Insightful articles on the world of finance and investing
Coronavirus Update from Cambridge Partners March 19th 2020
Presented by Richard Austin, Cambridge Partners Managing Partner
Watch Richard’s video presentation below, or read on for a detailed analysis.
These are extraordinary times. It has been just two weeks since we provided our last update, but a lot has changed.
The World Health Organisation officially declared Coronavirus a ‘pandemic’ on 11 March 2020
Travel bans have been put in place around the world, schools are being shut and large events cancelled
Anyone coming to New Zealand, except those from some Pacific Islands, must go into self-isolation for 14 days
In the US the Federal Reserve cut its overnight rate to between 0% and 0.25%
Closer to home, the Reserve Bank of NZ has made an emergency cut to the official cash rate this week, from 1.0% to 0.25% (a drop of 0.75%), which will last for at least the next 12 months
Governments in NZ and around the world are putting in place financial packages to help support business. This may help reduce the impact of the slowdown, but it is likely the economic effects of the virus will be widespread for weeks and months to come.
What is happening in markets?
Share markets react to new information and reflect general investor sentiment. As the scale of the effects of the virus have become known, markets have priced in the expected reduction in company earnings and outlook, causing share prices to fall.
As we release this update, the fall in the US S&P 500 from its recent peak in February has been around 30%. While the Dow Jones has fallen 33%. Returns differ depending on each country, but the falls are of a similar magnitude around the world.
It’s fair to say that investor sentiment has turned almost 180 degrees from being very positive at the start of 2020, following nearly 10 years of gains, to one of being fearful and full of uncertainty.
As we know we know markets are driven by both fear and greed, and we are now seeing a high level of fear return to markets.
What effect will the downturn have on my portfolio?
New Zealand is a relatively small economy and as a net exporter, we are exposed to events that happen around the world.
However, our portfolios contain many thousands of underlying investments to ensure we are not overly exposed to any one specific company, sector of the economy or country.
We also have an approach of holding a high proportion of the portfolios in offshore assets. The benefits of this approach are generally two-fold – our clients receive greater country diversification, but also any losses experienced offshore are dampened if the New Zealand dollar falls.
In addition to holding growth assets like shares, our portfolios also hold defensive assets, such as New Zealand and International Fixed Interest. In times like these, the aim of the defensive assets is to reduce the overall effect of the fall in share prices.
For example, a 50/50 portfolio with 50% in growth assets and 50% in defensive assets is down around 13% from the recent peak in February and around 6% over the past 12 months.
Whilst these are significant falls, and no doubt concerning for investors, its less than the 30% fall that equity markets are experiencing.
Should I sell shares and reduce risk?
Share prices react very quickly to new information. A good starting point is to assume that all the information that is currently known about the virus and other events around the world is effectively ‘priced in’.
As new information becomes available – markets react. If the news is negative or worse than previously predicted, markets generally fall, whereas if the news is positive, or not as bad, markets generally rise.
Whilst we cannot predict tomorrow’s news, or events that are yet to happen, we do know that if investors sell in times of market stress such as these, they are much more likely to lose money, than to gain.
Not only have you got to predict the best time to sell, you have to predict the best time to buy. When investors try and do this, or base decisions on the emotions of fear and greed, they sell after markets have fallen, and buy only after markets have gone up. This is a sure fire way to lose money.
As a client of Cambridge Partners, it is also worth remembering the planning process you went through with your adviser, when you initially determined what type of investment strategy was suitable for your needs and objectives.
This strategy was designed knowing that events like this can, and sometimes do, happen. This means if your plans or objectives haven’t changed, your portfolio may still be appropriate for your long-term objectives.
How long will it take for things to recover?
The short answer is that nobody knows.
However, it looks like the next three months could be rough for the global economy, financial markets and investors. It’s likely that we’ll see plenty of profit warnings from companies and some economies in recession.
But at some point, things will get better. In the Northern Hemisphere the summer will arrive, which may take some sting out of the virus and, at some point, a vaccine may emerge.
It’s important to bear in mind that no one waves a flag, or blows a whistle, when the markets hit their peaks or come off their lows. But at some point, markets will recover – and it is normally before we’ve seen hard evidence of the global economy improving.
If we remember the Global Financial Crisis that started in late 2007, the S&P 500 hit its low in March 2009, while the world was still in the depths of recession and investors couldn’t see a way out.
However, six months later the S&P 500 had rallied 53% – anyone who was sitting on the side lines waiting for firm evidence of the improvement, missed out.
The message here is that abandoning your longer-term investment strategy and reacting to your fears, may hurt your portfolio’s overall performance.
Is there anything I should be doing now?
If you are feeling concerned or anxious – that’s OK and perfectly normal. We encourage you to reach out to your adviser.
There is a heightened level of uncertainty and anxiety at present, but what we do know is that, at some point, markets will recover. However, what we don’t know is exactly when.
In interim, there are some practical measures you could consider:
If you are regular taking money out of your portfolio, then consider reducing the amount you are withdrawing, or suspend withdrawals for the next few months.
While it may seem perverse, if you are holding cash in your portfolio, the fall in markets, does represent the opportunity to re-balance into growth assets at these lower prices.
Work with your adviser to review your current investment strategy and objectives against the outlook for your portfolio.
We also encourage you not to let fear drive your decisions and sell after markets have fallen.
It is a difficult time right now, but we know from experience that you’re much more likely to lose money than to gain, if you try and time the low and high points in markets.
How will the virus affect Cambridge Partners?
Last month as part of our Business Continuity Plan we conducted tests on our processes in the event we had an outbreak of Coronavirus in the office. This included how we would communicate with clients and manage the effects within the office, along with maintaining business as usual.
We’re pleased to advise that our tests were successful and with laptops, mobile phones and secure internet connections we are confident that we will be able to continue to operate at close to normal capacity if we are required to work elsewhere.
We are very conscious of all the health warnings and have advised staff to stay at home if they are feeling at all unwell.
Meetings are still being held in the office and we are monitoring the appropriateness of this daily.
We aim to continue to provide updates as the situation develops. But if you have any questions or concerns, please reach out to your adviser or one of the team.
A Market Update on the Effects of the Coronavirus
Presented by Richard Austin, Cambridge Partners Managing Partner
Watch Richard’s video presentation, or read on for a detailed analysis.
The world is, as we are, watching with concern the spread of Coronavirus (COVID-19). Uncertainty is being felt around the globe. It is unsettling on a human level as well as from the perspective of how investment markets will respond.
Market declines can occur when investors are forced to reassess expectations for the future. The expansion of the outbreak is causing worry amongst governments, companies and individuals about the potential impact on the global economy. Earlier this week the OECD predicted that global GDP growth could now be 1.5% in 2020, which was half the rate it was predicting before the outbreak.
But what should you do regarding your investments? As always, we lean into the evidence to determine our advice.
Looking back to recent pandemics, particularly SARS, helps provide context.
There are no definitive timelines for when SARS started and stopped, but broadly speaking the virus was active over an eight month period between November 2002 and July 2003.
It was certainly an unusual time. For anyone travelling overseas in that period, they may recall individual health screening at country borders. At the time travellers felt unsettled, but people continued to go on with their lives. Business and commerce still functioned.
Interestingly, our model portfolios performed well over that eight month period. Despite SARS and increased global uncertainty, our portfolios were up between 4% and 5% after funds management fees. One year after SARS was first observed, our model portfolios were up between 6.8% (for an 20/80 portfolio with 20% in growth assets and 80% in cash & fixed income) and 11.6% (for a 98/2 portfolio with 98% in growth assets and 2% in cash).
If investors had chosen to sell out of their investments, it would most likely have been a poor investment decision, given the subsequent performance of markets.
It may also be worth noting that SARS had a mortality rate of approximately 9.6%. How is this relevant? Well, perhaps it isn’t, but the Coronavirus has a mortality rate currently hovering around 2% and doctors are predicting it will ultimately be less than 1%.
Whether that makes it less scary than SARS might be a moot point, but regardless, markets treated investors well through the SARS outbreak and there is no reason that the same won’t happen through the Coronavirus outbreak as well.
As at February 27th, most of our model portfolios had been only modestly impacted by the increased market volatility experienced. Year to date, the approximate performances of our model portfolios ranged from +0.3% for our lowest risk portfolio (a 20/80 portfolio) to -7.0% for a 98/2 portfolio. For many, a better indicator may be something closer to a balanced 50/50 portfolio which is currently showing a year to date return of -2.0%.
The media are doing their best to paint a picture that markets are crashing, but these sorts of returns, whether Coronavirus was an issue or not, are not out of the ordinary for portfolios containing allocations to higher risk assets.
Of course, SARS hasn’t been the only global health scare to hit the headlines in the last 20 years. The following table highlights a few of the higher profile pandemics in recent history. We have identified an estimated start date for each of these pandemics and then looked at the subsequent performance of a balanced 50/50 model portfolio over the next three months, six months and twelve months.
The results may surprise you…
Model 50/50 portfolio returns: After 3 months After 6 months After 12 months
Source: Consilium. A 50/50 Portfolio has 50% allocated to growth assets and 50% allocated to cash and fixed income.
Within the first few months, the performance of markets and portfolios can be mixed. During SARS, which was the first global pandemic to emerge in quite some time, the early reaction of equity markets was quite negative. During the Avian Flu outbreak a few years later, it was relatively flat.
What is even more striking is that markets within six and twelve months from the start of each of these outbreaks, regardless of their perceived severity, generally rebounded strongly.
What will happen in the weeks ahead with respect to the Coronavirus outbreak?
The truth is that no-one knows. Markets today are reflecting heightened uncertainty in the form of lower prices. As soon as there is new information (good or bad) this will also be priced in. When the tone of the news flow gradually changes from contagion to containment, and eventually cure, then market risk and uncertainty should reduce, which is likely to be positive for risky assets.
While this heightened uncertainty may be uncomfortable for investors, don’t be surprised if the Coronavirus can be added to the list of issues that might make an investor think about selling, our general response is that it’s unlikely to be a good idea to sell investments. Although we can’t see into the future, we can observe the past and we have witnessed the best recommendation is to stay focused on the long term and maintain your strategy.
Cambridge Partners Grow Their North Island Presence
Cambridge Partners has always had a strong client base in the North Island, so we are delighted to announce the opening of dedicated offices in Auckland and the Waikato. These are in the capable hands of Brigette Arnold and Bryce Turner.
Brigette, based in Auckland, has worked in the financial industry for over 18 years, across markets in the UK, Europe, Asia, North America, Middle East and Australasia. She advises both private clients and institutional investors, specialising in working with iwi and Māori entities, and women’s wealth.
Bryce is Waikato based and has over 20 years’ applied knowledge and experience specialising in providing business development and consultancy services to Treaty Settlement Entities, Authorities, Trusts and Incorporations, Institutions, SMEs (small-to-medium sized enterprise) businesses and individuals.
Welcome to the team Bryce and Brigette – great to have you on board!
2019 Financial Review Released
Presented by Scott Rainey CFA, CFPcm, AFA Senior Adviser
At the start of 2019, much of the world was in a state of turmoil. A lot of the big issues weren’t resolved by year’s end either. It might have been logical to expect financial markets to perform badly as well.
But, as Cambridge Partners’ Adviser Scott Rainey points out in this informative 4-minute video, what actually happened could not have been more different.
The GFC (Global Financial Crisis) is widely considered by economists to have been the worst financial crisis since the Great Depression. Its effects were so wide-spread and profound that even Queen Elizabeth, whose personal fortune had fallen by more than $50 million, demanded economists explain why they hadn’t seen the crisis coming.
Around the world blame was distributed far and wide – lax regulations, too much regulation, excessive debt, irresponsible lending, complex financial products, compromised ratings agencies, an over-reliance on mathematical models, and just plain old greed were all cited as culprits.
But aside from a temporary seizure in short-term money markets, global share and bond markets performed as you would expect at a time of heightened uncertainty. Prices adjusted lower as investors demanded a higher expected return for the risk of investing.
And it wasn’t long before the markets started to see a reversal – By the end of 2009, the New Zealand market rebounded by more than 19% after a near 34% decline in 2008. Australia’s S&P/ASX 300 index performed even better, returning to almost the same levels as before the GFC.
Emotions are hard to keep in check during a crisis and there can be an overwhelming compulsion among investors to “do something”. But, as it turned out, those who listened to their advisors and stayed disciplined within the asset allocation designed for them have done considerably better than many people who capitulated and went to cash in 2008−2009.
An investor who had begun investing in the New Zealand market at the start of 2008 would still have experienced a 7.6% annualised return by the end of 2017. Using a global balanced strategy of 60% equity and 40% fixed interest, the return was 5.4%p.a.These results show we can do ourselves a favour, both materially and emotionally, by accepting that volatility is a normal part of investing and by sticking to a well-thought-out investment plan agreed upon in less stressful times.
This blog has been taken from an article by Jim Parker of Dimensional. Read the full story here
Putting the recent market volatility into a longer term context
In the first three weeks of January 2018 alone the S&P 500 crossed ten new record closing highs in 13 days of trading. Then, in February, the index lost all its gains from 2018 in a few days. Over the next 7 months it built up gains again, and then lost all them over the course of three weeks in October. What’s going on?
Let’s remind ourselves how markets work.
Prices went down because some investors decided to sell. But for every seller there is a willing buyer. The aim of the buyer wasn’t to lose money. The buyer bought because they felt that the discounted prices offered them enough return to justify the risk.
Markets bring optimists and pessimists together by finding a price at which they are both willing to trade.
This is our shorthand way of saying at least half the market participants transacting in the last few days thought it was a good time to buy. Not everyone believes the sky is falling, even if the sensational headlines promote such a view.
But what about our investors?
For our clients with a 50/50 portfolio, we recommend a seven-year time horizon at a minimum, and most have a 20 or 30 year time horizon. In other words, any of our investors that are planning to spend money out of their portfolio this year or next year probably have that money sitting in bonds and cash, not in shares.
