your mid-week visit to your local beach, but also a few strangers who have obviously heard about the great waves with which your turf is blessed.
Though there are many of you, each surfer shares at least one main goal: To catch some awesome waves. Success is measured mainly by how long you spend on your feet, but also can be a combination of speed, power and tricks. Just as with any group, each respective surfer is likely to have their own individual preferences and their own way of attacking different problems or issues. And so each of you are likely to try and maximise your performance in slightly different ways.
Surfer 1 - The newbie
Inexperienced in the art of surfing, they are not likely to know what waves are best to attack and may not have the skill to ride the more advanced waves. They are likely to play it safe and stay out of the way of more advanced riders.
Surfer 2 - The follower
Like the newbie, they are likely to be a little inexperienced or may just find safety in numbers. They will spend more time watching other surfers than watching the waves coming through.
Surfer 3 - The out-of-towner
Though skill is not likely an issue, unfamiliarity with the layout of the beach and the temperament of the swell will induce a more conservative approach. They will likely spend most of the time following other skilled surfers, especially as they take the time to become comfortable with their surroundings.
Surfer 4 - The non-discriminator
They are the ones who catch every wave that comes by, regardless of height or direction. They may be likely to spend a lot of time riding, but they also spend time getting dumped or heading towards underwater dangers.
Surfer 5 - The grommet
With youthful exuberance and local experience, they are likely to be first out and first on to the next wave. However, their need to pull off awesome tricks is likely to see them crash off most waves early.
Surfer 6 - The local
At times aggressively territorial, they have an intimate knowledge of the beach; the breaks, the currents, the rocks, and the reefs. They know what a good wave looks like and will seek to enforce their rightful claims to an unimpeded ride. This can lead to frustration for both the local and others.
Surfer 7 - The old timer
Having spent decades coming down for a morning surf, they are likely to take their time out the back of the waves, patiently waiting for the best wave and looking to avoid the crowds.
Metaphor time… In the investment world there are many types of investors. There are those that follow. There are those that are contrarian. There are those without a lot of experience. There are those that aggressively take advantage of their experience. There are risk takers and there are risk minimisers. But, in general, all are trying to reach the same goal of maximising expected returns.
- Sometimes it can be good to follow - if you're not sure of the conditions, following those that do makes sense. However, just as trying to ride a crowded wave has its issues, a crowded market can make it hard to get into an investment at a reasonable price.
- Sometimes it can be good to avoid the crowds - markets move in cycles and contrarian investors can often pick up good rides on unappreciated waves. However, sometimes crowds avoid investments for a reason and there can be the risk of falling into the 'value trap' and being dumped onto a reef.
- Sometimes it can be good to ignore the crowds all together and just focus on the waves - fundamental investors focus their attention on the many dimensions of approaching investment opportunities. However, given that there are thousands of other wave watchers it is likely that many of the attractive rides are already full.
- Sometimes it can be good to be indiscriminate - index investing by definition means that you 'll likely have an average experience. You'll get plenty of wave time, but some of that may be trying to avoid a large crowd or worse, a rocky outcrop.
If you only watch the waves (investments) you rely upon your individual ability to pick good waves and run the risk of trying to get onto overly crowded trades. On the other hand, if you only watch other surfers (investors) you run the risk of missing good waves (whether or not you are following the crowd or looking to avoid the crowd). If you watch neither, you may have a more peaceful experience for most of your time, but riding the wrong wave becomes more likely. It is likely that to be a successful investor, you should keep an eye on both the waves and the other surfers and, in so doing, increase the chances of maximising risk-weighted returns.