Uncertain environment

The unprecedented events of recent months, including the collapse of Lehman Brothers, the acquisition of Merrill Lynch by Bank of America, the US authorities bailing out AIG, the proposed takeover of Halifax Bank of Scotland (HBOS) and the collapse of the Icelandic banks, are likely to have left many of your clients feeling dazed and confused.

Economies usually suffer when credit dries up, as companies and individuals cannot finance spending, or at least not so easily, and their debts become harder to service. Money and debt have been too easy to come by in the past, but the chain of events we are witnessing is beyond everybody’s expectations, and still we do not know what is around the corner.

Federal authorities have been trying to stimulate economies with the injection of cash, the support for financial institutions and some dramatic interest rate cuts. We are yet to see how successful these actions will be and over what time period they will be drawn out. What is obvious is that world economies are in, or are rapidly moving into, recession. Unemployment is rising significantly as firms try to react to the current, and perceived future, environment. If that were not bad enough, it is not just consumers who have over-indulged on money they are yet to earn.

The UK government has managed to do the debt thing, too, by squandering a promising fiscal position. Its finances can be compared to a very poor endowment policy, whereby the investment timing has been embarrassing, selling gold at the bottom of the market, profits squandered on public services and hence an increase in premiums is going to be required, through stealth, and not so stealth, taxes. It may be that tax rises will have to wait as the government tries to stimulate the economy, but sooner or later they, or should that be we, will have to pay back what has been borrowed.

Current environment

Investors don’t like what they are seeing on the investment horizon and have been increasingly taking the view that cash is king. Banks and building societies are desperate to increase their levels of deposits and are trying to offer attractive rates, despite the backdrop of falling interest rates. Depressingly for investors, bonds, equities and commercial property have all taken a significant performance holiday.

However, market gyrations are nothing new and the ability to ride out such events is a key trait that ensures investors get rewarded and why there is an equity risk premium.

Unfortunately, a sizeable chunk of the investing population captures materially sub-market returns simply because they do get squeezed out of difficult markets, only to re-enter the fray when conditions have improved and the market is substantially higher. No one is going to sell investors their assets at a discounted price when good news abounds. Equally, no one is going to take those assets off our hands, in a falling market, at prices that do anything other than suit them.

However, in the current environment, it is difficult for clients to move away from the TV and for investors to ignore flashing red screens, both of which are begging for ‘action’. Ellen Peters, a senior scientist at Decision Research was quoted in the New York Times as saying, ‘with negative emotions we tend to have a desire to change the situation’. It is at market extremes that emotion surges into investor consciousness. At different times, both fear and greed can influence investment decisions, both with predictably poor outcomes.

The same New York Times article describes the current panic in the markets as deriving from a ‘negative feedback loop’, where no news, or even some positive news, on any given day, can still lead to a slump. In a complex adaptive system there does not need to be cause and effect – for instance, to this day, no one is really sure what caused the Black Monday crash in 1987.

As a result, the current market looks as though it could become a case study for researching the psychology of crowds. The New York Times article describes investors as ‘selling first and asking questions later’, with fear ruling. They quote Andrew Lo, who is a professor at MIT, and he stresses that fear is more powerful than greed (the amygdale part of the brain controls fear and responds faster than the parts of the brain that handle cognitive functions).

So, the point here, at a time of extreme market turbulence is that clients should try and think objectively and dispassionately.

Too much risk

It is likely that many of your clients will be particularly anxious about the stock market falls, especially if they have too much of their savings invested in equities. These clients will have already endured significant losses. Many private investors had not previously appreciated the risks they were taking in their portfolios, and this has not been helped by an investment industry that has been keen for their clients to buy ever more funds or stocks, often driven by the need to generate commissions or stockbroking fees, such that a client equity weighting in excess of 70 per cent has been considered the norm. An investment portfolio predominantly made up of equity unit trusts, or a portfolio of individual shares, has been shown not to provide the diversification that private investors need.

It is not surprising, therefore, that these investors, fearing further losses, are getting squeezed out of markets, looking for the safer haven of cash and, potentially, planning to return to stocks again when the coast is clear.

However, the likelihood of investors being able to time their way in and out of market tops and bottoms is minimal at best. We often see ‘experts’ predicting which asset classes will perform well and which will do badly. Some will use a vast array of economic data to come to their conclusions while others use little more than guesswork. They then suggest that investors should alter their portfolios to take account of, and benefit from, this information. However, the track record of these forecasters is far from convincing. In the words of renowned economist J K Galbraith, ‘We have two classes of forecasters; those who don’t know and those who don’t know they don’t know’.

The solution

So, what can they do then? Well, as ever with sensible investing, the answer is ‘asset allocation’. Whilst we cannot predict the future performance of different asset classes with any degree of certainty, what we can identify is that over the long term these asset classes can relate to each other in predictable ways. For example, the price of property in the UK usually bears little resemblance to movements on the London Stock Exchange, but share prices in London often mirror those in New York, Paris and Frankfurt.

Correlation, or lack of it, is important because it affects the diversification and volatility of portfolios. If an investor held just UK and US equities, then a market fall in the United States is likely to take the whole portfolio in the same direction, as the UK and US stock markets are highly correlated. However, if they added index-linked gilts, commercial property and alternative investments, which do not correlate so closely with western markets, then the portfolio would tend to be better diversified.

Ideally we would like a mix of negatively correlated assets so that when some of our holdings are going down, others are going up, but where all assets have the potential to reward us in the long term.

Even with the fall in value in most asset classes over the last year, a diversified multi-asset class approach will have protected a portfolio’s downside much better than a traditional equity-dominated strategy. By holding a range of different asset classes, such as equities, government bonds, fixed interest, commercial property and alternative investments, but without too much emphasis on any one asset, then risk can be more effectively managed.

Then, by consistently and systematically rebalancing back to target asset allocation weights, one can maintain the appropriate risk exposure on the portfolio, but also take profits in the better-performing asset classes and average down the relative purchase price of those that have lagged. This takes advantage of mean reversion and ensures a contrarian stance (i.e. investing in assets after they have performed badly rather than the common investor mistake of investing in them after they have already performed well). The risk of not rebalancing is that performance can greatly impact on the structure and risk profile of a portfolio.

So, we have a diversified portfolio, with below average volatility, which can gain traction in the markets without any need for particular insight on anyone’s behalf.

While such an approach will still be showing losses in recent times, if properly constructed it should weather most storms and rebound more efficiently from bear markets, inevitable as they are. So, the best advice for your clients, who hold suitably diversified portfolios, would be to sit tight and try to avoid getting frightened out of a sensible investment approach only to buy back in at higher levels.