So, the portion of the portfolio suffering the most from this recent volatility is the portion that an investor has almost no chance of spending or using any time soon. That’s important, because it means that, whilst it’s not particularly comfortable to see volatility like this, it has little practical implication on their portfolio or current lifestyle. For most of our clients, we hope they’d look on this current situation with a level of disinterest.
For clients that are regularly purchasing assets in their portfolios or via KiwiSaver, this is fact a positive development, because they’ll be able to buy more shares with their same regular savings contribution and that will help grow their long-term wealth.
And let’s remember, when we as investors agreed to purchase shares, we accepted this would generally lead to more volatile returns. However, it’s volatility such as this that gives shares their wonderful return characteristics. Without temporary dips such as this most recent one, shares would have the returns of cash – which would not help us reach our financial goals.
Shares are volatile. The chart below shows the quarterly return of a portfolio 98% invested in shares. It goes up and down a lot; there’s no way around it. The chart below, however, shows the growth of wealth this same portfolio has produced since 1991. While the volatility was uncomfortable, it produced large growth despite the Asian financial crisis, the tech wreck, the Global Financial Crisis and anything else you want to throw into the last 20 years or so.
The critical point to remember in all this is the outcome that long term investors get to experience. It’s that share markets, on average, go up more than they go down, and that consistent exposure to these markets is a key driver of long-term wealth creation.
We know the markets can be volatile in the short term, but this is already factored in to our long-term strategies. The worst decision investors can make is to react to short term volatility in a way that jeopardises the achievement of their long-term plans.
If you are still concerned, we want to talk. Give your adviser a call and we’ll be happy to talk through the recent changes to your portfolio in the context of both your short and longer term goals.
Our thanks to Ben Brinkerhoff from our associate company, Consilium, for this great article.
Cambridge (Partners) goes to Oxford
Cambridge Partners Principal Adviser, Jacob Wolt, is on his way to Oxford University to take a major role in the annual conference of GAIA (The Global Association of Independent Advisors). This is a hugely significant event on the international financial scene and will be attended by major, independently-owned investment advisory firms from around the world.
The global conference will be held this Wednesday and Thursday and, on Friday, Jacob will be chairing the Australasian session, which is traditionally attended by member companies from other parts of the world as well. “It is an enormous honour and privilege to be chairing this event,” Jacob explained on the eve of his departure. “GAIA firms are identified by their independence and their over-riding commitment to fiduciary excellence and to ensuring they always put their clients’ needs first. So these get-togethers are always an opportunity to learn from the world’s best and to reinforce our commitment to unified global thinking.”
Cambridge Partners are the only company in the South Island with GAIA membership, and one of only two New Zealand wide. GAIA membership is limited to those companies who meet stringent standards of total independence and transparency in wealth management practices. GAIA member companies must also be certified by CEFEX – an equally demanding independent global assessment and certification organization which provides an independent recognition of a firm’s adherence to a defined standard representing the best practices in the industry.
Everyone at Cambridge Partners would like to wish Jacob safe travels and all the best for this demanding and prestigious role – we have no doubt he will do us all proud.
Now and Then
You are more likely to recognise the stairwell than the person here! That’s because it’s from the set of The Big Bang Theory – one of the longest-running and most popular sitcoms on our screens today. Its Executive Producer Dave Goetsch reflects here on how much his attitude to investing has changed in the last ten years. One of the biggest differences? Finding a good financial adviser.
I haven’t changed because the stock market rebounded. I changed because I learned that there was a different way to think about investing.
Seeing all the recent headlines about the sudden downturn in the stock market has transported me back to February of 2009, when I was close to despair. It’s striking how different I feel now.
In February 2009, the stock market was down around 50% from its high, and everyone seemed to feel like the sky was falling. I was familiar with this state of panic because my relationship to the financial markets was that I didn’t trust them.
They were always going up and down in ways no one could predict, and I couldn’t trust those folks who said that they could anticipate what was going to happen. So when the market went down, I went down with it—sinking into a depression, knowing there was nothing I could do.
What a difference nine years make. I haven’t changed because the stock market rebounded. I changed because I learned that there was a different way to think about investing. I was right not to trust those people who thought they could predict what was going to happen in the markets, but I was wrong in thinking that there was nothing to do. I’ve learned that I can have a great investment experience if I just accept a few simple truths.
I have to understand the uncertainty of the market. The stock market, as measured by the S&P 500 Index, has returned about 10% per year over the last 90 years,1 but there are very few individual years in which it has ever actually returned that amount. In fact, how many of those 90 years do you think the S&P 500 was up more than 20% or down more than 20% for that year? The answer is 40. Astounding, right? I wish somebody had explained that to me decades ago. Then I would have known to look at stock market returns in terms of decades—not years, months, days, or hours. I would understand that so many of those articles and cable news pieces are just noise, designed to keep an audience obsessed and unsettled.
I haven’t changed because the stock market rebounded. I changed because I learned that there was a different way to think about investing.
In order to be a long-term investor, you have to have a long time horizon. This can be hard to remember when you’re being assaulted by noise, but if you can stay strong, the results are stunning. By results, I don’t mean the investment returns, which hopefully are good. The return I’m talking about is how I feel every day. I worry less—not just about the future, but also about the present. Of course, I know that there are no guarantees when it comes to investing, but I feel like I’m going to be okay. I have a plan.
There’s no way I could’ve done this without a financial advisor. I needed someone who could not just talk me through what my asset allocation should be, but also help me work through how I felt about investing and what exactly I could do to change my perspective.
I was a mess nine years ago. Now, my outlook is totally different. The markets haven’t changed; they still go up and down. The difference is, I don’t anymore.
Thanks to our Associates at Dimensional Fund Advisors for the use of this article.
The “Right Time” Myth
When markets are rocky, some investors tell their advisors they would prefer to wait till things are ‘more settled’ before committing money. The problem with that view is the market never is free of worries. Currently, it’s oil and China. A year ago it was the Euro Zone. So when is the ‘right time’?
When is the right time to invest in the market? Or is there ever a right time?
Let me know if any of these narratives sound familiar to you:
2013 Analyst: “We are deeply concerned about the sharply rising 10-Year Treasury Yield as a headwind for stocks. The end of quantitative easing and the Federal Reserve’s unprecedented monetary policies may forestall further gains in equities.” Total return of SPDR S&P 500 ETF (SPY): +32.31%
2014 Analyst: “A sharp drop in virtually all commodity prices may be signaling a contraction in the global economy and warrant reducing exposure to risk assets. Furthermore, the strongest performing asset class is the 30-year Treasury bond, which is a virtual assurance of the coming apocalypse.” SPY total return: +13.46%
2015 Analyst: “We are worried that market breadth is deteriorating so rapidly. The “FANG” stocks are the only bright spots in an otherwise bleak investing landscape. In fact, the average publicly traded company is now firmly in bear market territory.” SPY total return: +1.23%
2016 Analyst: “We are troubled that utilities and consumer staples stocks are the market leaders and momentum is waning in growth sectors. This bulking up in defensive assets may lead to….” SPY total return: TBD
Should be interesting to see how that last one ends.
Those aren’t real headlines, but made-up approximations based on very real themes that assaulted investors over the last four years. I could go further back in time to sensationalize the concerns of market participants in the cross hairs of any given moment, but I think the point has been made.
The stock market never looks perfect. There is always something to worry about. That is why they call it climbing the “wall of worry”.
If you are waiting on a specific point of certainty in order to invest, you are going to be the last guy or girl holding the bag before the wheels really come off. There are always going to be wars, elections, corruption, debt cycles, stock upheaval, commodity insecurity, and a whole lot of people who are bigger, faster, and smarter than you are in the market. In addition, there are shifting cross currents that offer little in the way of predictable patterns.
For example, right now the stock market is entirely fixated (read: correlated) with the day to day fluctuation in oil prices. Stocks want a rebound in oil to boost the sickly energy sector, prop up the credit markets, and generally re-initiate a sense of inflation or consumption in the global economy.
Years ago, oil prices were a thorn in the side of stocks. If you saw a 5% jump in overnight crude oil futures, you could pretty much count on a big drop in the stock market. Funny how perceptions change over time and “rules of thumb” seem to disintegrate under differing global circumstances.
This all goes to prove a point. There is no certainty when it comes to investing.There is only process and discipline to guide you through the difficult periods. Much of that discipline may involve tuning out the noise of the media that is constantly focusing on short-term themes or sensationalist headlines. They aren’t intentionally trying to hurt or persuade investors down any particular path. They are just motivated by different forces than we are.
Is the stock market rigged? Maybe. Probably even. But it’s the best system we have and it’s continued to multiply the wealth of methodical investors for many generations.
There are going to be periods of turbulence that test the resolve of even the most ardent buy and holder or battle-hardened trader. However, it’s imperative that you lean even further on your specific philosophy during those tumultuous days to achieve a successful outcome.
For me that means taking a balanced approach that pairs multiple asset classes together to smooth out volatility. This includes a stringent focus on security selection and structural asset class combinations to ensure risks are matched appropriately. In addition, I have the flexibility to shift the portfolio to fresh themes in order to take advantage of new opportunities or pair back on areas showing undo stress.
I know that many investors have been chasing their tails with individual stocks or sectors and trying to divine the next big trend. However, in my opinion this type of environment is more conducive to avoiding those hit-or-miss propositions by committing to broad-based ETFs showing lower volatility or relative strength versus their peers.
Put it this way – your ego wants you to own Facebook and Google so you can brag about it on the golf course or over the water cooler at work. Of course, that probably means you own Twitter and Yahoo as well (we’ll just keep those quiet).
When the media blandly reports that “sellers were out on force on the market today” it’s worth asking who they were selling to. For every seller, there has to be a buyer. And these latter individuals tend to hold the long-term view that falling prices mean stocks are on sale. Ben Carlson explains.
The best times to put your money to work are often when things seem like they’re never going to get better:
How Australia has come out on top in this currency war
Every night on the finance news, reporters put on a grim face when talking about the declining fortunes of “our dollar”. Yes, the weakening currency is bad news if you’re travelling overseas, but it is also cushioning the impact on Australia of China’s downturn. Candice Zachirahs explains.
Pessimism Unwarranted: The Australian Economy Isn’t in Bad Shape
While much of the media has been sounding warnings about the Australian economic outlook recently, the doyen of economic writers thinks the doom is overdone. Ross Gittins, a 40-year veteran of Fairfax Media, says people are over-estimating the impact on Australia of bad news abroad.
Is Australia’s economic outlook as bad as the media headlines suggest? No, says SMH economics editor Ross Gittins. Read original article here:
Just because markets price in tough times does not mean they are right. Markets move as expectations change. And expectations change on news. Remember also that short-term market movements are not such a concern for long-term investors. UK writer Ben Wright explains.
What markets do today or tomorrow has little bearing on outcomes for people with a decades-long horizon. Read original article here: http://bit.ly/1PKz7GM
How should the average investor react as global stocks experience volatility? Charisse Jones with five tips for the every day investor.
If you haven’t figured this out by now, it’s time you did: Stocks are risky. They are risky — as in volatile — over the short and the long term.
But that doesn’t mean you should avoid investing in stocks … except maybe Chinese stocks. Nor does it mean that you should just ride out the jaw-dropping volatility in the market, either. What to do?
First, turn off the TV. Joseph Tomlinson, a certified financial planner with Tomlinson Financial Planning, in Greenville, Maine, suggests “turning off CNBC” and not reacting to these sorts of events by trying to time the market. “Don’t attempt a strategy of bailing out temporarily until things ‘calm down,'” he says.
Second, think big picture. The longer your investment time horizon the more likely it is that you can not only ride out this current crisis, but continue to invest in stocks as they go “on sale,” as some investment experts like to say during times like these. People today can expect to live on average to nearly 80. So someone in their 20s has an investment time horizon of at least 60 years, and for someone in their 40s its four decades. And, while past performance, as the famous investor warning goes, does not guarantee future results, stocks over the long term have gained on average 10% to 12% per year since the late 1920s.
“Millennials shouldn’t be concerned with volatility,” said Dirk Cotton, a financial adviser and author of the Retirement Café blog in Chapel Hill, N.C. “They have decades to recover from losses, and risk enables them to earn higher returns.”
On the other hand, pre-retirees — those in their 50s and early 60s — as well as retirees have shorter investment time horizons, say 20 or 30 years, and can’t afford to put their retirement lifestyle at risk. They just don’t have as many years to recover from bear markets as do Millennials and Gen Yers. So they might revisit how much they invest in stocks.
As a general rule, consider subtracting your age from 100. That should tell you how much to invest in stocks. So, if you’re 50, consider investing 50% in stocks and 50% in bonds. And if you’re 25, consider investing 75% in stocks and 25% in bonds.
Third, review (or create) your investment policy statement. Investors, no matter their life stage, should always have an investment policy statement (IPS) for their portfolio. It’s a blueprint outlining how much to invest in stocks, bonds and cash given their time horizon, risk tolerance and investment goals.
Your IPS — not your emotions — should tell you when to rebalance your portfolio, when to sell and buy. Again, regardless of life stage, the tumult in the Chinese market, might be a chance to buy, not sell, stocks.
Robert Powell is editor of Retirement Weekly, contributes regularly to USA TODAY, The Wall Street Journal and MarketWatch.
How about that 550-point intraday dive last week in the Dow! Did that finally get you to sell?
Or was it one of the many headlines about the trillions of dollars that have been wiped out of the stock market in the worst start for the Dow in history — since 1897! And worst start for the S&P 500 since the Great Depression began in 1929.
Oh, c’mon, that was “so last Wednesday.”
Surely, when all the major indices ripped higher on Friday, and stocks registered their first positive week of the year, and that diving-Dow had two straight days with triple-digit gains, you had plowed right back into the stock market and banked all those big gains.
It seemed like the panic and the paranoia were over — until the Dow dropped by another 200 points on Monday.
