Investor

What is an investor?

An investor is someone who wants a greater return on their money than bank deposits can deliver. To achieve this, they are prepared to run greater risks in the hope of greater eventual rewards. Wise investors never forget they may lose all their money.

Where have you heard about investor?

Financial services advertising focuses on 'retail investors', the individual investors who buy and sell securities for themselves rather than a larger organisation. 'Institutional investors' are the organisations that invest on behalf of their members. Pension funds, hedge funds and mutual funds are some examples of these larger investors, which often feature in reports on huge infrastructure projects.

What you need to know about investors...

Investors are often seen as people backing a new business venture. Plenty of such investors do exist, but so do those who buy government bonds or shares in long-established big businesses. Investors can be enthusiastic amateurs playing the market, or experienced solo operators or well-capitalised investment firms with billions of dollars of assets under management.

While most jurisdictions provide compensation for defrauded investors, none is available for those whose investments have simply not worked out. Investment, whether in relatively safe assets like bonds or more speculative ventures, always carries some risk.

Types of investor

You will hear about many types of investors, from angel investors to ethical investors, but these refer to the things they are investing in rather than their own characteristics. Essentially there are two types of investor, retail and institutional.

Retail investors are individuals operating on their own account or trusts acting on behalf of individuals. As they are not allowed to be members of any stock exchange they must buy or sell through broker-dealers.

Institutional investors are large entities investing on behalf of their clients, such as pension funds, hedge funds, unit trusts or mutual funds. Client assets might be held by broker-dealers but can also be held by custodian banks. Hedge funds are generally regarded by the market as having a greater risk appetite than investment managers acting on behalf of, say, pension funds. Investment collectives such as private equity funds acting on behalf of a group of individuals are still regarded as institutional investors.

Investment strategy

Investment can be defined along three lines:

Which of these broad groups is best suited to each investor will depend on their circumstances, goals and desires. How often can they invest and how much? How long do they want to hold onto the investment? How quickly might they need to realise their gains? What is their attitude to risk? Are they experienced or do they need advice? What sort of return are they seeking - capital appreciation or income?

Outlined below are some common investment strategies.

Buy and hold: as its name suggests, the investor buys shares or funds with a view to holding them for a long time in the hope of capital appreciation and/or income. The idea is that holding over the long term will flatten out volatile market periods. This also removes the imperative for the investor to try and buy at a market low and sell at a market high.

Value vs growth: essentially, value investing is looking for a bargain. The investor believes that the market is currently under-pricing a selected company’ shares and that it has a higher intrinsic value. Growth investors focus on the earnings potential of the company and whether this is forecast to beat the rest of the sector. In both cases, the aim is to maximise capital appreciation.

Dividend growth investment: certain companies, especially large caps, have a strong track record of increasing dividend payments over time and also tend to have more stable share prices. Investors who reinvest their dividends will gain a compound benefit over time.

Indexing: the investor buys a small share of all of the stocks in a given index such as the FTSE 100 or more easily they can do the same thing via a mutual fund or exchange-traded fund (ETF).

Passive and active: buy and hold is regarded as a passive investment strategy as is investing in index funds, which will track a portfolio rather than trying to outperform it. The advantage is that less analysis is required and fewer trades undertaken, keeping costs down. Active traders try to bring superior financial skills to bear to outperform benchmarks.

Momentum trading: this is an example of an active strategy where investments are chosen according to their recent past performance, typically a stock that is moving strongly in one direction with high volume. This is a short-term speculative investment strategy. Other technical and speculative trading strategies include ‘long short’ and ‘pairs trading’.

Contrarian: the investor buys many shares in a strong company in a depressed market with a view to make a profit in the long run. A strong company is one with solid fundamentals: for example earnings potential, the financial ability to withstand the down market and a defined competitive edge in its sector.

Investment bias

Shoppers will often employ sophisticated thought processes to justify the purchase of a new pair of shoes or a smartphone. Investors are human too, well much of the time, and are prey to the same instincts. The difference is that investors can lose many thousands of pounds if they make the wrong decision.

A whole investment psychology has grown up within financial markets with investors aiming to forewarn themselves and avoid making irrational purchases. The various pitfalls have come to be categorised into two types: cognitive bias and emotional bias.

The CFA Institute has identified 20 biases as shown below. Organisations run courses on the bias topic and there is too much to discuss here so we will explain a few of the more interesting or less obvious ones below.

Cognitive dissonance: here an investor has two opposing thoughts at the same time. This is best illustrated by way of an example. The investor decides a fair price to buy share X, which is currently trading at £23, is £20. However the market then experiences an upturn and the share price starts tracking up to £26. The investors’ valuation is being contradicted by the market and they end up buying at £27 to align with the trend and remove the apparently conflicting valuations. This is not a good reason to buy the shares at that price.

Confirmation bias: it’s human nature to value opinions that align with your own. This is how newspapers have succeeded over decades and social media works in a similar way. The same goes for investors who find one research report that tips the stock they were eyeing and buy. What about the three other analysts with a ‘sell’ recommendation?

Framing bias: here the investor will make different decisions based on the context of exactly the same offer. To return to the shopping analogy, we are more likely to go for meat that is 80% lean than that labelled with 20% fat. Similarly, investors are more likely to seek risk when something is framed positively and avoid risk when an investment is framed negatively.

Recency bias: this is where investors make incorrect decisions about their portfolios based on recent market performance or how they perceive recent results, leading to a flawed outcome. They may for example be looking at a small part of the cycle that does not fit with their portfolio strategy.

Loss-aversion bias: a paper loss is a lot more palatable to an investor than realising the reduced cash from a stock that has fallen by 30% since it was purchased. But rationally the under-performing stock may be reaching its intrinsic value and the albeit smaller sum realised could be reinvested into a stronger stock.

Overconfidence bias: this is the investor who believes they have more information or superior skills to their peers. For example the amateur investor who thinks they know about computing company shares because they work in IT. The market has caught out many experienced financial professionals, let alone small investors with limited time and resources.

Status-quo bias: investors can be reassured by familiarity and may end up returning to the same investment universe they researched back in the day. This approach might not be disastrous but the lack of confidence or laziness not to investigate new options is likely to limit investment gains.

Endowment bias: this is where the investor assigns an irrationally high value to what they own and lose objective sight of what the market is prepared to pay for it.

There are plenty of other investment biases based on fear, greed or incorrect extrapolations of outcomes.

How to overcome bias

Ignoring investment hunches and impulses is hard and takes time and experience. A good way to bring these into check is for the investor to set themselves strict parameters on how they want to trade and not to deviate from those rules.

A spreadsheet is a useful way to keep track of the performance of every stock to assess the returns and associated risk. Investors can set upper and lower targets, either in absolute terms or relative to their preferred benchmark index, and then buy or sell accordingly.

Find out more about investors…

Thisismoney.co.uk March 2017 provides a sketch of five investor personalities based on their risk appetite: What type of investor are you?

From a mutual fund perspective, if investors want to take more of a back seat, The Balance in October 2017 published its guide on: The Best Investment Strategies.