A Balanced Approach to Investments. How Gullible are we?
By Stuart Thomson, Managing Director, Johnsons Chartered Accountants
It’s easy to follow the crowds and jump on the bandwagon when a new fast-growth disruptor enters the market. However, we should probably be taking a more balanced view. Can we trust the data, and discern when we are being sold ‘positive spin’? And should we maintain a healthy scepticism when assessing the merits of such investments?
We all grow up learning to lie. All children bend the truth, and teenagers excel at it. Our rules-based culture and the reliance on evidence in the court of law, means that we are all, admittedly inadvertently, promoting a skewing of facts. Therefore is it any wonder that our largest companies are corrupted from time to time? Consider Bernie Madoff’s pyramid scheme, Enron, Arthur Anderson and more recently WireCard. And yet every year we invest more. And every year there are stories of life savings lost, fraud and audit failings.
Patisserie Valerie collapsed after a £94m black hole was found in its accounts, and allegations of fraud surfaced. Why was it not spotted before? Why did analysts not deter investors? Why did the auditors not spot concerns? How could management not know about or conceal a missing £94m? As humans we are caught in an investment sandwich that is not skewed to best outcomes.
We look at company reports and announcements, and base investment decisions on what they contain. We innately trust what is written, ignoring our natural scepticism. In any written report, the choice of words is important to ensure the right message is conveyed. But whose message is being delivered? We must accept that published reports do not prioritise the interests of investors, but rather the corporation that employs the writer. On the other side, we listen to financial advisors and wealth managers whose remuneration is based to a large degree on funds under management, or influence. Do we adjust our opinions for such bias? Of course not. We have blind faith in the ‘experts’.
So when we see a company fail, we often look to the auditors. After all, we trust everything they and others said, and now that their opinion has been proved to be inaccurate, we seek to blame in order to justify our naivety. Humans are flawed. Investors are over-confident and justify their decisions based on supporting statements from a system that is only as resilient and honest as the data that has been supplied. Any risk-based approach can result in failings – it’s only a matter of time. Auditors are human, and we know they can make mistakes. Crucially, auditors assess the risk of accounts being incorrect using a system of spot-checks, not by reviewing every single transaction. Of course auditors are supposed to minimise the risk of audit failings, and they do work to a strict code of ethics, but they rely on information provided by the companies whose employees are not only subject to human failings, but work in an environment where ‘positive spin’ is key.
Are audit failings the auditors’ fault or is the system to blame? Take the situation at WireCard. My former employer, EY (in my day, Ernst & Young), audited this German company for years. The company collapsed when it was discovered that a bank account with EUR1.9bn did not exist! How could the auditors not have known? Surely they asked the bank for evidence. It transpired that this was part of a global fraud, where conspirators faked evidence upon which the auditors relied. Is that the fault of the auditors, or the guilty employees, or the company bosses? Depending on your own perspective, you will reach your own conclusion on who was responsible.
Whatever your view, public company failings do happen. These occurrences are infrequent, but WireCard is not an isolated case, so what’s the solution? Auditing the auditor will not achieve much in the long term as their training is already rigorous. It might improve short term audit quality, as auditors seek to prove their superiority over one another, however in the longer term humans (yes even auditors are human) will revert to type, and the risk of error and complacency can creep back into behaviours.
I am in favour of a tripartite solution:
- Maintain a healthy scepticism
Investors need to develop healthy scepticism – a neither entirely optimistic nor pessimistic bias. For example, WireCard was considered, prior to its very public failing, to be the European golden child, proving that the EU could create fast-growing tech companies comparable to the stars of Silicon Valley. Surely that rumour should have been enough for people to question its validity. Why would there be only one company in an economic block the size of the EU that justified comparisons to the Silicon Valley behemoths? My own perspective, admittedly with a benefit of hindsight, is that the social democratic EU is run based on improving the EU average, and not on creating positive successful outliers. Therefore it will not naturally create rapid-growth market disrupters. WireCard employees were under pressure to justify their EU success label, and that skewed their behaviour. Healthy scepticism would have limited investors’ desire to join the gold rush.