And so far in January, investors have yanked near-$7 billion from U.S. stock funds, according to Thomson Reuters Lipper data. Investors have also put more than $3 billion into money market funds — the market’s under-the-mattress cash equivalent. But the more alarming data comes from last month, when investors pulled $48 billion from stock funds. That is eerily similar to 2008, as the financial crash hardened: Investors took $49 billion out of stock funds in Sept. 2008 and $55 billion out of stock funds in October 2008.
Kudos to investors for the great timing. Except for the fact that from 2008 to 2012, the S&P 500 generated a cumulative return of 8.6 percent.
Here’s the problem: If an investor missed the 36 percent drop in the S&P 500 in 2008 — or even worse, bailed on the markets mid-carnage — they probably also missed the 26 percent gain in the S&P 500 in 2009, and the next three positive years for the index that followed.
In 2011, investors pulled another $94 billion from stock funds, and in 2012 another $129 billion, when the S&P 500 was up 16 percent. Hundreds of billions of dollars pulled out of stocks during a period of time when a stay-the-course strategy would have netted an 8.6 percent cumulative gain. Not a shoot-the-lights-out strategy, but nothing to sneeze at either in today’s low-return — not to mention nil savings rate — environment.
“The global financial crisis created such a high level of risk aversion that people didn’t just wait for the start of the rebound. In some cases, they waited for years,” said Kristina Hooper, U.S. investment strategist at Allianz Global Investors. “I can’t tell you how many investors I came across in 2011, 2012 and even 2013 who had missed out on a lot of the comeback in the stock market and were still sitting in cash.”
It’s what Lipper’s head of Americas Research, Jeff Tjornehoj, calls the dilemma of the do-nothing investor: More often than not, the do-nothing investor does better.
“It’s a rocky ride, but the do-nothing investor would have been fine and avoided headaches,” Tjornehoj said, referring to those who stayed invested through the crash. He added, “If you know precisely how to move between stocks and bonds and everything else, you would have done better, but how many investors know how to do that?”
“The big issue is that when you go to cash, you have to be right twice,” said Mitch Goldberg, financial advisor and president of Dix Hills, New York-based ClientFirst Strategy. “First, you have to be right about getting your timing correct when you sell. If you are selling because it is your panic reaction in a down market, I think it’s fair to say you probably got that part of the decision wrong. The second part you have to get right is the timing of your buy orders. And if you are waiting for the perfect time to buy, you’ll never pull the trigger.”
And here’s a key that many investors who plan to be smarter than the “herd” miss, especially in markets like the one investors faced last week, with huge swings in the norm day-to-day. A move to cash works against the investor to a greater degree when there is greater volatility.
“Friday’s rally in global equity markets is a case in point of how investors who just binged on cash are missing out on a big rebound,” Goldberg said. “It’s tough to time, and missing out on the best days of the year has a restraining effect on long-term performance,” Goldberg said.
Allianz Global Investors provided an example of just how much investors can lose out in just a few days. The Allianz economic research and strategy team looked at the period from 1973 to the end of 2014, comparing four different approaches to investing in the U.S. stock market. Investors who missed the three biggest days of each year see their gains go down dramatically.
In the first approach, $100 is invested on the first day of the year and another $100 dollars added at the start of each year thereafter. The total return over the four decades was $52,251.
In the market-timing approach, if an investor invests the same $100 at the start of each year but misses the top three days of the year, the total return was $2,953.
The best return of all came from investing $100 on the day of the lowest index level of the year — the best day of the year to invest — and adding $100 on the lowest-index-level days of subsequent years. That approach netted a total return of $54,355.
“The problem is that we can never predict when the best days will occur, so we have to stay fully invested all the time to experience them,” Hooper said, adding that most days in any given year (both positive and negative) will typically produce a net flat performance.
Those “big day” misses, or gains, compound over the years.
The key problem I see when investors go to cash has a lot to do with procrastination,” Goldberg said. “They think about getting back into the market in a conceptual way, but when it comes right down to it, they often don’t because they didn’t implement a disciplined strategy to get back in. If the stock market bounces and rips higher, they say to themselves, ‘I could’ve gotten in lower, so now I’ll wait for another pullback.’ Then the market pulls back and they say to themselves, ‘I’ll wait to see if it goes lower.’ And so on.”
Tim Maurer, director of personal finance for The BAM Alliance of financial advisory companies, said that the field of behavioral finance has demonstrated how our brains often think (wrongly) when it comes to evaluating the pain of losses versus the pleasure of gains.
Maurer said to consider the decision between staying invested after a market decline or moving to cash as a four-step process:
The pain of staying invested is that I could lose even more.
The pleasure of moving to cash is that my worry is eliminated and I’m guaranteed not to lose any more.
The pain involved in moving to cash is that I’ll miss the upside, thereby eliminating my opportunity to recoup recent losses in the next market up move.
The pleasure in staying invested is that I’m giving myself a better chance to achieve my financial goals in the long term — the reason I invested in the market in the first place.
He said the four-step process has one purpose: to bring the vast majority of investors back to the conclusion that they shouldn’t get out of the market.
“The market has historically paid investors a premium over cash and bonds precisely because it requires investors to endure times of volatility,” Maurer said. “Without volatility, we’d have no reason to expect higher long-term gains.”
A few weeks ago — amid one of the many recent bouts of extreme daily selling — a friend asked me whether they should sell their Facebook shares. I asked, “And replace them with what?” She didn’t have an answer.
Another friend, in his 40s, texted in a panic to ask if it was the time to get out of stocks. I asked him what stocks, in particular, he meant to sell. He said no stocks, just moving his retirement portfolio as a whole out of equities. I replied with several exclamation points — you can imagine the words that preceded the punctuation yourself.
“At the start of December, I addressed a roomful of high-net-worth financial advisors and asked them, ‘How many of you expect the market to fall more than 10 percent in 2016?'” said Allianz’ Hooper. “Nearly every hand in the room went up. And yet now that the market has experienced the sell-off, many are not viewing it as a healthy correction but are panicking and fearing the worst.”
Hooper said the psychology is easy to understand. Sell-offs are by nature disorderly and create a contagion of fear, and investors believe that when stocks go down 10 percent in value, there’s something “the market knows” but a Main Street investor doesn’t.
“In reality it is just a herd, and herding is a dangerous activity for investors,” Hooper said.
There is always a good case to be made for rebalancing from stocks that have run up a lot into stocks that seem undervalued. Maurer said it’s good to be “greedy” like Berkshire Hathaway chairman and CEO Warren Buffett through stock rebalancing. But when Lipper fund-flows data shows net negative flows in equity funds, that’s not what’s going on with the mass of retail investors.
Goldberg isa “big proponent” of raising cash at times, but said the time to do it is when stocks are rising and then wait patiently for new opportunities. “I never feel pressure to be fully invested at all times. But I do not believe in going to cash as an ‘all or nothing’ trade,” he said.
Cash proponents will argue that staying invested is a disaster-in-the-making for retirees. Goldberg said retirees are naturally the most fearful, but it’s the cash mentality rather than staying in equities that is the “never-ending wealth destroyer pattern.”
“You’re now giving up on an asset class that historically has been a hedge against inflation,” Goldberg said. “Sure, inflation is nonexistent according to headline statistics. But if you pay for health insurance, which as a senior could easily be sending a big proportion of your income on health care, you know you are ground zero for inflation pain.”
In fact, if any retiree has a portfolio constructed with investments that would collectively go to zero in a stock market correction, the only question worth asking is, Who designed your portfolio, and how quickly can you fire them?
There’s a reason that famed investors like Vanguard Group’s Jack Bogle and Buffett sound like a broken record with the“stay the course” mantra.
It’s not just because their millions and billions allow them to do so with comfort — though that helps.
Watching the Olympics a few weeks ago, I got pulled in to the drama of short-track skating. It has to be one of the more entertaining Olympic events. The races are fast, and almost anything can happen. If you had a chance to watch the women’s 500-meter final, you saw a perfect example of the fine line between skill and luck that drives this sport.
Seconds after the race started, Elise Christie of Britain made a passing move in the second turn that caused her and Arianna Fontana of Italy to crash. Park Seung-hi of South Korea then slipped in the next turn. Only one skater, Li Jianrou of China, didn’t fall down. While the other skaters managed to get back up, there was no way for them to catch Ms. Li, and she won the gold medal.
Ms. Li is clearly an exceptional athlete (she was overall world champion in 2012), but it’s impossible not to see the role that simple luck played in the race. Even she described her win as “very lucky.” Skill may have gotten her to the Olympics, but luck played a role in her gold-medal victory.
So if Ms. Li, a world-class athlete, is willing to acknowledge the role of luck in her success, what makes it so hard for the rest of us? Well, we like thinking we’re just that good, particularly if we’re talking about our investment success. As a result, we become the lucky fools that Nassim N. Taleb described in his book “Fooled by Randomness.”
“Lucky fools do not bear the slightest suspicion that they may be lucky fools — by definition, they do not know that they belong to such category. They will act as if they deserved the money. Their strings of successes will inject them with so much serotonin (or some similar substance) that they will even fool themselves about their ability to outperform markets (our hormonal system does not know whether our successes depend on randomness),” Mr. Taleb wrote.
What sets off the lucky fool syndrome? Psychologists call it the self-attribution bias. It means we’re inclined to take all the credit for things going well, but we have no problem blaming outside forces when things go wrong. On top of our bias, we have a very difficult time separating skill from luck.
As a result, we’re susceptible to the lucky fool syndrome and the problems that come with it. In a 2013 study, the researchers Arvid Hoffmann and Thomas Post highlighted how a self-attribution bias can hurt investors and lead to repeated mistakes because they “simply attribute bad returns to factors beyond their control.” The same study also showed that when we ignore the role of luck, we’re also blind to bad investment behavior like overtrading or underdiversification.
Knowing that these issues exist, we have a choice. We can continue to float along on a cloud of serotonin, playing the fool and suffering the consequences, or we can challenge our biases. It’s not easy to make the right choice, but it’s doable. It starts with getting a better handle on the difference between skill and luck.
“There is actually a very interesting test to determine if there is any skill in an activity, and that is to ask if you can lose on purpose. If you can lose on purpose, then there is some sort of skill. Investing is very interesting because it is difficult to build a portfolio that does a lot better than the benchmark. But it is also actually very hard, given the parameters, to build a portfolio that does a lot worse than the benchmark. What that tells you is that investing is pretty far over to the luck side of the continuum.”
So if investing involves a fair bit of luck, then the next step is to measure where our success falls on the luck-skill continuum. Plus, the more we measure, the more likely we are to avoid the bias and act the lucky fool. After all, investing leaves a pretty clear trail of breadcrumbs.
Start by pulling out tax records and year-end brokerage statements that lay out the facts. If we’ve been cruising along and assuming we’ve done something special, it’s time to put on our no shame/no blame hat and look at all the data. For instance, many investors I know designate a small portion of their portfolio as a play account. Because it’s a play account, they feel comfortable betting on riskier investments, and sometimes those riskier investments deliver an excellent return.
But it doesn’t take much for us to project that small success across our entire portfolio. So we need to ask ourselves how our whole portfolio did. Then, we need to calculate our rate of return and compare it with the return of index funds representing the broad market.
My experience shows this test will surprise almost every investor. The numbers will invariably make the case that what we thought was a spectacular success can’t compete when it’s measured as a part of the whole and compared with a benchmark. With this knowledge, it becomes a bit easier to counter our bias and avoid the lucky fool syndrome.
It’s easy to get sucked into believing that investing success is all about skill. I suspect it follows the rule that the smarter you are, the smarter you think you are, and that’s a problem for investors who believe intelligence determines our investment returns. It becomes a self-confirming cycle if they see great investments returns. The great returns verify the original idea that our smarts determine our investing success, and the next investing success starts the cycle all over again.
We can interrupt the pattern, and avoid the mistakes that come from it, by testing the context of our success with a second, simple question: Were the markets already going up? Even though it’s tempting, we shouldn’t confuse being a genius with a rising market. For instance, if we experienced superior returns in 2013, it’s very difficult to attribute our success to skill. However, we’re inclined to be very selective when we look at our success. We highlight the events that confirm our bias and ignore the facts that point to outside forces.
In this case, we’ve got the data to test our theory. How did we do in a non-record-breaking year? Did we see incredible results or were they close to the benchmark? If it’s the latter, it’s hard to argue that our smarts have built a portfolio that does a lot better than the benchmark.
Look, I understand that we really like how the lucky fool syndrome makes us feel. Besides all that lovely serotonin flooding our system, we love the idea that we’re really that good and capable of beating the market. That said, I doubt any of us wants the consequences of being the lucky fool. So it comes back to the choice I raised earlier: Do we float along or do we challenge the bias?
Nobel Prize-winning psychologist Daniel Kahneman lists the “over-confidence effect” as one of the most common ways people fool themselves. In this short video, Professor Kahneman explains that over-confidence often runs in tandem with the contrary tendency of loss aversion.
Human beings can at once be irrationally over-confident and unnecessarily loss averse. How is that?
Staying Apart from the Herd
Don’t Be Afraid to Stand Apart From the Herd
Just because everyone else is investing or spending in a certain way doesn’t necessarily make it safe. The herd often moves according to cycles of fear and greed. In this article, Carl Richards says you should always start from the basis of what is right for you.
When it comes to investing, sticking out from the herd is not always a bad idea:
New Zealand’s expert independent wealth management provider, Bradley Nuttall Ltd is pleased to announce that its DIMS (Discretionary Investment Management Services) licence from the Financial Markets Authority is effective from 30th October 2015.
A DIMS licence is where buy-sell decisions about a customer’s investment portfolio may be made on behalf of a customer, without the need for their authorisation for each transaction. Licensing of DIMS was introduced as part of the Financial Markets Conduct Act 2013, which is replacing most of New Zealand’s existing financial markets conduct law. The new DIMS licensing arrangements place greater obligations and minimum standards on providers, which regulators hope will deliver better protection to investors.
The DIMS licence enables Bradley Nuttall Ltd to continue to provide the financial market services it has been offering clients for the last 25-years. Please click here for more information concerning the DIMS licensee obligations.
