The increasingly prominent role of interest rate trends in budget debates is a new reality facing policymakers. The rising costs associated with borrowing also have a significant impact on business leaders’ investment decisions. The bar must be raised—not only to ensure the best possible service, but now also to recoup the higher interest costs.
This is because they reduce the leverage effect and extend the net payback period associated with debt-financed investment projects. A thorough understanding of the project’s feasibility, payback period, and economic sensitivity is becoming increasingly important for business leaders responsible for investment decisions. In times when money is no longer free, these considerations will increasingly come to the forefront. The scope for non-core investments is narrowing.
However, as an asset manager, these choices are at the heart of our responsibilities. Determining which asset class or stock will generate the highest return on your capital based on today’s information is a dynamic process that involves a multitude of considerations (regardless of whether interest rates are negative, at current levels, or higher). Nevertheless, one principle remains at the forefront: investing in what we understand and monitoring underlying developments in these companies, while continually evaluating them against the initial investment thesis. These insights are translated into a diversified portfolio that supports purchasing power over the long term. It is precisely this aspect of diversification that is a strength for active managers such as Econopolis, at a time when passively managed funds are increasingly neglecting these considerations and the degree of diversification is steadily declining, resulting in a concentration in a select group of stocks.
As an entrepreneur, you don’t have a daily stock price for your company. What remains is perhaps even more essential: in-depth knowledge and insight into the latest technological developments, the financial health of your company, or that of your most important customers. All these factors enable you to adapt your strategy, to the best of your ability, to the changing circumstances your company needs to grow in a financially sustainable way.
A double-edged sword of entrepreneurship may well be the lack of diversification: on the one hand, this is actually an advantage—as an entrepreneur, you can focus on what you know best and where you can have the greatest impact. This in-depth knowledge and accumulated experience allow you to make increasingly better investment decisions. On the other hand, however, your business accounts for an increasingly large portion of your total assets as it experiences sustained financial growth. The sense of control that comes from years—or sometimes generations—of experience and knowledgeallows you to accept the increasing concentration of your company’s value within your total assets. Especially in capital-intensive or cyclical sectors, it’s not always straightforward to effectively “trim” this exposure by paying out dividends.
A major advantage of investing in the stock market is that diversification is much easier. Although the arguments do not relate exclusively to the defensive aspect, as is so often claimed. A groundbreaking study by Hendrik Bessembinder, based on data from 1926 to 2016 on U.S. stocks , shows that only 4 percent of the stocks in that data set accounted for all returns that exceeded those of bonds over that period. In other words, a full 96% of the stocks in that study did not generate a return higher than that of bonds between 1926 and 2016. An extremely concentrated portfolio increases the likelihood that you’ll miss out on those winners. But a portfolio that’s too diversified also prevents active managers from identifying the winners among the vast majority of stocks. A thorough understanding of the stocks in the portfolio is therefore crucial for identifying those winners—and perhaps even more importantly, for holding onto them during periods of market volatility and for deciding whether to buy more at an attractive price. There is absolutely no hard-and-fast rule for striking this balance in diversification, and as the macroeconomic situation changes, it’s a good habit to spread your investments rather than concentrate them in a select group of stocks that are (whether temporarily or not) riding high.
Given the current concentration, choosing a passively managed fund is an active choice in favor of a select group of “winners”; the top 10 in the global index account for no less than 25% of the index’s weight. Being aware of this is an important first step, but at current levels, a solid understanding of the financial growth prospects of those “winners” may be even more crucial. You’ll quickly realize that the cognitively easy choice to buy an ETF—given the increased concentration— increasingly requires a solid understanding of the stocks that make up 25% of the index.
Source: Bessembinder , H. (2018). Do stocks outperform Treasury bills? Journal of Financial Economics, 129(3), 440–457. https://doi.org/10.1016/j.jfineco.2018.06.004
