It is increasingly clear that there is an almost unstoppable momentum towards re-regulating the UK and EU electricity markets. In the process, we are in danger of forgetting the lessons of the past. Markets may not be perfect, but, to paraphrase Churchill, it is just that other means of organising our energy needs are likely to be worse.
Let me give one simple example of some topical relevance. A market that conventional wisdom increasingly considers to have ‘failed’ is the EU ETS. The low carbon price is cited as evidence of this. However, a low price in a market is every bit as much evidence that a market is working as as a high price. The quantity variable has been set. The price simply clears the market. What will certainly destroy the underlying credibility of the market is if we go along with those that now want to tinker with allowances through ‘back end loading’, in a way to try to drive the immediate carbon price back up. Or those that want to follow the UK ‘lead’ of putting a floor price into the mechanism.
In the world as we characterised it in my last post, the over-riding investment principle is that of survival. In practical terms this implies that knowing when and in what not to invest is the guiding heuristic for wealth preservation. This approach is at odds with CAPM, which encourages us to be fully invested across the spectrum of stocks and markets, whatever the prospects. For the CAPM investor, the notion of survival is captured in diversification; from our inductive perspective, it is not. For us, there are uncertain situations that it is best to avoid, given the imperfect nature of our understanding.
An example from outside the financial world comes mountaineering. For a mountaineer nearing the summit, if the conditions suddenly deteriorate and suggest an unacceptable degree of uncertainty in continuing to the top, the reasonable decision is to turn back. Survival is the guiding principle.
So, for an inductive investor, the real issue in wealth preservation is to devise sensible survival tools and rules to guide us on the mountain of investment. As these are gleaned from experience, they are, by definition, imperfect, and need to evolve in the light of experience. However, the critical point is that this experience has a value that goes well beyond the ‘experience’ encapsulated in CAPM’s beta.
Asset management is increasingly defined in terms of wealth preservation. This is perhaps unsurprising, given some of the spectacular stock and market collapses we have witnessed in recent years, and, at least in Europe, the increased risks associated with battered banking systems and frayed fiscal accounts. In view of this, I thought I might do a couple of posts on survival principles for asset managers. To do that credibly, I first must explain my ‘vision’ of markets. It would be premature to suggest rules for surviving in hostile terrain, without first mapping out that terrain. I will do that in this short post. I will then follow up with the principles themselves in one, or maybe two posts, in the weeks ahead.
I am always rather nervous at the faith we put in the UK on solving problems ‘by committee’. To even challenge this very British tradition may seem irreverent to some, especially as it applies to our City fathers sitting on pension fund committees etc, who spend their time and our money deciding just exactly how to allocate our wealth across various asset classes. It all seems very proper. After all, two or three heads are better than one when looking at difficult problems such as portfolio management, are they not?
Well the answer is actually not quite so simple. In fact, as far as asset allocation goes, you are probably just as well to devolve that to a dictator you trust, rather than to an investment committee, even if all of its members are individually quite rational!
In my previous posts on this subject, I discussed the underlying problem associated with private investment in infrastructure, that is how to ensure that investors receive a fair return on, and eventual return of, their capital. In some (perhaps many situations), this aspiration may prove impossible. As a result, either the relevant infrastructure will not be built at all, or its construction will have to be undertaken directly with whatever State funds are available. However, we know that in practice, State investment brings its own set of problems, and anyway, the State’s ability to invest is not limitless. Is there no way we can reliably ensure a steady flow of private investment into infrastructure?