There’s no getting away from it. Market volatility tends to make investors feel uncomfortable, leading to knee-jerk decisions. Investor educator Brian Portnoy, CFA, Ph.D., recommends asking yourself at these times whether you are trying to resolve a long-term financial problem or a short-term emotional need.
Hello, volatility. It’s been a while.
As stock market investors, we should appreciate that we’ve had it relatively easy for years. It’s hard to understate how smoothly the equity markets have climbed since things settled down after the 2007-09 crisis. Since then, returns have been way above average while volatility has been way below average.
Profiting from a risky asset always involves a cost – a “price of admission.” That price is not only the uncertainty of whether the asset’s expected returns will be reached in the time frame relevant to us, but also the ride along the way. Contrary to the conventional wisdom of legends like Warren Buffett, Howard Marks, and Gene Fama, volatility is indeed a form of risk because lots of volatility often compels us to make bad decisions. (I’ll offer a full rant on that topic in a subsequent blog.)
Volatility’s return is a source of discomfort for all of us as it forces us to pay more attention to near-term market moves, which is mentally tiresome. And it tempts us to make more near-term decisions than we’ve been used to. It’s hard to resist counterpunching. In the moment, a rope-a-dope strategy means you’re getting pummeled.
Some basic tenets of behavioral finance can prove insightful at times like these. The goal is not to change your mental make-up – that’s impossible – but to appreciate that our hardwiring leads to some quirky behavior. Self-awareness can help us hedge bad decisions.
It’s the disposition effect that is top of mind for me now as I speak with financial advisors about how they’ve begun to brace themselves and clients’ expectations for choppier times. This effect states that you are wired to invest differently depending on whether you’re winning or losing.
We tend be to risk averse when we are sitting on gains and risk seeking when we are sitting on losses.
But why? The godfathers of behavioral finance, Amos Tversky and Daniel Kahneman, wrote in a 1979 seminal paper: “Our perceptual apparatus is attuned to the evaluation of changes or differences rather than to the evaluation of absolute magnitudes.”
To interpret the academics: It’s the journey that counts, not the destination. Life (and our portfolios) happens incrementally. So you measure progress based on where you now sit relative to your starting reference point.
Zero, it turns out, is a powerful reference point. When you’re ahead – great. But then we tend to sell winners quickly because we crave the psychic gratification of being right and the financial joy of booking a real gain. This is sometimes the wrong move, especially as stocks with positive momentum tend to keep going up.
On the other side of zero, we tend to feel the pain of losing far more than the joy of winning; this is the powerful notion of “loss aversion.” Thus, we’ll go further out of our way to avoid realizing a loss by holding on to a position in the red. Selling a loser? Boy, can that sting.
Realizing a loss renders us “officially” wrong. For advisors, that can prove to be a painful conversation with clients. Overall, advisor and client alike are often desperate to get back to scratch, even when it doesn’t matter much to the bottom line (“absolute magnitudes” to the academics). Sometimes, we’ll even “double down” – add more to a losing position – in the hopes of recovering from losses even more quickly. We look like a hero when we get off the ropes and land a haymaker.
With a more-heightened alert to choppier markets and the hard-to-shake feeling that we must “do something” during such times, please be cognizant of this disposition effect. It says nothing about the underlying value or risk in any of your investments. From a purely analytic point of view, there can be both good reasons to sell a loser (e.g., you were in fact wrong on the thesis) or to hold a loser (e.g., the value’s still there, perhaps even more so now).
But it does speak volumes when emotions trump analysis. Doubling-down, or any other number of trading strategies, might feel like the right thing to do in the moment. At those times, take a breath and ask whether you are solving for a short-term emotional need or a long-term financial problem.
The answer to that question will likely put you in good stead.
What Do the New FMC Regulations Mean for Investors?
Late last year, with very little media coverage Phase 2 of the implementation of the Financial Markets Conduct Act (FMC) and full FMC regulations came into effect resulting in some of the most modern financial markets regulation in the world. The intention of the changes is to provide greater protection for investors and more user friendly information about investments. It also means that financial professionals will be required to be licensed to make investment decisions on behalf of their clients.
This regulatory change will significantly impact all financial advisory businesses, Bradley Nuttall included. However, Bradley Nuttall will, as usual, continue to strive to attain a standard far in excess of the minimum set by the regulator.
Rob Stock’s brief opinion piece from the Dominion Post at the time identified two key changes for investors.
1. New licensing requirements for Financial Advisers, and
2. Short-form disclosures for investment products.
New Licensing requirements
The new licensing requirements apply to advisers who provide a discretionary investment management service or DIMS. That includes us here at Bradley Nuttall. Essentially, this license will hold advisers who exercise investment making discretion on clients’ behalf (that’s what a discretionary investment management service or DIMS is) to a more rigorous standard.
Bradley Nuttall is applying for a DIMS license. This is not simple and it will definitely add a further layer of complexity to our business and having started the application process, it is very apparent that a license will not be given easily and it will come with far greater ongoing monitoring by, and engagement with, the regulator.
For our clients, while the way that we do things won’t appear to change, the new rules will require us to update our paperwork with you in the near future and we’ll explain what is required as it is needed.
Investment products in New Zealand must now conform with new short-form disclosure requirements. All new investments must have a short-form product disclosure statement (PDS) that is concise and easier to understand.
Fund managers have a two year transitional period to comply so there’s nothing on the website yet but once it is up to date it should be a treasure trove of funds management information which will make it easier for both the public and the FMA to monitor funds.
Bradley Nuttall have always made the information required in the short-form product disclosure statements available to those that were interested. The key benefit of having all of this information on the one website is to make it much easier for all of us to ‘look under lots of bonnets’ in one place. That will enable everyone to compare like with like without having to trawl the internet for the information.
We think that’s a great change.
Scott Rainey is an Authorised Financial Adviser.
Disclosure statement is free and available on request
Market Timing: A Picture is Worth a Thousand Words
They say a picture is worth a thousand words.
I could easily spill a thousand words on market timing. I could talk about how each trade involves a willing buyer and seller; each with equal interests, each with the same access to information.
I could talk about the fact that, over about 85 years, the S&P 500 has gone up on only 51.02% of the days.[i]
I could talk about the concentrated nature of returns. I could show that being out of the market, and missing the best month each year, drops returns by about 7% per year.[ii]
I could talk about a psychologist from Berkeley, named Philip Tetlock, who studied over 82,000 varied predictions of 300 experts from different fields over a period of 25 years, and concluded that expert predictions barely beat random guesses. Ironically, the more famous the expert, the less accurate his or her prediction tended to be.[iii]
I could talk about Nobel Prize winner Bill Sharpe’s contention that timers need to be right 74% of the time to overcome the frictions and costs of their moves.[iv]
I could talk about magazine covers, like the Death of Equities[v], that featured just before five years of 14.44% average compound returns for the S&P 500.[vi]
I could talk about how studies – ranging from the landmark paper by Brinson, Beebower and Hood[vii], to the most recent study on NZ managed funds – have found that the average contribution of market timing to returns is negative.[viii]
I could talk about a study of 1,557 managed funds and 210 institutional funds, where the author concluded timing ability of managers is, on average, negative.[ix]
I could talk about how the majority of market timing newsletters underperform the market.[x] I could talk about how, on average, market timing newsletters underperform the market by over 4.00%.[xi]
I could talk about how the market timing gurus whose calls are tracked have less than 50% accuracy.[xii]
I could talk about evidence that shows economists can’t time markets either.[xiii]
I could talk about how the predictive power of last year’s return to correctly forecast this year’s return is 0.01%.[xiv]
I could talk about the wise words of Warren Buffett, who said “The only value of (share) forecasters is to make fortune tellers look good.”[xv]
I could talk about the simple logic that all market timing calls offset each other. If you buy, someone must sell. If you sell, someone must buy.
I could talk about a lot of things.
I could show you this picture of monthly returns and simply ask you to find the pattern.
Wishing you the very best of luck…
[i] www.ifa.com, “Positive vs. Negative Returns in Various Time Periods”, 85 Years, 5 Months (1/1/1928 – 5/31/2013); S&P 500
[ii] NZX and Returns 2.0. Calculations performed by NZ Wealth. Returns gross of all fees and taxes
[iii] Burton Malkiel and Charles Ellis, “The Elements of Investing”
[iv] Sharpe, William, “Likely Gains From Market Timing”, Financial Analysts Journal, March – April, 1975
[vii] Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, “Determinants of Portfolio Performance”, Financial Analysts Journal, July-August 1986, pp. 39-44; and Gary P. Brinson, Brian D. Singer and Gilbert L. Beebower, “Revisiting Determinants of Portfolio Performance: An Update”, 1990, Working Paper.
[viii] Rob Bauer, Roger Otten, Alireza Tourani Rad, “New Zealand mutual funds: measuring performance and persistence in performance,” Accounting and Finance 46 (2006) 347–363
[ix] Wei Jiang, “A Nonparametric Test of Market Timing.” Journal of Empirical Finance 10 (2003) 399– 425
Why More Information Can Lead to Poor Investment Decisions
How many people make investment decisions based on the last thing they read in the paper or heard on TV?
In their minds, they believe they’ve found the missing information that resolves their uncertainty. But is the uncertainty truly resolved? No; what they’ve done is overemphasise the value of the new information they’ve heard. While we probably know that’s true intuitively, experts can provide insight into this process.
We like to think that more information drives smarter decisions; that the more details we absorb, the better off we’ll be. It’s why some of us subscribe to Google Alerts and cling to our iPhones.
Knowledge, we’re told, is power. But what if our thirst for data is actually holding us back? What if we are biased to weight the value of new information inappropriately and disproportionately, therefore compromising our decision-making process?
That’s the question raised by Princeton and Stanford University psychologists in a fascinating study, titled “On the Pursuit and Misuse of Useless Information” (Journal of Personality and Social Psychology, Vol. 75, No 1).
Their experiment was simple. Participants were divided into two groups.
Group 1 read the following:
Imagine that you are a loan officer at a bank, reviewing the mortgage application of a recent university graduate with a stable, well-paying job and a solid credit history.
The applicant seems qualified, but during the routine credit check you discover that, for the last three months, the applicant has not paid a debt to his charge card account. The existence of two conflicting reports makes it unclear whether the outstanding debt is for $5,000 or $25,000, and you cannot contact the credit agency until tomorrow to find out which is the correct amount.
Do you approve or reject the mortgage application immediately, or wait until tomorrow when more information is available?
Group 2 saw the same paragraph, with one crucial difference – instead of the amount of the debt being unclear, the second group was told upfront that the unpaid debt was exactly $5,000.
Here’s where it gets interesting. Once the participants in Group 1 who decided to wait for more information were told the size of the debt was only $5,000, 21% of that group rejected the mortgage application. Compare this with the 71% of Group 2 participants (remember, that group didn’t need to decide whether to wait for any further information) who chose to reject the applicant immediately.
To say the findings are surprising is an understatement. Why would the rate of rejection be three times higher in Group 2?
The answer underscores a troubling blind spot in the way we make decisions.
The human mind hates uncertainty. Uncertainty implies risk, randomness and danger. When we notice information is missing, our brain raises a metaphorical red flag and says, “Pay attention. This missing information could be important.”
Seeking out information comes with a downside, however, which accounts for the intriguing difference between the two groups in the study described above. When data is missing, we overestimate its value. Our mind assumes that, since we are expending resource locating information, it must be useful.
The majority (75%) of participants in Group 1 couldn’t help but wait for additional information. And because their attention was now focused on whether the debt was $5,000 or $25,000, their thinking about the loan had shifted – it was all about the size of the debt rather than the simple fact that the applicant had not paid anything off this debt in three months.
This instinct to find the missing information, and subsequently assign it too much importance, explains why investors love market forecasts. Investors want to fill in the missing piece of information, which for most is something along the lines of “what is the market going to do next year?” But the forecasts are consistently wrong.
Below are leading Australian economists’ forecasts in the Sydney Morning Herald for 2011, compared to the actual results:
This shows how difficult it is to forecast correctly, even over short periods of time. How wise is it to make investment decisions based on forecasts like the above?
Information is addictive; learning is associated with the release of dopamine! In a world where every click brings the promise of a discovery, we are all at risk of becoming addicts. The challenge lies in deciding which questions are worth exploring and how much importance we give to their answers.
The role of the adviser is to know the questions that really add value, and then make considered decisions based on the sum of all the information. This means avoiding overemphasising the importance of recent information, and understanding what is unknowable, so we can avoid trying to fill the gap with forecasts. By doing this, we can keep clients’ investments on track and afford them peace of mind.
With thanks to Rick Walker and an article published by Ron Friedman, PhD, in Glue, 4 December 2012.
Many Happy Returns
The holiday season encourages media retrospectives about financial markets. It’s fun to match these up with what people were saying a year before.
In December, 2011, the publication Barron’s told investors to “buckle up”. The consensus prediction of its panel of 10 stock market strategists and investment managers was for the US S&P-500 to end 2012 some 11.5% higher at about 1360.1
“That sounds like a big gain, but a lot of things have to go right for the market to make such impressive headway,” the writer said. “Even the most bullish of these Street seers fears stocks could be more wobbly in the next six months than in the six months past.”
There was so much for forecasters to get right – a negotiation of the Euro Zone crisis, uncertainties over the growth of earnings, the roadblock of the US presidential election and the challenge for emerging economies to sustain high economic growth rates.
Twelve months later, markets are still grappling with many of the same issues, though from different angles. Much of Europe is either in recession or growing only modestly, unemployment is high and a number of countries that share the single currency are unable to pay their debts. The US presidential election gave way to worries over the so-called “fiscal cliff”, while Chinese exports have been hit by the slowdown elsewhere.
In the meantime, however, there have been solid gains in many equity markets, including parts of Europe and Asia, as well as North America. That Barron’s panel forecast of the S&P-500 reaching 1360, which the magazine said was ambitious, is now looking conservative. The index was 4% above that level by mid-December. What’s more, some of the strongest performances have been in emerging and frontier markets.
