Ten Years On From The GFC – What Have We Learnt?
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.
Billionaire David Booth’s Investment Tips for New Zealanders
Investment guru David Booth visited New Zealand to talk about his mission to change people’s lives through investments, reports Richard Meadows.
When a billionaire gives you investment advice, you listen.
When it’s backed by the research of several Nobel-prize winning economists, you really pay attention.
David Booth is co-founder and chairman of Dimensional Fund Advisors, which manages almost US$400 billion (NZ$600b) of assets.
Here’s his advice:
Avoiding “Lucky Fool Syndrome”
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.
Michael Mauboussin, the managing director and head of global financial strategies at Credit Suisse, suggests clearing up the confusion with a simple question:
“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?
Read original article here.
Eugene Fama Wins the Nobel Prize
The 2013 Nobel Prize in Economics was awarded to Eugene Fama, with two others, for laying “the foundation for the current understanding of asset prices”. Having been (along with our clients) the direct beneficiaries of Fama’s work, we wish to congratulate him on this achievement.
As with many Nobel Laureates, it’s difficult to appreciate the work of Dr Fama. Fama’s great achievement is helping us to understand how financial markets ought to work. In research that began as a PhD thesis, he demonstrated that markets absorb all available information about the future prospects for shares.
This means that research to identify mispriced shares is likely to be wasted. This is a very counterintuitive notion; surely some investors have more, or better, skill than others?
This counter-intuition calls for some investigation. A purchaser must buy their share from an existing owner. Does the current owner of the share know less about its value than the buyer? Probably not, and they have no incentive to sell cheap.
So, if buyer and seller (with equal and opposite interests) agree on a price, the price is probably both fair and the best estimate of the actual value of the firm, at that time.
That caveat is important and reflective of another of Fama’s conclusions: when new information does become available, both buyers and sellers act upon it, and it is absorbed into prices very quickly.
More important for investors than Fama’s theory in itself, are its implications. If prices are right, then trying to outguess the market is at best speculation, where being good and being lucky are one and the same. Why pay a fund manager for luck?
Fama’s work led directly to the creation of index funds at very low prices. Investors in index funds pay for diversification and to pool transactions with other investors, which drives transaction costs down. They do not pay for a fund manager to find mispriced securities.
History has shown, time and again, that Fama is correct.
Each year, Standard & Poor’s (S&P) performs the Standard and Poor’s Index vs Active study or SPIVA. The results are clear – the majority of fund managers underperform the market. As Fama suggested almost 50 years ago, this has to be the case as it’s a gamble before costs. And the costs (both in fees and via transactions) can be quite high.
Below is an excerpt of the most recent SPIVA study.
Table 1: SPIVA Percentage of Selected US Based Funds Outperformed by Benchmarks
Overall, in 97% of fund categories, the majority of managers underperformed their benchmark index.
In 2010 Fama performed his own study and found that only 3% of fund managers showed skill. “Skill” is defined in academic circles as a less than 5% chance of luck. So, if monkeys were picking shares (that is, all outcomes are determined by chance), he’d expect statistical tests to find that 5% of the monkeys were skilled. Finding only 3% skilled was telling.
To Fama’s credit, he has not merely sat on his original ideas. He questioned whether or not a subset of the market should have persistently higher returns than other subsets, and found that this was indeed the case. Smaller companies and, generally, companies with lower prices, produce higher expected returns. Fama concluded it was because these companies were riskier, therefore investors demanded higher returns to own them.
Again, history has shown his conclusions to be correct.
Investors owe a debt of gratitude to Dr Fama for giving us the insights to lower costs, diversify widely, and base portfolio decisions on our appetite for risk, rather than speculation on the future.
Although many investors may not realise it, they’ll have a more prosperous and secure retirement because of his work.
By Scott Rainey and Ben Brinkerhoff
 “The Prize in Economic Sciences 2013 – Press Release”. Nobelprize.org. Nobel Media AB 2013. Web. 20 Oct 2013. <http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2013/press.html>
 S&P INDICES VERSUS ACTIVE FUNDS (SPIVA) SCORECARD http://us.spindices.com/documents/spiva/spiva-us-mid-year-2013.pdf?force_download=true
What Does the Bank Do With Your Money? Alternatives Beyond Term Deposits
When debating whether to invest in a diversified New Zealand fixed interest portfolio or put your money in the bank, one question worth asking is, “What does the bank do with your term deposits?”
The bank can’t simply hold on to the term deposit and continue to pay interest.
What do they do with the money?
Simple, the bank invests in a diversified portfolio of fixed interest. They issue loans backed by property to mortgagees. They lend to large corporations and small businesses and receive interest in return. To control their risk the bank pays close attention to the credit worthiness of the borrowers and the length of the loans. Importantly, the bank issues many loans and is careful not to put all its money in one basket.
Alternatively, investors could consider investing in a diversified portfolio of fixed interest similar to the bank’s own portfolio. To provide a diversified portfolio of fixed interest there will be an advice fee plus a management fee, say 1.20% combined. However, I’d contend that fee is much smaller than the bank’s implied fee of what they earn on investors deposits versus what they give depositors in terms of guaranteed returns.
