16 May Wine and investing
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Our recent visit to Australia (six flights, four cities, two conferences and seven firm visits in two weeks) fortunately also included a couple of visits to the excellent wineries to be found in the country. An evening meal in a convivial atmosphere (even one spent with other financial planners) sampling some fantastic wines brought to mind the similarities between wine production and effective investing. I make no claims to be any kind of expert on the subject but over the years I have picked up a few things even if I still struggle to identify a Shiraz compared to a Cabernet Sauvignon.
There are numerous factors which affect the extent to which a wine is positioned on the scale from excellent to undrinkable. The soil, the climate, the location of the vineyard, the grape variety, the cultivation and the harvesting all contribute. However, once the grapes are picked, there is still plenty more that can affect the outcome. The crop must be crushed, pressed, fermented, clarified, aged and possibly blended before being bottled and stored appropriately. If any of the stages is not executed correctly, the result can be negatively affected.
Investment management similarly requires an attention to detail, in the form of identifying the factors that drive investment returns, creating strategies designed to capture them efficiently, constructing diversified portfolios and executing those strategies in such a way as to minimise the costs and thus deliver as much of the market return as possible to the end investors.
While a winemaker has no control over the weather, an investment manager similarly has no control over market returns. The winemaker cannot expect an excellent vintage from every year and neither can the investment manager but each can increase their chances of success by spending their time and effort on those things which they can influence.
For the former, this means picking the grapes at the optimal time for the characteristics desired. The latter, on the other hand, looks to target as closely as possible the risk factors which they have identified as providing higher expected returns while maintaining enough diversification to reduce the uncompensated risks such as that arising from concentrating on a specific sector or stock.
While fermentation is a natural process, it still requires input from the winemaker to ensure that it is delivering the desired outcome in terms of flavour and style. For an investment manager, it is useful to start with a theoretical framework to guide the process but in the real world, there are other factors that influence the outcome. A strategy which looks fantastic when applied to market indices (such as focusing on small companies) can come horribly unstuck when trying to apply to an actual portfolio when the frictional trading costs start appearing as these can diminish or even wipe out any gain from the strategy. For investors whose trades are subject to taxes, these too must be taken into account – the possibility of an extra £1,000 return a year from a cost saving by switching funds becomes less attractive if achieving it will entail a £100,000 tax liability at outset.
There are also external factors which can arise. Often these are unexpected (even though there are always those who point out after the event how obvious they were), such as political turmoil, a global financial crisis or a government defaulting on its debt repayments or imposing exchange controls. The best defence against these is a robust process which reduces their impact as far as possible, such as diversification across markets and asset classes. If everything in a portfolio is going up at the same time, it may not be diversified enough because sooner or later, it will probably be going down instead.
Although great ideas are important, the unglamorous application of robust discipline and attention to detail are easier to overlook. Yet it is often the implementation which makes the difference as even growing the best grapes in the best location will result in an undrinkable wine if the cork doesn’t provide a good seal. Oddly, the analogy still holds true with investing.