Annualised returns for the past three years of 20 developed and 20 emerging markets, using MSCI country indices. Returns are ranked on a year-to-date basis and expressed in New Zealand dollars.
Among developed markets, three members of the 17-nation Euro Zone – Belgium, Germany and Austria – were among the top performing equity markets this year. Leading the way among emerging markets was Turkey, which regained its investment grade ranking from agency Fitch in November.
New Zealand was one of the top performers this year driven by better than expected growth and Haier’s bid to purchase Fisher and Paykel. What is perhaps more amazing is that New Zealand has had the highest 3-year returns (9.4%) of any country in the developed world… by a big margin. Further, the United States is number 3 (5.7%), just behind Denmark (5.8%). Show me the media outlet that predicted this?
And while much of the media focus has been on the so-called BRIC emerging economies of Brazil, Russia, India and China, the real stars in the emerging market space these past three years have been the south-east Asian markets of the Philippines, Thailand and Indonesia.
There a few lessons from this. First, while the ongoing news headlines can be worrying for many people, it’s important to remember that markets are forward looking and absorb new information very quickly. By the time you read about it in the newspaper, the markets have usually gone onto worrying about something else.
Second, the economy and the market are different things. Bad or good economic news is important to stock prices only if it is different from what the market has already priced in.2
Third, if you are going to invest via forecasts, you need to realise that it is not just about predicting what will happen around the globe, but it is about predicting correctly how markets will react to those events. That’s a tough challenge for the best of us.
Fourth, you can see there is variation in the market performance of different countries. That’s not surprising given the differences in each market in sectoral composition, economic influences and market dynamics. That variation provides the rationale for diversification – spreading your risk to smooth the performance of your portfolio.
So it’s fine to take an interest in what is happening in the world. But care needs to be taken in extrapolating the headlines into your investment choices. It’s far better to let the market do the worrying for you and diversify around risks you are willing to take.
In the meantime, many happy returns!
By Jim Parker, Vice President – Dimensional & Ben Brinkerhoff, Head of Partner Growth at Consilium NZ Ltd
How the Best Investor in the World Beats the Market
For good reason, Warren Buffett has long been considered one of the most judicious investors of his generation. In fact, his firm Berkshire Hathaway has the highest risk-adjusted returns of any listed U.S stock or managed fund with a history of more than 30 years.
Which begs the question: What’s the source of Buffett’s above market returns?
The “conventional wisdom” has always conveniently been that his success is explained by his share-picking skills and his discipline. However, a new study1provides some very interesting and unconventional answers.
The following is a summary of the study’s findings:
From November 1976 through December 2011 (a 35 year period), Berkshire realised an average return of 19.0% pa over and above the risk free asset (being U.S Treasury bills). In comparison, the S&P 500 (or the 500 largest listed stocks in the U.S) returned 6.1% above the risk free asset. That is an incredible result over such a long time period.
(It’s important to remember that Standard & Poor’s research comprehensively demonstrates that most investors don’t even get the market return – or in this case the S&P 500 return – over 5 years or longer. This is entirely due to ill-disciplined behaviour in volatile markets).
As risk and return are related, you would expect Berkshire to have been exposed to more risk than the overall market to achieve this result. And indeed it was, with one measure being that Berkshire’s share price was 58% more volatile than the overall market. So only investors who remained disciplined and held onto their Berkshire stock would have enjoyed the long term performance.
Berkshire had to endure periods of substantial losses compared to the overall market and significant drawdowns to achieve its results. For example, over the 20 month period to February 2000 (during the IT boom), Berkshire shares lost 44% of its market value, while the overall stock market gained 32%.
Not many fund managers could survive a 76% underperformance over a two year period! And no doubt there were many media commentators desperate to fill their column space each day who wrote off Berkshire shares during this time.
Buffett is clearly a proponent of our mantra “It’s not timing the market that counts, it’s time in the market that matters.”
Buffett has boosted returns through the use of low cost debt to invest.
Buffett has stuck with his strategy for a very long time period, surviving rough periods where others might have been forced into a fire sale or allowed emotion to interfere with the disciplined process of investing.
Buffett’s approach is to buy large stakes in operating businesses and, in certain cases, provide strategic advice to management. He tends to nurture and support management more than other investors.
The study concluded that it is Buffett’s strategy that generated the alpha or above market returns, not his stock selection or market timing skills.
Our approach of targeting the dimensions of higher expected returns focuses on the factors that drive returns and deliver a premium:
Cash & Fixed Interest
Credit & Term – only take credit risk and term risk where the bond portfolio is widely diversified and investors are adequately rewarded.
Market – over time the sharemarket provides higher expected returns than cash and bonds because risk and return are related.
Small – a well-diversified portfolio of small companies provides a higher expected return than large ‘blue chip’ shares because small companies are riskier assets to own and tend to have a higher cost of capital. A higher cost of capital over the mid to long term results in a higher expected return.
Value – a diverse portfolio of ‘cheap’ shares as measured by book to market ratios provides higher expected returns than large, established ‘growth’ companies because these value companies are riskier assets to own.
It is the ones relating to the sharemarket – plus some additional elements like low cost borrowing – that the report concluded were the foundation of Buffett’s success.
Buffett’s genius thus appears to be in recognizing long ago that “these factors work… and sticking to his principles,” the study finds. It notes that it was Buffett himself who stated in Berkshire’s 1994 annual report: “Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.”
When the study considered all the factors that Buffett targets in his investment approach, it found that only 0.1% pa of Berkshire’s stock price outperformance compared to the market could not be explained. In other words, whilst 0.1% could be attributed to skill or luck, the remaining outperformance could be quantified by academically accepted investment strategies employed by Buffett.
So we know that Buffett has one extrodinary gift that few others share, he is disciplined. He combines that discipline to buy primarily value (out of favour) shares and using low cost debt.
Whilst the average high net worth investor cannot access the type of low cost debt available to Buffett, you can access the other factors that contributed to his market-beating results.
Bradley Nuttall’s Asset Class investment approach already captures the academically accepted factors that drive returns, plus ‘momentum’.
The academics we work with in the U.S have, after extensive research, uncovered a sixth factor that is currently being tested. This may be another evolution in our investment approach that is helping to provide our clients with the greatest probability that their lifestyle and financial goals will be achieved.
So in our own way, we are capturing the nous of Buffett through our evidence based approach to investment. However instead of our clients spending their time like Buffett studying the market for opportunities, we hope our clients are instead enjoying full and meaningful lives that don’t involve the day to day worries of investing.
Adapted from Larry Swedroe, Money Watch, 2 October 2012, and from Rick Walker at Stewart Partners, Sydney Australia
1. ‘Buffett’s Alpha’, by Andrea Frazzini and David Kabiller of AQR Capital Management, and Lasse Pedersen of New York University and the Copenhagen Business School, 29 August 2012
A recent article appearing in the Financial Times caught our eye—or perhaps we should say ear. At first glance it was unremarkable—just one among dozens of recent think pieces suggesting that investors were losing interest in stocks as markets around the world continued to stagnate.
But the tone of the article sounded remarkably familiar. We dug out our copy of the “Death of Equities” article appearing in BusinessWeek on August 13, 1979, to have a fresh look. Similar? You be the judge:
“This ‘death of equity’ can no longer be seen as something a stock market rally—however strong—will check. It has persisted for more than ten years through market rallies, business cycles, recession, recoveries, and booms.”
Financial Times, 2012:
“Stocks have not been so far out of favor for half a century. Many declare the ‘cult of the equity’ dead.”
“Individuals who are not gobbling up hard assets are flocking to money market funds to nail down high rates, or into municipal bonds to escape heavy taxes on inflated incomes.”
Financial Times, 2012:
“The pressure to cut equity exposure is being felt across the savings industry. … In the US, inflows to bond funds have exceeded equity inflows every year since 2007, with outright net redemptions from equity funds in each of the past five years.”
“Few corporations can find buyers for their stocks, forcing them to add debt to a point where balance sheets seem permanently out of whack.”
Financial Times, 2012:
“With equity financing expensive, many companies are opting to raise debt instead, or to retire equity.”
“We have entered a new financial age. The old rules no longer apply.” —Quotation attributed to Alan B. Coleman, dean of business school, Southern Methodist University
Financial Times, 2012:
“The rules of the game have changed.” —Quotation attributed to Andreas Utermann, Allianz Insurance
“Today, the old attitude of buying solid stocks as a cornerstone for one’s life savings and retirement has simply disappeared.”
Financial Times, 2012:
“Few people doubt, however, that the old cult of the equity—which steered long-term savers into loading their portfolios with shares—has died.”
When the first “Death of Equities” article appeared, the S&P 500 had underperformed one-month Treasury bills on a total return basis for the fourteen-year period ending July 31, 1979 (107.0% vs. 119.6%, respectively). Was buying stocks in August 1979 a smart contrarian strategy? Yes, but only if one had the patience to stick it out for years. Imagine the frustration of an investor who had been counseled to “stay the course” in response to the “Death of Equities” article appearing in August 1979. Stocks did well for a while, jumping over 27% from August 13, 1979, to March 25, 1981, when the S&P 500 hit an all-time high of 137.11. But by July 31, 1982, stocks had given back all their gains, and the S&P 500 was almost exactly where it had been nearly three years earlier. As of July 31, the S&P 500 had extended its underperformance relative to one-month Treasury bills to seventeen years (total return of 150.5% vs. 213.6%).
Imagine this same investor arriving at her financial advisor’s office on Friday, August 13, 1982, with a three-year-old copy of BusinessWeek under her arm. Stocks had drifted lower in the preceding weeks, and the S&P 500 had closed the previous day at 102.42. “You told me three years ago to stay the course, and I did,” she might have remarked to her advisor. “It hasn’t worked. Obviously, the world has changed, and it’s time I changed too. Enough is enough.”
We suspect even the most capable advisor would have faced a big challenge in seeking to persuade this investor to maintain a significant equity allocation. For many investors, seventeen years is not the long term, it’s an eternity.
Superstitions aside, stocks rose that day, with the S&P 500 advancing 1.4%. It wasn’t obvious at the time, but August 13, 1982, marked the first day of what would turn out to be one of the longest and strongest bull markets in US history. The S&P 500 was 16% higher by the end of the month and went on to quadruple over the subsequent decade. The table below shows data for the S&P 500 on a price-only basis. With dividends reinvested, the return would be materially enhanced.
“Death of Equities” Anniversary
1st Anniversary August 12, 1983 – 58.3%
5th Anniversary August 12, 1987 – 224.5%
10th Anniversary August 12, 1992 – 307.9%
20th Anniversary August 12, 2002 – 782.4%
(Almost) 30th Anniversary June 19, 2012 – 1,225.9%
One of the authors of the FT article, John Authers, is familiar with the BusinessWeek article and wary of making pronouncements that might look equally foolish ten or twenty years hence. In a follow-up article appearing several days after the first, he appealed for divine assistance in his forecasting effort: “O Lord, save me from becoming a contrarian indicator.” Nevertheless, after revisiting his arguments he remained persuaded that the climate for equities was too hostile to be appealing.
We should not use this discussion to make an argument that stocks are sure to provide investors with appealing returns if they just wait long enough. If stocks are genuinely risky (which certainly seems to be the case) there is no time period—even measured in decades—over which we can be assured of receiving a positive result. Nor should we seize on every pundit’s forecast as a reliable contrarian indicator. With dozens of self-appointed experts making predictions, some of them are going to be right. Perhaps even John Authers.
The notion that risk and return are related is so simple and so widely acknowledged that it hardly seems worth arguing about. But these articles (and others of their ilk) offer compelling evidence that applying this principle year-in and year-out is a challenge that few investors can meet, and explains why so many fail to achieve all the returns that markets have to offer.
“The Death of Equities,” BusinessWeek, August 13, 1979.
John Authers and Kate Burgess, “Out of Stock,” Financial Times, May 24, 2012.
John Authers, “The Cult of Equities Is Dead. Long Live Equities,” Financial Times, May 27, 2012.
S&P data are provided by Standard & Poor’s Index Services Group.
Stocks, Bonds, Bills, and Inflation Yearbook. Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield).
Bad news sells. It sells because fear is a more powerful emotion than greed. Newspaper editors know that, which is why the front pages are often so depressing. But sometimes you need to dig inside the paper for a more balanced view.
The bad news has been dominant in global markets in recent years, starting with the banking crisis of 2008 and more recently the sovereign debt crisis focused on Europe.
But other things have been happening. And any investor wanting an antidote for the grimmer headlines might like to reflect on the following recent news snippets:
US stocks rose for a sixth week, giving the S&P-500 its longest rally since January 2011, as economic reports beat forecasts and Germany backed the ECB’S bond-buying plan. – Bloomberg, Aug 18, 2012.
US consumer sentiment improved in early August to the highest in three months as sales at retailers and low mortgage rates spurred Americans to boost their buying plans, a survey shows. – Reuters, Aug 17, 2012.
Germany’s Finance Ministry says the nation’s tax income was nearly 9% higher in July from a year earlier – helped by recent wage increases and underling the continuing strength of the economy. – The Associated Press, Aug 20, 2012.
Sweden’s centre-right prime minister has backed a cut in corporate tax for his Nordic state as it defies the gloom of the euro zone. – Reuters, Aug 18, 2012
UK jobless claims unexpectedly fell in July and a wider measure of unemployment dropped to its lowest in a year as the Olympic Games created jobs, showing the labour market’s resilience. – Bloomberg, Aug 15, 2012
Australia is the new safe haven. Robust tax revenues and restrained government spending have put this ‘AAA’-rated nation on investors’ radars. Government 10-year bonds have returned 17% so far this year. – WSJ, Aug 14, 2012.
