Five Central Investment Attitudes

Diversification: this is particularly important in emerging markets where individual country or company risks can be extreme. Global investing is always superior to investing solely on the investor's home market or one market. Searching world-wide leads an investor to find more bargains and better bargains than by studying only one nation.

Timing and staying invested: as Sir John Templeton says, "the best time to invest is when you have money." In other words, equity investing is the best way to preserve value rather than leaving money in a bank account. As a corollary, an investment should not be sold unless a much better investment has been found to replace it.

Long-term view: by looking at the long-term growth and prospects of companies and countries, particularly those stocks that are out of favor or unpopular, the chances of obtaining a superior return are much greater.

Investment averaging: investors who establish a program from the very beginning to purchase shares over a set period of intervals have the opportunity to purchase at not only high prices, but also low prices, bringing their average cost down.

Accepting market cycles: any study of stock markets around the world will show that bear or bull markets have always been temporary. It is clear that markets do have cyclical behavior with pessimistic, skeptical, optimistic, euphoric, panic and depressive phases (see Manias, Panics and Crashes). Investors should thus expect such variations and plan accordingly.

In assessing emerging market investments, Mobius stresses the importance of constantly being aware of influences and biases. These are strongest in the places where you spend most of your working and leisure hours and from where you obtain most information. For this reason, the emerging market investor must continually visit all the countries in the emerging market areas and read news and research reports originating from all over the world. (However, as a counterpoint, the internet now makes available a wealth of information on individual markets and countries perhaps better and less costly in time and effort than that obtainable on the ground.)

Emerging markets theory

As a category of equity investment, emerging markets may be considered to have begun in 1986 under the sponsorship of the International Finance Corporation (IFC), an arm of the World Bank. David Gill, then head of its Capital Markets Division, convinced the IFC to invest in equities in some of the strongest countries the World Bank was financing with debt, initiating private involvement in what had largely been a public domain. The Emerging Market Fund, which Gill started, gave its investment mandate to Capital Group in Los Angeles, a firm that now manages $75 billion in these markets. David Fisher has successfully managed this group since the early days.

But no one epitomizes the emerging market manager better than Mark Mobius of the Templeton Emerging Markets Group. Mobius meets the requirement for physical stamina of an emerging market investment guru. Now in his sixties, he is in top physical shape to maintain the pace of fifteen-hour days, seven days a week. From a childhood in the United States, he has been based in Hong Kong since the 1960s and travels on a German passport. His scope is global with more emphasis on the fast-growing economies, like Asia, that especially challenge an investor when reminded that volatility is two-way.

Mobius is a hard-headed investor in markets that do not usually inspire confidence. His tough valuation bottom-up discipline demands that investments sell at no more than five times earnings five years hence. And the cheaper the better for him. He is a fundamental investor who visits companies and studies the businesses, while fretting little over the country's macro issues (see Value Investing, Economic Forecasting and Politics and Investing). Since his techniques are common to the well-schooled analyst, he has to find different markets and different industries from other analysts. He is often out of step, buying investments that look like they may continue to decline. It is discipline the old-fashioned kind.

Mobius is a frequent commentator on emerging market investing and has written a well-received book, Mobius on Emerging Markets, which summarizes his keys to success:

Hard work and discipline: the more time and effort put into researching investments, the more knowledge will be gained and wiser decisions will be made.

Common sense: the clarity and simplification required to integrate successfully all the complex information with which investors are faced.

Creativity: looking at investments from a multi-faceted approach, considering all the variables that could negatively or positively affect an investment. Creative thinking is also required to look forward to the future and forecast the outcome of current business plans.

Independence: when making investments, it is most unlikely that committee decisions can be superior to a well thought-out individual decision.

Risk-taking: investment decisions always require decisions based on insufficient information. There is never enough time to learn all there is to know about an investment and even if there were, equity investments are like living organisms undergoing continuous change. There always comes the time when a decision must be taken and a risk acquired.

Flexibility: it is important for investors to be flexible and not permanently adopt a particular type of asset or selection method. The best approach is to migrate from the popular to the unpopular securities, sectors or methods.

Understanding Emerging Markets

"Emerging markets may be a euphemism but it is also a declaration of hope and faith," Mark Mobius has said. "Although some of the stock markets of developing nations may sometimes seem `submerged,' they are generally emerging into bigger and better things."

