“All animals are equal, but some animals are more equal than others.” (George Orwell)In regulation, all investors are assumed to be of equal character, wealth, sophistication, and intention etc. The paradigm, regulators have been following is the idealization of a stereotype of a ‘reasonable investor’. This is over simplifying character and strategies of investors. Investors exist in any form and kind. This includes the Sharks of Wall Street, as well as pensioners with only little excess capital. An allocation of hunting grounds for professional investors, who are trading with listed stock, and amateur shareholders, being limited to investing through their local bank, has been true until the 1980’s. Numerous market trends have eroded the traditional territories for either group. The melting down of the financial markets, the bursting of the bubbles, the access to global capital markets through digitization of the financial industry, as well as the evolving Start Up scene and internet culture, to name just a few, has shaken & stirred the investors community. We find highly sophisticated investment professionals investing in small Start Ups, as well mum & pop investors analysing the markets and finally attending the General Assembly of stock quoted corporations with a clear opinion and a bunch of petitions in their briefcase.
“Investing is laying out money now, to get more money back in the future.” (Warren Buffett)Whereas the paradigm of investing should be the same for all investors, the variety of investor types also creates different strategies, time horizons, risk appetite etc. Here through friction and disagreement about the best strategy for a company is inevitable. The idealized stereotype of a “reasonable investor” as blueprint for all investor’s and, hence, their approach and investment strategies is jeopardized. Investors are categorized along four dimensions:
“Investing is the intersection of economics and psychology.” (Seth Klarman)Five types of investors are characterized:
- The Reasonable Investor
The Reasonable Investor is the prototype of all shareholder types and has been used by the regulators, to define regulations and rules of protection. The reasonable investor is an idealized retail investor, concluding a number of characteristics. In this sense, the Reasonable Investor is perfectly rational about his investment decisions, in order to maximize returns in the marketplace. Ideally, he is in a position, to collect, read, analyse and incorporate all available data. This spans from formal disclosures of the investment targets, to macro economic data and market trends. Also, he is able to distinguish between important information, senseless speculation and irresponsible rumours. After his analysis, he will be able, to compute correctly, risk premiums and fair market return for his investments.
His ownership behaviour is long-term oriented and passive. He will hold the equity stake for a longer period, while not interfering with the management, the strategy or the board of the company.
As a private human being of moderate wealth and financial acumen, financial regulators comfort him with significant protection.Voices are, this type of investor is also preferred from managers and boards as an easy to deal with, type of shareholder; not causing any unrest for the board and the management, as long as compliance is observed.
Yet,…..”Life ain’t like that!” (Bodycount)
- The Irrational Investor
The prototype investor is considered as perfect homo economicus. Extensive work on behavioural economics has proven the homo economicus being fictional. Any expectations, investors being excepted from behavioural traps and pitfalls are misled.
The Irrational Investor is suffering from scarce resources, to analyse the vast amount of complex data, available on companies and markets, but may also lack financial acumen, to fully understand and correctly interpret the information at his hands.
In 2012, the U.S. Securities and Exchange Commission (SEC) conducted a study “regarding financial literacy among investors”, concluding a lack of financial sophistication, disabling them to protect themselves from securities fraud.
Evidence is cheap: Examples include, investors in the late 1990s, during the first internet bubble, investing primarily based on company names, suggesting technology or Internet affiliations. Companies have been observed, outer performing their peers up to 63% simply by changing their names to include “.com”, “.net” or “Internet”. Also, the Subprime crisis revealed, a huge number of retail investors, having signed real-estate loans, they did not understand.
The lack of financial literacy leads to unjustified optimism, ignorance towards risk and insensitivity towards market signals, likewise to sell or to hold stock. Irrational investors tend to sell winning positions too early and hold on to losing positions too long.
The absence of rational building blocks for the decision process is filled, with emotions, biases, heuristics and framing effects.
The irrational investor does not conclude an investor population, which is absolutely clueless. Under the impression of excess data, infinite market noise, shockwaves and a herd-behaviour of investors, pattern of irrationalism are part of many decision processes, as long as humans are involved. Following the financial crisis, the irrational investor’s behaviour has become more influential in the markets.