Japan has offered its strongest indication yet it sees a way out of deflation next year, after being mired in a corrosive mix of falling prices and weak economic growth for much of the past two decades. – Reuters, Aug 17, 2012
Norway’s sovereign wealth fund – the largest in the world – is planning to take on more risk as it seeks to exploit its role as a strategic investor. – The Financial Times, Aug 20, 2012
Now, none of these headlines are news to the markets. And pointing them out this way does not constitute a forecast. But it is worth reflecting on the fact that the economic and financial news is not all bad at the moment.
Sometimes, as citizens, consumers and investors, we can become overwhelmed by negative headlines and can end up making counter-productive decisions about our lives based on historical events that we have no influence over.
The fact is markets quickly incorporate news, good or bad. And for every person who capitulates and sells stocks based on news, someone else with a less negative view and/or a longer-term horizon is on the other side of the trade buying.
Maybe the best approach is to start reading the newspaper from the back page.
Taking the Plunge: Is Now the Time to Start Investing?
Anxiety about the equity market is understandable, but if we wait for the “perfect” time to invest, the risk is we never will.
The child was inconsolable. A day at the pool had ended without her joining her friends in the water. Time after time, she had dipped her toe in, only to shrink back in fear of the unknown. Now she was going home full of regret.
Investing can be a bit like that.
In a period of uncertainty, as we have been seeing, it is quite understandable that investors should seek to time the market. Like the little girl standing at the poolside torn between fear and anticipation, it can be easy to rationalise against taking the plunge.
But the problem is that fear and uncertainty can never be eliminated. Those feelings are the emotional manifestation of risk that is the price we pay for the returns we are seeking. In the case of the girl at the pool, she wants to join her friends in the water, but her fear of the unknown is preventing her from doing so.
The way to deal with these feelings is firstly to recognise them as legitimate and in so doing bring them back down to size. Fear tends to loom larger when we don’t confront it. It’s OK to feel anxious, but not to the point where it stops us ever doing anything.
Secondly, we should think back on the best experiences in our lives and reflect on how often they involved taking a risk – whether it was enrolling in a degree course or changing careers or moving towns or having children. If we waited for everything to be perfect, we might not ever have got around to doing those things.
Thirdly, we might like to reflect that while there is a potential cost in taking that plunge, extreme risk aversion also comes at a cost. For the little girl at the pool, the cost of avoiding that brief moment of fear was a miserable car ride home feeling excluded as all the other kids talked about the fun they had had.
In global financial markets recently, the premium on perceived safety has been particularly high. For instance, investors in the sovereign bonds of Germany, the US and the UK have been prepared to accept negative real yields for the privilege of governments looking after their capital – a risk without a return in other words.
Now those decisions might be completely defensible given the risk appetites of those particular investors. But it’s important also that we realise safety comes at a cost.
Finally, it is worth considering how quickly conditions can change while we are waiting for our anxiety to subside. Financial Author, Westin Wellington recently pointed out that amid all the recent turmoil, 22 prominent US firms have hit at least 52-week highs. These included household names like Johnson & Johnson, Hershey and Wal-Mart.
But this isn’t just a US phenomenon. In Australia, for all the talk about an underperforming equity market, a large number of leading companies have hit 52-week highs – including Commonwealth Bank, CSL, Tatts Group and News Corp.
In New Zealand, many companies recently hit 52-week highs – including Abano Healthcare Group, Infratil, Ryman Healthcare, Summerset Group Holdings, and Telstra.
We don’t know which shares will be the next ones to push to new highs. But we do know that those people sitting on the side-lines in cash – like the little girl shivering on the side of the pool – risk going home without sharing in the returns enjoyed by others.
The takeaway message is that there never is a perfect time to invest. How can there be, everyday half the shares are bought and half are sold. There’s always going to be two equal and opposite opinions. And since 1928 markets behave by going up 51.01% of the days.
We deal with that uncertainty by understanding the risks we are taking, diversifying broadly, making decisions for the long term not based on day by day fluctuations and being mindful of the factors within our own control – like our own behaviour.
So sometimes, you just have to close your eyes and take the plunge.
 Source: www.ifa.com, based on S&P 500 Index data going back to 1928
Insights on the Global Economy from Leading Academics
This week Bradley Nuttall attended an Investment Symposium where some of the world’s leading financial academics, including 1997 Nobel Prize in Economic Sciences recipient Myron S. Scholes and former White House adviser and chairman of the U.S President’s Council of Economic Advisers, Prof. Edward P. Lazear, gave presentations.
It was an opportunity for us to talk to and hear their views on recent global economic events and their thoughts on possible future outcomes. We have aggregated the key points made at the Symposium.
The risk of a contagion in Europe has been overstated
Governments are too focused on often ineffective short term fixes rather than long term growth
Excessive regulation and tax stifle economic growth
Four pillars drive an economy
Dr Scholes considers four key components when considering how economies operate:
Population – impact of ageing, employment and movement of people;
Technology – medical advances, innovation, internet and productivity
Scarcity – of resources, people and assets
Politics – the political system and legislative framework
Economies are such complicated systems that it is almost impossible to forecast the implications, particularly over the short term, of single changes and decisions. Too many commentators take overly simplistic views on how one factor may impact an economy.
Where is the US economy now?
The US economy is the world’s largest, so it is important to everyone, even though Australia and New Zealand’s economic growth has become more closely tied to China in recent times.
If long term economic growth trends had continued over the past 5 years (post war average has been 3.1% pa), the US economy would be 12% larger today. If government stimulus packages hadn’t occurred, the economy would be 3% smaller than today. So the value of doubling U.S government debt over the past 5 years has been minimal. The US economy was never on track for a repeat of the Great Depression as many commentators speculated – 3.5 years after the Great Depression started the US economy was 38% smaller.
Current US economic growth is about 2.4% pa, which is lower than some developed nations like Germany (3.3%) and Canada (2.8%), but higher than most.
The potential of the US economy is much greater than current output, with 8 million jobs still required to get employment back to pre-GFC levels. To some extent the share market is already forecasting a gradual recovery based on current pricing.
US labour market is still in quite bad shape, with the number of hires today less than in 2009. If this persists, it will take until 2017 to get employment levels back to pre-GFC levels, so it needs impetus.
The significance of Lehman Brothers failing has been overestimated
Dr Lazear was in the White House the day Lehman Brothers failed, and he considers it a minor event in the US recession.
By the time Lehmans collapsed on 15 September 2008, the following had already occurred:
US recession had started in December 2007
Bear Stearns failed in March 2008
In the summer of 2008 the Dow Jones lost 3000 points and 1 million jobs were lost
Fannie Mae and Freddie Mac failed before Lehmans, and AIG failed on the same weekend. With hindsight, the US government should have focused on AIG as a priority rather than Lehman Brothers.
The fallout from Lehmans is that many people now believe that contagions can spread if one event is allowed to occur. This takes the focus off fundamental policy and onto short term policy responses. Almost all short term policies in recent years have failed to jump start the economy.
As an example, the US had a ‘cash for clunkers’ scheme, encouraging people to trade in their old cars to buy new ones. The results show zero improvement in new car sales over the last few years compared to what was expected. The ‘spike’ upwards was matched by an equal ‘spike’ downwards over the following years for no net benefit. Australia had a similar failed scheme.
Fears of a ‘contagion’ in Europe are misplaced
Following on from the Lehman’s lessons, we should not believe the media hype that if one Euro country fails, more will follow.
As an example, the day after the recent Greek elections – when Europe received the best outcome with Greece remaining in the euro – interest rates on Spanish and Italian bonds rose, meaning the market now thought these bonds were more risky.
Each country in Europe has its own domestic problems – they have little to do with Greece.
Spain, like the US in 2008, has a housing market problem that has leaked into a banking problem as property prices fall. This is why their banks recently needed additional capital from the government.
Italy has a government problem, where a lack of control over government expenditure over many decades has resulted in high government debt. If not for Italy’s annual interest payments on its debt, the country would actually run a government budget surplus. So Italy’s problems aren’t new, they’re just getting greater focus with the other problems in Europe.
Governments need to focus on productivity to stimulate growth
Academic research clearly demonstrates that the most effective way to stimulate economic growth is by focusing on productivity, as this has the greatest impact on real wage growth and thus expands the tax base. This close linkage is true in every economy around the world.
What are potential scenarios for the global economy going forward
Main themes for the next decade
Technology will make the US more competitive, so production and manufacturing will grow domestically as the costs in countries such as China increase. Many Chinese businesses are themselves outsourcing to lower cost nations like Indonesia and Vietnam.
US will become more self-sufficient for energy, particularly from shale oil and gas.
US trade deficit should start to reverse
Peak oil may have already occurred due to nations like Saudi Arabia spending less on exploration and more on delivering services to their domestic populations. Some estimate that all of Saudi Arabia’s oil production will be consumed internally within 15 years.
Dr Edward Lazear, who was responsible for releasing US economic growth forecasts, reconfirmed how difficult it is to make short term forecasts about anything, but much easier over the longer term. However, two potential scenarios for global economic growth were discussed:
Reversion to a normal economic cycle from a severe recession. Europe will continue to be a drag on global economic growth due to uncertainty rather than any real economic issues. The additional cash being made available to European economies will provide sufficient liquidity to allow banks to rebuild their balance sheets. No real signs of inflation in Europe or the US may see interest rates remain low until 2014
Debt/deflation and fiscal concerns with monetary reflation. Various parts of the world will repeat the Japanese experience over the past 20 years, where the economy grew but at the cost of large growth in government debt to support it. In response, governments could impose greater regulation on economies that stymies innovation and increases uncertainty, which in turn acts as a drag on growth. New enterprises will be vital to provide employment opportunities for those displaced by the effects of automation. For example, Walmart employs 1.9 million people whilst Google employs 20,000 people. (Walmart’s market capitalisation is only 25% higher than Google).
Money in the Bank – Term Deposits vs Fixed Interest
Key Points Overview
For many people, there’s no better bet than money in the bank. And with New Zealand interest rates among the highest in the developed world, why should you risk your capital in fixed income funds when term deposits are so tempting? In answering that question, it’s useful to reflect on what fixed interest is, the risks involved and the various roles this asset class can play in a diversified portfolio.
Term deposits have the attraction of safety. But bear in mind it is harder, and often expensive, to get quick access to your money when it is locked up in the bank. In addition, the recent premium offered by deposit rates is historically unusual and there is the prospect of interest rates going down during your chosen term, leaving you with risk you won’t be able to reinvest your money at attractive rates.
At the height of the global financial crisis in 2008, the New Zealand Treasury made explicit an implied guarantee on retail bank deposits. The initial scheme was extended in 2010 at lower levels of protection, but was removed altogether at the end of 2011.
Concerned at the advertising around term deposits, regulators in Australia (a country whose major banks dominate the NZ market) have warned that if investors are not vigilant and exercise a choice before maturity, banks can roll-over their term deposits at much less lower interest rates than what they originally signed up for.
Term deposits are very safe, but so is a well-constructed portfolio of diversified fixed interest spread between banks, governments and very large corporations.
Finally, when you look at tempting term deposit rates on offer with managed fund returns, the more appropriate comparison is between actual managed fund returns and what you would have been offered on deposit one, three or five years ago. With your funds managed conservatively in a unit trust, you can generate an expected return over cash without compromising liquidity or sacrificing the need to preserve your capital. For an investor looking to grow the purchasing power of their assets, this is a more attractive option.
So, let’s now go back to first principles and examine the definitions and use of fixed interest in a diversified investment strategy…
Fixed Interest 101
What is fixed interest? It’s a broad term that describes bonds or loans that can be purchased and sold on the open market. The borrower, who can be a bank, a corporation or the Government, receives a loan for an agreement to pay it back with interest.
How much interest does the borrower pay?
The rate of interest is typically determined according to two key factors:
The first is the certainty the borrower will pay back the loan. This is called ‘credit’ risk. The more certain the borrower is to pay back the loan, the lower the interest they have to pay, and vice versa
The second factor is how long they’d like to borrow money for. This is called ‘term’ risk. The longer the term of the loan, the more interest the borrower typically has to pay
So investors can seek exposure to these two risk factors, in exchange for interest. The extent and mix of each will depend on both the individual’s risk appetite, and why they are investing in fixed interest in the first place.
There are many reasons why you would want a portfolio of fixed interest:
Fixed interest is typically much less volatile than, for example, shares, so is a good place to put your “just in case” money
Because bonds, and especially bond funds, can be sold quickly, you can get access to your money, in cash, within one day
Fixed interest generates higher returns than an at-call bank account. More on this later…
Fixed interest is a good diversifier to shares. Fixed interest can increase in price exactly when shares are falling, helping smooth out the ride for an investor holding both assets
Speaking to number 4 above, we have a chart showing New Zealand bonds (ANZ Composite Investment Grade Index) compared to New Zealand shares (NZSX All Index) from January 2002 through December 2011.
But there is an alternative to fixed interest: term deposits. Let’s look at term deposits next.
The Attraction of Term Deposits
If your number one goal as a depositor is having next to no chance of any drop in price, then a term-deposit in a large bank looks like a good investment.
A term deposit provides you with two types of certainty:
Certainty that your original investment is highly protected
Certainty that you’ll receive an agreed amount of interest at the end of the negotiated term
Both those certainties are in marked contrast to the experience of many NZ investors, stung in recent years by the collapse of a succession of finance companies. Today, the focus is more on managing risk and sacrificing some return.
Next, a term deposit is typically better than just leaving your money in on-call bank accounts. According to the Reserve Bank of New Zealand[i], the ‘spread’, or premium, offered by retail term deposit rates over wholesale rates has increased since the GFC. This is because banks’ alternative source of funding – in the wholesale money markets – has become more expensive. Hence, they are increasingly reliant on deposits from retail investors and the resulting competition has driven up retail term rates relative to wholesale.