I acknowledge that the diversified portfolio of fixed interest bears more risk than the banks guaranteed deposit. However, if such a portfolio fails over the long term to provide positive returns, you can be sure the bank is also going to be in trouble. Why? Because the bank and the diversified fixed interest portfolio are investing in the same thing.
Now a diversified portfolio of fixed interest is liquid. The client can convert it to cash money in one week. But how safe is it?
Looking at New Zealand Fixed Interest over the past 21 years, the worst:
- 1 year return was 2.35% per annum (best was 16.34%)
- 3 year return was 4.89% per annum (best was 9.37%)
- 5 year return was 4.94% per annum (best was 8.11%
- 10 year return was 5.71% per annum (best was 7.51%)
In other words it’s very unlikely to lose money over periods more than a year.
In some ways a diversified fixed interest portfolio is more secure than the bank. How so? Well, for one, many of the securities in the diversified fixed interest portfolio are bonds issued by banks. If the bank is borrowing from investors it must be lending to less credit-worthy borrowers at a premium. Note that most often a bank will borrow from investors at premium compared to what they pay depositors. Beyond banks, the diversified fixed interest portfolio consists of large corporates like Fonterra and Auckland International Airport as well as the New Zealand Government.
What about the bank’s portfolio? Well in order to make larger returns the bank will often invest in small businesses. Almost every small business has a banking relationship. Small businesses pay big premiums to borrow money. The bank loves it. Remember they are still paying depositors 5% while they can charge small businesses, say, 15%. However, these businesses are much more likely to default than Fonterra or the NZ Government.
Now it doesn’t matter to a depositor if a single small business fails to return the money they borrow from the bank because the bank guarantees the deposit. And the bank protects itself by being widely diversified. But I’d argue that the bank’s fixed interest portfolio is riskier than the one we have on offer.
In other words, the diversified fixed interest portfolio has outperformed short term bank deposits. This is exactly what we expect to occur (especially over 3 or 5 year periods) into the future. Month by month, or even year by year, who knows, but over the long-term this advantage is almost required to occur. If it doesn’t, how can a bank offer those fat deposit rates? If the bank can’t get a high return on its fixed interest portfolio, how are they going to pay big deposit rates to investors? Thus the diversified fixed interest portfolio over the long term is almost destined to outperform deposits. Over the long-term it’s just about inevitable.
By the way, it’s the same principle for foreign diversified fixed interest, but the story is even better because you get much better diversification overseas than you get in New Zealand.
The End of Wall Street as We Know It – and We Feel Fine
When I (Ben) had the privileged of working for Index Funds Advisers (IFA.com) in California, one individual I worked most closely with was Jay Franklin, a very bright and passionate advocate of investors.
As IFA and BNL are now associated (BNL is a Network Member of IFA) we are able to publish some of Jay’s articles on our website. Although this one seems a bit focused on the USA I think it’s message is clear and fully endorse it. Link
by Jay D. Franklin Tuesday, February 14, 2012
Lately there has been a great deal of news coverage of the ever-shrinking pool of bonuses awarded to the traders and investment bankers of the too-big-to-fail Wall Street firms. At UBS, for example, certain highly compensated employees will have to face the indignity of having part of their previous bonuses clawed back in the wake of a $2.3 billion loss resulting from the actions of a rogue trader. New York magazine recently ran a detailed piece on this subject appropriately captioned, “The Emasculation of Wall Street.” One of the article’s most poignant statements was voiced by an unnamed hedge fund manager.
“If you’re a smart Ph.D. from MIT, you’d never go to Wall Street now–you’d go to Silicon Valley. There’s at least a prospect for a huge gain. You’d have the potential to be the next Mark Zuckerberg.”
To this, we at Index Funds Advisors, Inc. say “Bravo!” and we wish it would have happened many years sooner. Society derives far greater benefit from the application of brainpower to real world innovations as opposed to financial innovations. The simple fact of the matter is that the primary financial instruments that are used to connect providers of capital with users of capital have existed since the nineteenth century. Much of the innovation that has come from the geniuses of Wall Street has been useless at best and incredibly destructive at worst. Nevertheless, we have seen a few advances that have truly helped investors such as index funds, but none of these required the talents of PhD. Physicists from MIT.
As noted by Matt Taibbi of Rolling Stone in his blog post of 2/8/2012, “The financial services industry went from having a 19% share of America’s corporate profits decades ago to having a 41% share in recent years. That doesn’t mean bankers ever represented anywhere near 41% of America’s labor value. It just means they’ve managed to make themselves horrifically overpaid relative to their counterparts in the rest of the economy.” All we really need from Wall Street are prudent people who will be reliable stewards of their client’s money for which they can expect to be well compensated as opposed to outrageously overpaid. What we don’t need are Fabulous Fabs aided by rocket scientists who help them conjure up new ways to “blow up the client” or “rip the client’s face off.” The world is a better place when the rocket scientists are actually designing rockets (i.e., actual products or potentially beneficial scientific research) and Wall Street bankers are playing their proper role as handmaidens to capitalism.
Regarding the big-time traders, as more and more individual investors as well as trustees of foundations, endowments, and pension plans become wiser and go passive, the traders will have only each other to play against in their zero sum game. We wish them the best.
Finally, the increasing adoption of passive over active will automatically reduce the bloated 41% share to a more reasonable level. This is far preferable to wielding the heavy hand of government regulations which all too often have unintended consequences.
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.