Such a definition of emerging markets expresses the typically optimistic view of people specializing in this branch of equity investment. Certainly, this relatively new focus of investor enthusiasm is always exciting with something happening all the time, somewhere in the world, with the opportunity for huge profits. Investment returns in some emerging markets have the potential to exceed those in the developed world.

But equally, for the dedicated emerging market investor, there are considerable challenges: the frequent frustrations of a lack of common standards and a lack of information, grueling travel schedules, language problems and cultural suspicions. And, of course, as the Asian crisis and subsequent global economic events have confirmed, stock markets and currencies in the developing and formerly communist worlds can be highly volatile, reacting strongly to international investor sentiment and economic and political changes.

Investments in emerging markets can result in spectacular returns, positive or negative. But picking potential winners, at the level of either country or company, is very difficult. There are frequently problems in comparing the relative merits of companies across markets: financial reporting and accounting standards vary, and indicators such as price-to-earnings ratios are often unreliable for international comparisons. Countries employ a variety of accounting conventions in their treatment of corporate profits.

It is clear that emerging markets carry considerable risks, including illiquidity, lack of transparency and sharp swings in prices. Individual investors seeking a stake in these markets should be either thinking long-term or prepared to take substantial risks. They should also consider carefully what proportion of their portfolios they can reasonably afford to commit to such markets.

Where Forecasting Goes Next?

Forecasting is a key task in financial institutions because of the profound effects economic developments can have on potential profits. And while leading economic indicators might provide a hint as to what the economic future holds, they do not anticipate what the additional effects of powerful economic agents like government policy and the financial markets themselves might be. To try to get ahead of the competition, companies will aim to model more accurately, and with more consideration of possible discontinuities in the markets.

One way to make forecasts more useful though not necessarily better might be to follow the principle of truth-in-labeling used on food packages and elsewhere. We could describe the kind of forecast we are making more accurately. For example, if we are using backtesting, we should say that that is exactly what we are doing and which of two varieties.

One form of backtesting is momentum: the forecast is derived from a view that the past momentum will continue in roughly the same direction often straight line as it has in the past. The other form is regression to the mean: we think things will not go back or up or down, but return to average conditions. This is like a series of coin flips that goes ninety-nine times in one direction, and we think the next event is related to the preceding one.

Alternatively, we can say that our forecast comes from our own insight or novelty, and label it that way so it is known as essentially out of our head and our own creativity or lack of creativity, which will be known in time. Sometimes different techniques like high-frequency forecasting come from this. Or it can come from news and our response to new news. This is not necessarily insider information but news that is not necessarily generally recognized by others a form of forecasting derived from information.

Finally, the most common form of forecasting is waffle: we do benchmark investing or stick to the middle because we do not know what else to do. That is perfectly all right, but we should label it as such. Let us say that is what we are doing, so people can understand what they are getting when they listen to us. Most of the time, a waffle is the right thing to do, but at all times, we can make our forecasts better by correctly labeling them.

Counterpoint for Peter Bernstein Theory

Financial analysts are professional forecasters. But why study the economy, a traditional lagging indicator, if you want to forecast investment measures? The investment record of this process is only rarely better than random and when you take account of the expenses of achieving these results, they come out a little bit less than chance. Why do it at all with that unconvincing record of success?

Economic forecasts are supposed to be meaningful. But if you believe that asset prices reflect a forecast of future outcomes, it would seem quite difficult to use a technique that reaches back into the past to get an idea of the future. But that is what economic forecasting does. It is teased for forecasting three recessions for every one hat actually happens. No wonder it is called the dismal science.

Financial Times economics columnist Sir Samuel Brittan makes a pointed reflection on the practice of forecasting: ''The golden rule for economic forecasters is: forecast what has already happened and stay at the cautious end. Forecasts tell us more about the present and the recent past than about the future."

Poor methods, bad models and inaccurate data are all blamed for the recurrence of serious forecast errors. But according to Oxford economics professor David Hendry, these are not the primary cause of systematic mistakes. Rather, unanticipated large changes within the forecast period are the culprit. The primary fault of economic forecasting is in not rapidly adjusting the forecasts once they go wrong.