While term deposits are very safe, you can sacrifice other benefits by opting for them:
1. You can’t always access your money as quickly as you might like when it is locked away for one, two, three or five years. You can always break the deal, of course, but fees and charges can be onerous
2. Secondly, keep in mind that the government’s deposits guarantee has now been removed. This is not to suggest the banks are at risk of default. But the proposed removal of an explicit, if not an implicit, safety net does diminish one perceived attraction of term deposits
3. Third, unless you explicitly intervene, term deposits can automatically roll over, when they mature, to much less favourable rates. You can then find yourself locked in for an extended period, at rates lower than are available elsewhere.
To this point, the Australian Securities and Investments Commission (ASIC) in 2010 released a major review of term deposits[ii] that raised serious questions about the marketing and disclosure of these accounts.
ASIC found that authorised deposit-taking institutions – including the big four banks operating in New Zealand – actively advertised higher interest rates on one or two term deposit periods, while maintaining lower interest rates for all other deposit periods. On average, these lower rates were 42 percent below the advertised offers.
Citing poor disclosure by the banks, ASIC also found a weighted average of 47 percent of the $16.63 billion in term deposit funds that rolled over for the first time, automatically defaulted to lower rates. In addition, the regulator noted that, while investors can break their term deposits before maturity, a penalty is still likely to apply. So it is not quite true to say there is no risk in term deposits
4. Fourth, term deposit rates are at historically high levels relative to the existing rates on offer in the money market. While this is a great thing for depositors, it is unusual and may not be maintained.
5. Next, and perhaps most importantly, after taxes and inflation term deposits don’t leave you much, if any, growth in the value of your assets. For example, assume a 3% rate of inflation and a depositor in the 33% tax bracket. If such an investor got a one-year term deposit at 5%, their actual after inflation return would be 5%*(1-33%) – 3% = 0.33%. If that depositor has any aspirations for his/her money to grow to provide future purchasing power, a term deposit is simply not going to achieve that purpose.
Rates Can Go Up…and Down
There is also interest rate risk. While official cash rates started to go up again in mid-2010, they returned to record lows of 2.5% in March 2011, after the Christchurch earthquake. This means investors can come out of a term deposit and have to roll over at less favourable terms, with all the uncertainty that generates.
What’s more, even without changes in the official cash rate, term deposit offers can fluctuate widely – depending on the funding needs of institutions.
How Safe is Fixed Interest?
Fixed interest is very liquid; you can get your money the next day, typically with only a small transaction charge and no penalty. Whatever interest you’ve earned while owning the investment is yours and no one can take that away, such as happens when you break a bank term deposit agreement.
But how safe is fixed interest? This is another way of asking about the risk of default. Investors feel very certain the bank will pay them back. What about a portfolio of diversified fixed interest.
Looking at one of Bradley Nuttall’s New Zealand Fixed Interest portfolios[i] as of 31 March 2012 we see that the top 10 holdings are:
Auckland Intl Airport
This is interesting, because the top holdings are the banks themselves. Banks raise money multiple ways. One is borrowing money in term deposits. Another is going onto the bond market and borrowing from investors. They typically pay investors a higher return; however, the likelihood of getting paid back is virtually identical. Banks are just as likely to pay back investors as they are to pay back term depositors. And if they get in trouble they will turn to the Government, which is the sixth largest borrower in this portfolio.
In other words, the portfolio, made up of the above borrowers, is unlikely to default. However, just like with the bank, it is not impossible.
International Fixed Interest
Bradley Nuttall’s choice for international fixed interest, Dimensional, has managed to be very competitive with term deposits over the long term, by adding only a small amount of term risk and credit risk. While this makes its fund more volatile than cash, it has not compromised the other goal of capital preservation. Plus Dimensional’s fund, like all funds used by Bradley Nuttall, can be converted into cash within one day and does not have the rollover risk that term deposits face.
Like our choice for domestic fixed interest, the international fund is also more diversified than a simple term deposit with a single bank. It invests in a broad range of high quality fixed interest securities, including the bonds of governments, major banks, international organisations like the World Bank and top-rated corporate borrowers.
Perhaps more significantly, the international fixed interest fund is not dependent on what happens to NZ interest rates. Instead, it is diversified across a range of advanced economies including Australia, Canada, the Euro zone, Denmark, Sweden, Switzerland, the UK and the US. Currencies are hedged back to the NZ dollar.
Both the domestic and international fixed interest funds are not locked in to one term. They vary maturities to take advantage of the best interest rates on offer. This reduces the risk of having only poor interest rate options available when the loan principle is repaid.
How Bradley Nuttall Domestic and International Fixed Interest Strategies Compare – January 2005 to March 2012
Finally, when comparing term deposit offers with fixed interest funds, it is important to compare apples with apples. That means comparing what has been delivered by the funds over a certain period with what the banks were offering at the beginning of that period. Below we present a table that compares the BNL strategies with one month bank bills, the overnight cash rate (the interest banks charge one another to borrow money, which is similar to the on-call rate for bank depositors) and six month term deposits.
* Source: BNL NZ Fixed Interest Jan 2005 to April 2009 is ANZ Corporate A Bond Index (Source: Morningstar). From May 2009 Dec 2010 it 100% Harbour Corporate Bond Fund. From January 2011 to Dec 2011 it 67% Harbour Corporate Bond Fund and 33% AMP NZ Fixed Interest Fund.
** Source: BNL International Fixed Interest Jan 2005 to Dec 2011 is Dimensional 5 Year Diversified Fixed Interest Fund.
*** Source: Reserve Bank of New Zealand, interest rates on lending and deposits; wholesale interest rates.
[i] Reserve Bank of New Zealand, Quarterly Statement on Monetary Policy, February 2012
[ii] Review of Term Deposits, Report 185, Australian Securities and Investments Commission, February 2010
Recent Events and Possible Outcomes in Local and Global Financial Markets
The Global Economy
US recovery underway with improvement in jobs, consumer sentiment, housing and industrial activity
US Federal Reserve signals low rates until 2014, to encourage growth
UK enters double dip recession ahead of Olympics
Greece reaches deal with creditors
European Central Bank helps Europe refinance €529b in loans
China GDP growth eased to 8.9% from 9.1%
Australian Reserve Bank lowers interest rates by 0.50%, to combat high dollar and weaker than expected inflation
Since the beginning of 2012, the tentative global economic recovery has gathered pace. The U.S economy is improving, ahead of elections later this year. This is also being helped by assurances that interest rates will remain low – or effectively close to zero – until late 2014, which has given a boost to domestic U.S confidence.
In Europe, Greece reached a voluntary deal with creditors to swap their current holdings of Greek bonds for new bonds with later maturity dates and lower returns. This enabled the Greek government to write off around €100 billion of its debt, and paved the way for a €130 billion bailout package by international lenders (although this is still reliant on the implementation of austerity measures).
Spain is also attracting more attention given a recent cut to its credit rating, which is now BBB+, after the country slipped into its second recession in three years. The Government is pushing through budget cuts to reduce its debt but this does little to address the country’s 24% unemployment rate, one of the highest rates in the developed world.
The Spanish government has already rescued a number of banks that were too exposed to a decade-long construction boom that crashed in 2008. Whilst the country’s banks will likely continue to require financial assistance from the government, the market does not expect Spain to default on its government-issued debt like Greece did.
In Asia, China’s annual economic growth slowed to below 9% for the first time in a decade. However, financial markets had been anticipating a slowdown for some time, due to lower demand for China’s exports and the government’s attempt to curb the growth of domestic house prices.
Australia’s economic growth is slowing below long term averages. The high value of the Australian dollar is curbing domestic activity, as it makes their exports less competitive in world markets. With Australia’s inflation rate now trending below the Reserve Bank’s 2% to 3% range, interest rates were cut by 0.50% on May 2nd. This was a steeper cut than markets were anticipating and reflects the fact that the positive effects of the mining boom are not flowing through to all sectors of the economy. The market is now anticipating Australian interest rates will fall by a further 0.50% over the next year.
The New Zealand Economy
Both business and consumer confidence levels are positive and/or rising, but this confidence is not being directly reflected in key economic measures.
The labour market is improving, but only slowly, with job numbers increasing by just 10,000 over the last three quarters of 2011. The economy itself managed modest annualised growth of only 1.5% over the same period.
In the housing market, while sales volumes are 25% up on a year ago, there is no widespread evidence of any significant price increases. New housing consents are also up modestly, but from extremely subdued levels, and new consent levels clearly remain well below historical averages. Non-residential consents were also flat for the last six months.
With domestic CPI inflation running at 1.6%pa, a relatively strong New Zealand dollar and the absence of any impetus yet to come from the construction sector or the Christchurch rebuild, the prospects are growing that New Zealand’s next interest rate rise may now not occur before 2013.
Financial Markets Overview
Q1 2012 was the best quarter for global equity markets in 14 years (this confirms the benefits of diversification and discipline)
“Risk On” climate boosted small stocks, value stocks and emerging markets
Strong rebound in financials globally, after poor 2011
New Zealand performed in line with major developed economies
Australia lagged due to high $A and slowing economy
In the second half of 2011, investor fears drove the New Zealand and global share markets down by, generally, between 5% and 10%. With investors’ worst fears ultimately not being realised, risk appetites rebounded in the March quarter. The MSCI World index (a proxy for global share markets) posted its best quarterly performance in 14 years. As can be seen below (data in NZD dollars) all developed markets produced positive returns in the quarter, except for Spain and Portugal.
Within the equity markets, there were strong performances from small stocks, emerging markets and value stocks.
The MSCI emerging markets index posted its best first quarter performance in 20 years. It was noteworthy that some of the countries that previously lagged in 2011 were among the best performers.
Compared to major developed markets, New Zealand shares performed relatively well. Small companies were the best performing asset class, globally, in the March quarter and New Zealand was no exception, where smaller company shares significantly outperformed the NZX Top 10 Index.
Appetite for yield continued to support the Listed Property Trust sector, with the New Zealand Property Index gaining 8.1% for the quarter.
With risk appetites reawakening, returns from fixed interest naturally lagged those of shares. Nevertheless, at the corporate level at least, they still were positive. While in 2011 the demand was for the highest rated government bonds, attention has now shifted to corporate debt.
Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.
Warren Buffett on Gold: Who Has the Midas Touch?
Over the course of a lengthy and illustrious business career, Warren Buffett has offered thoughtful opinions on a wide variety of investment-related issues—executive compensation, accounting standards, high-yield bonds, derivatives, stock options, and so on.
In regard to gold and its investment merits, however, Buffett has had little to say—at least in the pages of his annual shareholder letter. We searched through 34 years’ worth of Berkshire Hathaway annual reports and were hard-pressed to find any mention of the subject whatsoever. The closest we came was a rueful acknowledgement from Buffett in early 1980 that Berkshire’s book value, when expressed in gold bullion terms, had shown no increase from year-end 1964 to year-end 1979.
Buffett appeared vexed that his diligent efforts to grow Berkshire’s business value over a fifteen-year period had been matched stride for stride by a lump of shiny metal requiring no business acumen at all. He promised his shareholders he would continue to do his best but warned, “You should understand that external conditions affecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway.”
As it turned out, the ink was barely dry on this gloomy assessment when gold began a lengthy period of decline that tested the conviction of even its most fervent devotees. Fifteen years later, gold prices were 25% lower, and even after twenty-one years (1980–2010), had failed to keep pace with rising consumer prices. By year-end 2011, gold’s appreciation over twenty-two years finally exceeded the rate of inflation (205% vs. 195%) but still trailed well behind the total return on one-month Treasury bills (398%).
Perhaps to compensate for his past reticence on the subject, Buffett has devoted a considerable portion of his forthcoming shareholder letter (usually released in mid-March) to the merits of gold.
With his customary gift for explaining complex issues in the simplest manner, Buffett deftly presents a two-pronged argument. Like a sympathetic talk show host, he quickly acknowledges the darkest fears among gold enthusiasts—the prospect of currency manipulation and persistent inflation. He points out that the US dollar has lost 86% of its value since he took control of Berkshire Hathaway in 1965 and states unequivocally, “I do not like currency-based investments.”
But where gold advocates see a safe harbor, Buffett sees just a different set of rocks to crash into. Since gold generates no return, the only source of appreciation for today’s anxious purchaser is the buyer of tomorrow who is even more fearful.
Buffett completes the argument by asking the reader to compare the long-run potential of two portfolios. The first holds all the gold in the world (worth roughly $9.6 trillion) while the second owns all the cropland in America plus the equivalent of sixteen ExxonMobils plus $1 trillion for “walking around money.” Brushing aside the squabbles over monetary theory, Buffett calmly points out that the first portfolio will produce absolutely nothing over the next century while the second will generate a river of corn, cotton, and petroleum products. People will exchange their labor for these goods regardless of whether the currency is “gold, seashells, or shark’s teeth.” (Nobel laureate Milton Friedman has pointed out that Yap Islanders got along very well with a currency consisting of enormous stone wheels that were rarely moved.)
When Buffett assumed control of Berkshire Hathaway in 1965, the book value was $19 per share, or roughly half an ounce of gold. Using the cash flow from existing businesses and reinvesting in new ones, Berkshire has grown into a substantial enterprise with a book value at year-end 2010 of $95,453 per share. The half-ounce of gold is still a half-ounce and has never generated a dime that could have been invested in more gold.
Few of us can hope to duplicate Buffett’s record of business success, but the underlying principles of reinvestment and compound interest require no special knowledge. Every financial professional can point to individuals who have accumulated substantial real wealth from investment in farms, businesses, or real estate, and sometimes the success stories turn up in unlikely places. (See “The Millionaire Next Door.”)
Where are the fortunes created from gold?
by Weston Wellington, Vice President at Dimensional Fund Advisors Thursday, February 23, 2012
Warren Buffett, “Warren Buffett: Why Stocks Beat Gold and Bonds,” Fortune, February 27, 2012. Available at: http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/.
Milton Friedman, Money Mischief (Boston: Houghton Mifflin Harcourt, February 1992).
Stocks, Bonds, Bills and Inflation, March 2011.
Berkshire Hathaway Inc. Available at: www.berkshirehathawy.com (accessed February 21, 2012).
Dimensional Fund Advisors LP (“Dimensional”) is an investment adviser registered with the Securities and Exchange Commission.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.