The Active Investor
Whereas the general perception of the regulators of a typical investment pattern is a rather passive and long-term oriented, active investors show a different ownership style and investment horizons. Interacting with the management of the firm and influencing the strategy, operations and also the decision building processes of other investors, is part of their investment style.
Active investors are perceived in an ambivalent way. Whereas they earned the reputation of corporate raiders a while ago, today also voices advocate the positive impact of Active Investors, for keeping management and boards on their toes and hedging for agent conflicts.
The second part of this article will discuss the role of Activist Shareholders more in detail and also present strategies to deal with them; however, the claim, brought forward by Activists, to act on behalf of all shareholders and increase corporate performance, is highly disputable. Already with regard to misalignment among the investment horizons, Activist Shareholders are often observed, to concentrate more on short-term gains, whereas rational investors are assumed to hold their assets over (much) longer periods of time.
The Sophisticated Investor
A sophisticated investor is understood to command above average investment capabilities (wealth), and financial sophistication. In general, this describes professional investors, as typically the asset managers of e.g. institutional investors, hedge funds, pension funds, investment banks etc. However, following the definition of the SEC also private individuals “whose individual net worth, or joint net worth with that person’s spouse exceeds $ 1 mil” or “who had an individual income in excess of $ 200’000 (…)”, can be understood as sophisticated investors.
This is relevant, when it comes to private offerings, where exempts for some of the tighter requirements and protections, applicable for average investors, are relaxed for sophisticated investors.
The underlying assumption is, these groups, commanding higher financial acumen and sophistication are comfortable with higher risk, hence, require less protection and can “fend for themselves”, in case of dispute.
The Entity Investor
Whereas other types of investors are under the general assumption of dealing with private, natural persons, the Entity investor describes non-human, institutional investors, of private or public constitution as e.g. corporation, limited liabilities, partnerships etc. Herewith, hedge funds, mutual funds, family trusts and a huge variety of other businesses, with varying size and industry is included. Also, governmental funded investment initiatives, acting as invisible hand, very often with the intention, to promote and foster certain industries, or to balance out for inefficiencies of the system, are seen as Entity Investors.
Restrictions in investment capability is often unknown for Entity Investors, yet, their goals and investment objectives can vary widely from those of other investors and even be less driven by returns.
The significant power of Entity Investors and more complex strategies can lead to market shaping impact.
“In investing, what is comfortable is rarely profitable.” (Robert Arnott)Applying Robert Arnott’s quote on the different types of investors is already outlining one major source of friction for the management of a shareholder community. The differences in risk aversion among the five investor groups, driven by investment capability, sophistication and investment strategies lead to different assessments of a firms situation, interpretations, of the management’s performance, appetite for follow up investments, fear to lose the investment etc. This leaves a challenge for the non-executive board, to align the shareholder community behind the firm’s strategy and to create confidence among the bold, as well as the fearful shareholders. From the regulatory point of view, the complexity of investor types, indicates misalignment between investors and regulators. The burden is primarily loaded on corporations and financial service providers. Meeting the ever-increasing duties of compliance and the regulatory environment is consuming significant resources. Whereas sophisticated and entity investors are over protected and potentially limited in their investment strategies, irrational investors still will lose money. Specifically in the SME environment, the management invites investors, in order to raise funds for investment initiatives (e.g. acquisitions, growth strategies etc.). An uneasy shareholder community can create unrest and more complexity for the management. Ideally a shareholder portfolio is as well considered as a customer portfolio. If the management is in the fortunate position, to chose among investors, a close alignment with the strategy, as well the management style should be a relevant criteria for the selection of the right investors. Also similar ideas about risk, fair return and exit scenarios with the existing shareholder community can be very relevant, to avoid conflicts. Depending on company size and stability of cash flows, disharmony with / within the investor community can consume significant resources from the management and also limit the agility of the firm, itself. Both criteria (size & stability) apply to start up firms, as well as to turnaround cases to a high degree. Yet, only when a firm is prosperous and delivering returns, the management will be in a position, to chose among different investors. Whereas, under cash constraint, boards and executives tend to focus only on hard facts like share price, valuation, interest rates et al. “Soft factors”, as outlined, above are easily forgotten.