Hendry uses an analogy from rocket science: a rocket to the moon is forecast to reach there at a precise time and location, and usually does so. But if it is hit by a meteor and knocked off course or destroyed the forecast is systematically badly wrong. That outcome need not suggest poor engineering or bad forecasting models and certainly does not suggest that Newtonian gravitation theory is incorrect.

Peter Bernstein and Economic Forecasting

Despite the pressures for early and often forecasts, a number of Wall Street and City economists do as good a job as any forecasters, among them Abby Joseph Cohen, Stephen Roach and Edward Hyman. Most such investment economists are good students of market conditions careful keepers of useful data, and on occasion creative in extracting some kind of signal out of the noise. Ed Yardeni, for example, the chief economist at Deutsche Bank Securities, turns his website into a cyber-chart room. If you want to access data and view charts, Yardeni's site is an essential stop. He also makes his commentary available in a section for clients that is password protected, but a substantial amount of the content is openly accessible.

One economic commentator stands amid the few that many of us would class as the best: Peter Bernstein. He grew up heading his father's investment firm, Bernstein MacCauley, in New York. He was the first editor of the Journal of Portfolio Management, founded by Gilbert Kaplan, and has received many awards, among them the
highest honor granted by the investment management industry's professional body, the Association of Investment Management & Research.

Bernstein is able to walk on both streets with practitioners and academics. He writes a newsletter, Economics and Portfolio Strategy, to test and disseminate his analyses. And writing is one of his main strengths: his two books on the history of risk and on how capital ideas came to Wall Street have been regulars on the business best-seller lists during the 1990s.

Like a good academic, Bernstein marshals all the arguments, especially those that are counter to his own position. His mid-February 1998 letter, for example, examined the case for exuberant stock prices in the United States, giving particular emphasis to the market's reliance upon an all-knowing Federal Reserve for economic management. Bernstein concluded that "stocks are a risky investment and should be managed accordingly." Since that analysis was approximately the same as his November 1997 conclusion, he was ahead of the wave and for the right reasons. Bernstein is also faster than most to admit where he has been wrong and to try to examine what led him astray or, as he jokes, "what led the market astray when it failed to act the way I thought it would."

Understanding Economic Forecasting

Almost every financial services firm has an extensive economic forecasting effort. It is usually part of a so-called top-down investment process, which starts with an outlook for the economy and monetary conditions, continues to the strongest industries, follows with detailed company study for stock selection and may include an overlay of technical analysis to provide a timing dimension. Some would add analysis of social and political conditions even before economic studies (see Politics and Investing).

Economic forecasts derive from models usually of the aggregate national or global economy, but sometimes of parts of those economies: particular industrial sectors, regions of the world or even single products or firms. Basic approaches to forecasting simply extrapolate the past; more sophisticated models attempt to understand the sources of past changes and build them into their forecasts. The latter requires knowledge of economic history and economic principles, though, even then, forecasting is by no means an exact science. But while the accuracy of economists' predictions is frequently a target of jokes, forecasting remains a popular pursuit.

Forecasts for the macroeconomy are published regularly by academic institutions, thinktanks, governments, central banks and international organizations like the OECD and the IMF. In these places, modeling can, to a certain extent, be conducted free of the constraint of producing quick and usable data on a daily basis. But in the investment world, forecasts are required to be done early and often. A relatively short-term outlook is normally the limit of their aspirations what will happen to interest rates within the next month? with decision-makers demanding rapid output that they hope will be directly relevant to their immediate problems.

Much of the output of financial market models is naturally closely guarded in the hope that it may bring advantage to its owners and their clients. But, at the same time, investment economists like to maintain a public profile for marketing purposes, and are often called on by the media to give their opinion on the latest macroeconomic developments. Their interpretations of economic data may give some clues as to how the financial markets will react, though more often than not, they are explaining why the markets have already reacted as they did. Invariably too, there are disagreements about what various indicators mean, depending on different beliefs about the economy, and whether the firm is taking an optimistic or pessimistic view of the markets.

Each month, the Economist polls a group of financial forecasters and calculates the average of their predictions for real GDP growth, consumer price inflation and current account balances in a variety of countries. More specialized services like Consensus Economics survey over three hundred economists each month and offer details on average private sector predictions.