What Happened to 1 of the World’s Greatest Market Timers…
John Paulson is the multi-billionaire hedge fund manager and president of Paulson & Co.
He made one of the greatest calls of all time by short-selling subprime mortgages in 2007, earning him $3.5 billion.
As a result, he has developed guru, or cult-like, status.
With this fame has come new money, flowing in fast and furious into his funds and earning him a record $5 billion salary in 2010. Investors are only too willing to pour in their savings, expecting that his maverick predictions can earn them generous returns.
How could he get it wrong…he called the subprime meltdown?
Apparently nothing is more attractive to investors than the idea that you can pay someone to accurately predict the future and make a lot of money as a result.
Well, the guru John Paulson just submitted his latest regulatory findings. Paulson was expecting shares in Bank of America stock to reach $30 by the end of 2011. Instead, the shares dropped over the course of the year to around $5, at which point he sold (full disclosure: the shares bottomed out at $4.92.) Paulson’s big stake in the bank was one of several bad investment picks that helped lead one of his most high-profile funds to a negative 52.5% return last year, as reported by DealBook.
So far this year, Bank of America is up approximately 38%.
So, Paulson basically bought high and sold low. The www.BehaviorGap.com (and almost everyone else) calls that “Dumb!”
We’re sure that there are some hedge fund managers that made great calls last year and others that did worse than Paulson. Overall, according to Hedge Fund Research, the whole hedge fund industry lost money last year (down 4.8%), in a year when US Indexes were up. What’s crystal clear is that being last year’s guru is no guarantee of future success.
Yet the seduction of the successful speculator remains strong.
Why the heck is market timing so hard that even when people are paid billions to do it right…they can’t do it right?
Because you need to do the following:
Predict the future (nerds call this forecasting)
Predict that the future will be different from the consensus opinion
Be right way more often than you’re wrong (people don’t pay for average here)
Why do you have to predict the future “differently”? There’s no money to be made in having the consensus opinion. Prices already reflect that opinion. To make money you’ve got to bet on the price being wrong – preferably way wrong – and then make money when it ‘corrects’ according to your predictions.
We’re sure many of John Paulson’s investors, like others, are frustrated. What are they to do?
It may sound shocking but we first suggest giving up the idea that people can tell the future. Sure, we can all look at events happening today and say, “Hey, I think what’s happening today will lead to ‘this’ tomorrow.” But when you’re talking about investments, everyone is guessing tomorrow’s news based on today’s facts. Those collective expectations are factored into the price. To make money you have to know that the prevailing expectation is wrong. So really, it’s harder than just telling the future, it’s telling the future differently than everyone else and being right about it.
Who is “everyone else”? Everyone else is typically some pretty smart people who spend all day, every day, doing this or writing software to do it for them. John Paulson isn’t alone in trying to do this.
And here’s the frustrating thing: the prevailing view of the future is almost certainly inaccurate (it is the future, right?) but it seems to be randomly inaccurate.
What do I mean by “randomly inaccurate”? Basically the consensus opinion is such that there are about 50:50 odds its wrong or right. It has to be that way, or else a buyer and a seller would never agree on the price to exchange a share. Each have equal and opposite incentives, both are looking at the same publically available information, and both are free to transact however they wish. It’s only new information, not available at the time of the transaction, that will ultimately show who got the better end of the deal.
It looks like this time it was Paulson that got the worse end of the deal. We’re sure Paulson is not an idiot. He just couldn’t tell the future, and new information came out about Bank of America after he purchased that showed its prospects were worse than foreseen. You can’t blame Paulson for not knowing the future. But I believe you can blame him for acting as if he did… with a lot of other people’s money….people that paid him a literal fortune… people who probably aren’t very happy right now.
So if you give up prediction addiction, what are you left with? I suggest that you are left with investing for a long-term rather than short-term. You understand that in the long-run, bearing risk brings investment return as compensation. What if you don’t have a long-run time horizon? Then you take appropriate amounts of risk off the table by using a balance of more stable investments. Lastly, you focus on your goals, your savings and other things under your control. In doing so, you are bound to make many better decisions and be a whole lot less disillusioned.
“The hardest arithmetic for human beings to master is that which enables us to count our blessings” – so wrote the great American working man’s philosopher Eric Hoffer.
It’s a piece of wisdom worth recalling at the end of another year that has tested the nerve of many investors and prompted questions about what current generations have done to deserve to live in such a tempestuous stage of history.
As the year winds down, financial markets continue to face uncertainty over developments in the Eurozone crisis. Each day brings fresh headlines that send some investors scrambling from virtual despair to tentative optimism.
While not seeking to downplay the very real anxiety generated by these events, particularly in relation to their effects on investment portfolios, it’s worth reflecting critically on our often distant memories of the “good old days”.
A Brief History of the 20th Century
Nearly 100 years ago, Europe was engulfed by a war that destroyed two centuries-old empires, redrew the map of the continent and left more than 15 million people dead and another 20 million wounded. The economic effects were significant, with widespread rationing in many countries, labour shortages and massive government borrowing.
Just as the Great War was ending, the world was struck by a deadly pandemic — the Spanish flu — that killed some 50 million people on the most conservative estimate. About a third of the world’s population was infected over a two-year period.
A little over a decade after the Great War and the pandemic, the Great Depression cut a swathe through the global economy. Industrial production collapsed, international trade broke down, unemployment tripled or quadrupled in some cases and deflation made already groaning debt burdens even larger.
In the meantime, resentment was growing in Germany over its Great War reparations to the Allied powers. Berlin resorted to printing money to pay its debts, which in turn led to hyper-inflation. At one point, one US dollar converted to four trillion marks.
In a new militaristic and nationalist climate, fascist regimes arose in Germany, Italy and Spain. Under Hitler, Germany defied international treaties and began annexing surrounding regions in Austria, Czechoslovakia before finally attacking Poland in 1939.
This led to the Second World War, a conflict that engulfed almost the entire globe as Japan pushed its imperial ambitions in Asia, while Germany sought to conquer Europe. More than 50 million died in the ensueing conflict, including a holocaust of six million Jews. The war ended with the invasion of Berlin by Russian and Western forces, while Japan surrendered only after the US dropped nuclear bombs on two cities, killing 250,000 civilians. The human tragedy over this period was catastrophic.
In economic terms, the war’s impact was profound. Most of Europe’s infrastructure was destroyed, millions of people were left homeless, many urban areas in the UK were devastated, labour shortages were rife and rationing was prevalent.
While the 35 years after World War II were seen as a golden age in comparison, the geopolitical situation remained fraught as the nuclear armed superpowers, the Soviet Union and the USA, eyed each other suspiciously. The breakdown of the old European empires and growing east-west tensions led the US and its allies into wars in Korea and Vietnam.
The cost of the Vietnam and Cold Wars created enormous balance of payments and inflation pressures for the US and led in 1971 to the end of the post-WWII Bretton Woods system of international monetary management. The US dollar came off the gold standard and the world gradually moved to a system of floating exchange rates.
In the mid-1970s, the depreciation of the value of the US dollar and the breakdown of the monetary system combined with war in the Middle East resulted in the quadrupling of oil prices. Stock markets fell sharply and stagflation — a combination of rising inflation alongside rising unemployment — gripped many countries.
While the 1980s and 1990s were a relative oasis of calm — aided by the end of the Cold War — there still was no shortage of bad news, including the Balkan wars, the Rwandan genocide and recessions in the early part of both decades.
In the past decade, there have been many tragedies including 9/11, the 2004 Asian tsunami, the 2011 Japanese earthquake, tsunami and nuclear crises and, now, the financial crisis sparked by irresponsible lending, complex derivatives and excessive leverage.
So from this potted history, it seems clear that tragedy and uncertainty will always be with us. It is a moving backdrop to how many people invest. But the important point to take out of it is that previous generations have stared down and overcome far greater obstacles than we face today. And while it is easy to focus on the bad news, we mustn’t overlook the good news.
Alongside the wars, depressions and natural disasters of the past century, there were some notable achievements for humanity — like the development of antibiotics, civil rights, economic liberalisation and the spread of prosperity and democracy, space travel and advances in our understanding of the natural world and enormous advances in health, education and telecommunications.
Despite this backdrop of tragedy and despair over the past 85 years, the largest stocks in the U.S have still managed to return 9% pa, and the smallest stocks
13% pa. So for people who like terms like ‘new normal’, they’re absolutely right – the world is constantly changing. (Note we use US data as it is available for the entire 20th Century.)
But new challenges are the driving force for human endeavour, entrepreneurship and innovation. Collectively, these are the foundations for economic growth and investment returns.
Today, while the US and Europe are gripped by tough economic times, much of the developing world is thriving. Populous nations such as China and India are emerging as prosperous nations with large middle classes. And smaller, poorer economies are making significant advances too.
The United Nations in the year 2000 adopted a Millennium Declaration that set specific targets for ending extreme poverty, reducing child mortality and raising education and environmental standards by 2015. In East Asia, the majority of 21 targets have already been met or are expected to be met by the deadline. In Africa, about half the targets are on track, including those for poverty and hunger.
Alongside these gains, new communications technology is improving our understanding of different cultures and increasing tolerance across borders, while providing new avenues for the spread of ideas in education, health care, technology and business.
Through forums such as the G20 and APEC, international cooperation is increasing in the field of trade, addressing climate change (if slowly) and lifting the ability of the developing world to more fully participate in the global economy.
Rising levels of education and health and workforce participation also mean the foundations are being built for a healthier and peaceful global economy, dependent not on debt, fancy derivatives and fast profits but on sustainable, long-term wealth creation.
Anxiety over recent market developments is completely understandable and it is quite human to feel concerned at events in Europe. But amid all the bad news, it is also clear that the world is changing in positive ways that provide plenty of cause for hope and, at the very least, gratitude for what we already have. These are ideas to keep in mind when we scan the news looking for positive stories and long for the “good old days”.
When it comes to being worried about global events, perhaps we should leave the final word for the year to the Dalai Lama:“If you have fear of some pain or suffering, you should examine whether there is anything you can do about it. If you can, there is no need to worry about it; if you cannot do anything, then there is also no need to worry.”
 Source: Returns Program to 30 November 2011 for the largest 10% and smallest 10% of U.S listed stocks
What a Day at the Races Taught Me About Investing
Betting is a mug’s game for most punters.
At the races you see betters carefully reading their race books, looking up their research notes, following the advice of experts, betting on the favourites. Yet despite all this hard work they so often go home with less than they started with (especially when you include the price of drinks and food). Some days “their horse comes in” and they score big with a trifecta. Suddenly they are the envy of everyone as they proudly discuss their winning ways.
My view is simpler. I know nothing about horses but I do go to the races once a year – cup week – but more to enjoy the atmosphere and excitement.
My betting strategy is simple: easy bet trifectas, low cost, no skill, the computer makes the bet, no predictive powers and fun – you don’t expect to win but can be pleasantly surprised. Well this past year at the Riccarton Cup I won $1,148 on a $6 computer generated bet.
I was lucky right? This couldn’t happen again could it? Those around me were interested in my success but mostly stuck to their own methods.
Then I won again using the exact same random computer generated bet.
I was amazed by what happened. Firstly I had to do my best to resist the urge to believe that I had “discovered” a winning system. Whereas before the wins, I made bets just to enjoy the buzz, now I began to think in my head that I was actually good at this.
But what was even more interesting was that others were now very interested in my next pick. They actually believed I had some expertise worth listening to. Although my two wins were based completely and totally on dumb luck, there were people around me that were ready to try any suggestion I offered. In fact, some of my own friends started buying computer generated easy bets.
So it is with investing:
Investors like to follow managers and brokers with a good “track record” or winning streak and money flows in when a manager or an investing style has a couple great years in a row.
Our minds can spot a trend or a streak very easily. Fill in the blank 2…4…6…?
Intuitively and without thinking our minds go “8”. And when we see a manager or an investment style work very successfully for a few years in a row we unconsciously and automatically fill in tomorrow’s number. And armed with a belief that we know tomorrow’s results today we place our bets… who wouldn’t?
And so my betting companions wanted to know my “system”. Heck I was enthralled with my system too. But it wasn’t a system at all. It was random.
You know, one of my favourite charts is shown below. It catalogues the top 100 managers according to Morningstar, an investing research firm. To be a top 100 manager is quite an accomplishment. There are thousands of managers vying for that top spot. Here’s the question though? How many repeat their great performance the next year.
The answer is 13.2%. Those aren’t good odds!
And really if you look at those that do repeat it tends to be because the sector they invest in had two good years in a row. If you’re a manager that just happens to specialize in a style in favour it’s possible to have two straight great years.
So what am I getting at? Simply this, following winning streaks and investing with the herd is a horrible way to invest. Following my advice about how to bet at racetracks is probably equally as poor. A two year, three year or four year winning streak tells you almost nothing about whether an investment manager or broker is skilled or lucky.
But why let a little thing like statistical proof get in the way? Most investment managers know that investors do make decisions based on small streaks of outperformance. So they push and promote those funds that do have good records, getting rid of or absorbing the funds with poor records. Investors are left years later wondering why that “sure bet” pulled up lame.
What does matter then? Really it comes down to this. Invest at low costs with close attention to execution, stay consistent to your strategic asset allocation avoiding any temptation to drift with the crowds, and perhaps most importantly, don’t believe the media or media advertising.
In other words, don’t bet on the horse; invest in the track.
The track diversifies with many betters and many races;
The track pays close attention to costs;
The track stays consistent even when a few long shots beat the field;
The track never panics or follows the crowd;
The track doesn’t gamble; the track invests.
Then again you could always make $6 bets on a computer generated trifecta. And if you win you’ll certainly beat the pants off the track’s profit margin that day. And if you need advice on how to master this, contact Jacob who for a small fee will provide you the tools to generate your success. But don’t make my mistake and tell your friends it was just luck. Just tell them you’ve got a system. Trust me; you’ll be everyone’s best mate.