- Take a wider perspective
Humans make assessments based on their knowledge and experience. This results in assessments based on comparatives. So if something is that much better than others, does that really justify wholehearted backing? Possibly in the short term, but in the longer term surely market forces would eliminate that additional value. Auditors and investors typically focus on detail, and while I am not suggesting we ignore detail, I do say that a wider perspective is important. I studied economics, and spent some time looking at the centralised economies (for example, communist Russia). I remember a story (probably fictional, but it illustrates the point) that Russian factories were given a nail production target measured in weight. Most factories did their job and manufactured millions of nails. However one factory built one giant nail. It met its target – a certain weight of nails – but a wider perspective would identify that this factory demonstrated poor economic value despite reports indicating that it had met its targets. Comparatives act as anchors and reduce the value of innovation, but one can still use comparatives to assess the realism of the differences between prospects. It’s all about understanding the wider perspective.
- Base decisions on up-to-the-minute data
Audits, company reports and analysts’ buy/sell targets are all based on historic perspectives. In some cases this can be quite delayed, therefore I believe a step-change is required in our financial systems. Reporting timescales should be eliminated, in favour of real-time reporting to the public and also real time auditing. With today’s technology there is no reason why this cannot be achieved. Companies and auditors need to improve their visionary thinking, and auditing standards will need an entirely new approach.
So what’s the next big thing to fail? In my view, it’s crypto currency. Its value is not based on any intrinsic measure, since there are too few opportunities to exchange Bitcoin for goods and services. Its value is based on a presumption that in the longer term it will supplant national currencies without additional regulation. I cannot see this happening. Which established economy would be willing to concede its entire monetary policy to a third party that does not act in the country’s best interests? Bitcoin is a wonderfully clever concept, and there is much that central banks can learn from it, however it cannot supplant national currencies without accepting regulation. Bitcoin’s value is, in my opinion, based on the erroneous presumption that regulation will not be imposed upon it.
Put another way, why would anyone buy your Bitcoins? Presumably because they feel they will increase in value? And why would the next investor buy these Bitcoins? Presumably because they too feel they will increase in value. And so it goes on. Yet we have recently seen the value of Bitcoin slacken off, and market adjustments always mean someone will lose out. The value of the ‘next big thing’ is based on hot air, or attempting to find a naïve, poorly informed buyer who will take the fall.
So, analysing crypto currency using my tripartite assessment points:
- Crypto – Maintaining a healthy scepticism
Interest has driven up crypto values. However the real noise is coming from existing investors, who are biased, based on historic growth. Forgetting concerns over market manipulation, one has to think about ‘why’? If I knew about the next big thing, I would not be telling anyone. I would be hoping that the price remained low so that I could keep buying. Crypto currency market behaviour is the opposite of logical human behaviour, so I cannot trust it. Social media is fuelling this noise as it did with GameStop, where social media activity drove up the stock price, trolling short-sellers out of about USD5bn in 2021.
2. Crypto – Taking a wider perspective
The wider picture underpinning value is unlikely to be realised. Its very success will result in regulation, which will pierce its value balloon.
3. Base decisions on up-to-the-minute data
Crypto currency’s market value has generally risen rapidly – few assets can even hope for such success – however I cannot base any investment decision on the fact that yesterday the asset was worth half what it is today. History does not predict the future, it can only inform it. So do I agree with the reason for the increase in value? If I do, then I’m buying at today’s higher price but with justification. If I do not, then I cannot overpay for an asset believing it will fall in value. This rise in value is hype, driven by a herd mentality of investors. But not everyone gets to beat the market and become wealthy. Market contrarians become wealthy, not market followers – just look at George Soros and how he broke the Bank of England.
For clarity, I have never bought crypto currency, and do not imagine I will do so in the future, especially in the light of recent collapses. My capitalist instincts are not adverse to making a quick buck, but my conscience says I should not participate in such a flawed model, profiting from the losses made by more gullible investors. In spite of this, one of the strengths of the Johnsons team is the fact that we are close observers of the markets and advise a wide range of clients. We understand the bigger picture, both financially and commercially, so if you have income from crypto investments and want to stay on the right side of HMRC, don’t hesitate to reach out for a chat.