Every pack needs its leader! Investment decisions are a bargain of fear&greed.In SME environments, group dynamics among investors add an additional dimension and complexity and act as a strong driver in the investment decision building process. A balance of divers skills, characters, and profiles is generally understood to be an asset on any level of a firm; the shareholder community has to be assessed in a different way. The execution of growth, start up & innovation initiatives, aka situations with continuous funding requirements, benefit from a strong lead investor, supported by a portfolio of minority shareholders. Through a lead investor decisions in the shareholder community are addressed in a different way.
Retail investors are poised for prisoner’s dilemma.The decision building process in a heterogeneous shareholder portfolio is driven by fear, as result of the uncertainty of the combined investment behaviour of fellow shareholders. Elements of the game theory apply and irrational pattern of behaviour are observed. The interdependencies of the decision building process between a relevant number of investors, of equal weight for the company, can be time consuming and also create further uncertainties for the firm. Observed scenarios include:
- conditional investment decisions
- only committing to an investment, if a certain investment amount is reached
- only committing to an investment, if certain other shareholders invest
- also, this opens door for any conditions on the management, hence, is making it very easy for Activist shareholders, to exercise their influence.
- Only incremental funding – when investors decide only on a short term basis, limiting management’s mid-term planning capabilities.
- Misalignment of shareholders. Investors have been observed to be in a “wait and see”-mode, waiting for fellow investors to act.
Following the lead investor is subject to greedThe decision building process in a heterogeneous shareholder portfolio, can end up in a prisoner’s dilemma and limit the companies agility. Under the guidance of a lead investor, covering the major requirements of funding, retail investors are co-investing to avoid dilution. Worries of going concern (in start up and turnaround companies) are voided, for growth initiatives, lack of liquidity as a primary risk, is also transferred to the lead investor. Whereas retail investors are likely to block each other in a critical decision process, they are likely to follow a lead investor, to participate on her success. Requirements for sufficient investment capability for the lead investor are obvious. An above-average degree of rationalism, financial acumen/sophistication and a moderate risk aversion are also characteristics in support of the role of the lead investor. A good alignment with the management and a clear voice among the shareholder community is equally important.
It’s not black and white, rather colorfulNon of the described typologies shall be understood as an exclusive profile of an investor, but each of the typologies summarises criteria, which may be found in any possible combination. Whereas the rational investor defines an idealised prototype investor, the further typologies represent variations of this ideal picture (whereas the Entity Investor is opening a new category, which also falls in a number of sub-categories, and deserves further analysis and research, to differentiate the pattern of investment behaviour of e.g. private corporations vs. governmental investment agencies). As an easy-to-understand framework. the typologies help to understand and analyse investor behaviour quick and easy. Breaking it down to the core dimensions, three drivers for decision building in an investment process are identified: (Note: Decision building elements of e.g. market assessment, industry preferences, biases for asset classes etc. are ignored at this stage)
- Activism – as the interest & ability to influence / control the strategy & operations of the company.
- Risk appetite – as a function of investment capacity (wealth) and the proportional relevance of the investment combined with the sophistication, to technically understand and price the risks returns of the investment.
- Time horizon – as the remaining (!) planning horizon for the investment, reaching from very short term (e.g. day trading), to long term.
Take away:The common view on investors and shareholders is over-simplified. Dimensions of differentiation are cognition, wealth, activism and personage. These dimensions deliver five different types of investors. These are not strict black and white categories, but typologies, to identify certain pattern of investment behaviour, driven by activism, risk appetite and investment horizon. Activism and elements of irrationalism are trends, observed more often since the financial crisis. For SME and firms in special investment situations, a lead investor can create significant value by helping to manage the decision building process in the investor’s community.