The Importance of Fuzziness in InvestingAdvisor Perspectives
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
There are phenomena in finance and investing, whose presence and consequences we all feel and face, and yet cannot name. A case in point is “fuzzy” cash-flows and assets. In one sense, fuzziness is the norm rather than exception in investing. After all, as investors we have to forecast future cash-flows and discount them to come up with a fair price. We also know that forecasting is difficult.
Or is it really?
But the future is not merely random. There are certain cash-flows, which are stable, persistent, tangible and resilient. Those cash-flows can be volatile, but they are extremely unlikely to evaporate. Assets supported by those cash-flows, in turn, could be very volatile. But due to the underlying stability of their cash-flows, they, too, remain resilient. Let us call them “eigen” cash-flows and “eigen” assets. Modeling eigen assets is usually straightforward and, importantly, investor consensus tends to converge to similar values. In other words, assessing eigen assets is far less qualitative, and we can therefore refer to their valuation as objective.
In contrast, investors have also to cope with cash-flows, which are, for various reasons, unstable. This instability could be due to a disruptive technology replacing an old business model. It could also be because of irrational exuberance, assuming an unrealistically high P/E (equivalent to assuming unrealistically high earnings growth, which might not materialize). This type of cash-flow is often intangible, unstable, and based on assumptions rather than facts. I call these type of cash-flows “fuzzy” and assets based on them fuzzy assets. Fuzzy assets are obviously difficult to price and investors will come to substantially different valuations. In other words, valuing fuzzy assets is subjective and, as such, highly sensitive to changes in investor sentiment. The practical importance of this is that, in contrast to eigen assets, investors should worry not only about their own forecasting accuracy, but also about other investors’ subjective valuations of fuzzy assets. Fuzzy asset investors are game-theoretically entangled together.
In practice, there are seldom pure eigen or fuzzy cash-flows, and most cash-flows are a mixture of the two. The ratio can be 80-20 or 20-80 but the distinction remains relevant.
What are real-life practical applications of eigen-fuzzy distinction for investors?
The most important distinction is a better definition of capital preservation. In financial theory, the main discriminator of capital preservation is volatility. In reality, a volatile eigen portfolio might be a superior alterative to a low-volatility fuzzy portfolio. I would summarize this point by stating that fortunes are:
- made by investing in fuzzy assets;
- preserved by investing in eigen assets; and
- lost by confusing the two.
Read the full article here by Sassan Zaker, Advisor Perspectives