THE SOUTH AFRICAN INDEX INVESTOR

“Greater rewards, lower costs”

TOOL BOX

 Investment Philosophies, Theories and Practices (continued…)

 

 Prudent Lessons from the 2008 Global Financial and Economic Crisis

 

The lessons that investors can learn from the global financial and economic crisis that started in 2008 can be divided in two broad categories, namely what we should (or should not) expect from our investments and pitfalls we should avoid when formulating and implementing our investment strategies. 

 

 

1.              Investment Expectations and Mindset

 

Don’t bet the farm that professionals will protect you from bear markets

 

We entrust our hard-earned savings to professional money managers. In theory, at least, they should be best equipped to safeguard their clients’ monies from financial disasters. Nonetheless, in 2008 we saw the demise of top investment banks, such as Lehman Brothers and Merrill Lynch, despite the wealth of “skills” at both institutions.

 

Clearly, the recent experiences have shown investors are not at all protected from financial disasters even in the hands of professionals. The application of a few basic investment principles (diversification, quality of businesses or soundness of underlying investments, and avoiding highly leveraged positions) should relatively protect one’s investments against major crises, but unfortunately the age-old enemy of greed got the upper hand over sensible investing in recent years. Then again, this is not a new phenomenon; bull markets always lead to gross excesses at the expense of the innocent and unassuming investor.     

 

 

Past performance is not a predictor of future performance

 

How do we know into which fund or strategy we should invest? Typically, we evaluate the latest investment fund performance tables to identify those funds that exhibited above-average performances against their peers. Obviously, that is the only visible benchmark we have when making investment decisions. 

 

But have we really noticed how variable the outperformance may have been? Even if we could have identified some persistent winners in the past, it is no guarantee that future performance would continue to yield above-average performance.  Yet, somehow we think we have the perfect foresight to predict the winners.

 

Moreover, do we understand that while certain asset classes and investment strategies relatively outperform others, the situation could well be reversed in a next period? We need some understanding of the economic context in which certain asset classes and strategies will outperform, while realising that economic systems are dynamic; i.e. cyclical and largely unpredictable.  

 

Maybe we should stop chasing the next winners and focus on getting at least the market return; i.e. allocate at least some of our investments to low-cost passive funds. The latter strategy is prudent in so far as it forces our hand not to make bold bets about “what is going to happen next” or investing only in strategies that worked very well in a previous cycle. 

 

The fallacy of predictions

 

We tend to listen to forecasts from investment gurus, especially those who have accurately predicted the direction of markets and the economy in recent times. Yet, we do not know nor is there a scorecard how accurate the forecaster’s predictions have been in the past. Therefore, we may have a gross exaggeration of the forecaster’s ability to “see the future”.

 

William Sherden, author of “The Fortune Sellers”, studied the performance of seven forecasting professions: investment experts, meteorology, technology, demography, futurology, organisational planning and economics. He concluded that while none exhibited extraordinary expert skills, weathermen on average had the best predictive powers! Furthermore, Sherden formulated two insights: one, for every bullish economist, there is a bearish one, and secondly, they are both likely to be wrong. 

 

If we take forecasters too seriously, we may end up with disastrous performing portfolios by changing our portfolio too often in line with their expectations about asset class performances. Therefore, it would certainly help to anchor our investment portfolio to a pre-determined asset class structure; i.e. to diversify and retain exposure across multiple asset classes.

 

“The only value of stock forecasters is to make fortune-tellers look good.” [Warren Buffett]

 

Asymmetrical nature of equity returns

 

Investment returns from the equity market are not earned smoothly over time. Normally distributed return patterns are a fallacy. Most of the market’s returns originate from short, powerful bursts of bull and bear markets. In fact, a negligible, but unpredictable portion of market days over any period determines either the bulk of wealth creation or destruction, which makes market timing strategies to a large extent futile.

 

Crises will occur, diversify into high quality, low-risk assets

 

Crises will occur; they are virtually unavoidable. But we do not know what form the crisis will take, the depth thereof, or when it will happen; otherwise, they would not have been “crises”! Thus, diversify into quality, low-risk assets (cash and bond instruments) that offer a significant cushion or hedge against negative market sentiments (bear markets).

 

Innovative products meant to be sold, not bought

 

Chances are that complicated derivative products are always in the favour of the issuer and not the investor despite the perceived attractive attributes such products may offer to prospective investors.  Quite often what you do not see is the real problem; i.e. what are you giving up in return for attractive features like gearing or capital guarantees? The major concerns are liquidity and the strength and validity of the “guarantee” in dire financial crises.

 

Hope is not an investment strategy

 

“Hope” may win political elections, but such hyped emotions will not necessarily lead to investment success.

 

When entering unknown or unfamiliar investment territories it requires some homework upfront. Do not heed to the “investment advice” of friends or relatives not dealing on a professional basis with such investments, since chances are that they have incomplete knowledge of the overall risk.  

 

Know what you are doing, have realistic return expectations, and especially beware of the downside – typically not highlighted in marketing brochures and casual conversations – and possible serious liquidity constraints.     

 

Change an investment plan only based on a fundamental analysis of facts

 

When does it make sense to change one’s investment plan? Firstly, if one’s life circumstances have changed dramatically, say, with the death of spouse, divorce, inheritance, etcetera.  Secondly, when some gross errors were made in taking much more investment risk than was necessary or prudent. Typically, the latter situation originates from overconfidence in one’s ability to weather bear markets or by confusing “unlikely” with “impossible” events.

 

Everyone, even very smart investors, invariably makes mistakes. Importantly, one must learn from it, formulating benchmarks and rules never to repeat such mistakes again.

 

Nonetheless, a drastic change to one’s investment plan should be well-considered and not a knee-jerk reaction to an emotional state of panic and fear.

 

 

2.              Managing your investment risk

 

 

When using excessive leverage, you need to be right all the time, not only in the long run.

 

You might have had the right investment ideas that would work in the long run, but in the interim the market has moved in the opposite direction. Or, you could have followed a strategy that for years worked like clockwork and made you a lot of money, only to stop working unexpectedly in present circumstances.

 

The common thread in both instances is that you should have survived the market’s “irrationality phase”, but for the highly leveraged position you have had. Suddenly you are at the mercy of your financiers who are most likely to take away the “umbrella” they once gladly offered while the sun was shining on you.

 

The failures of Lehman Brothers, Bear Stearns, AIG and many others proved that highly leveraged positions warrant a strategy that will work all the time, not only in the long run.

 

Check the quality of your investment diversification

 

In times of extreme volatility even low-correlating assets have a tendency to move in unison with the direction of the equity market; i.e. correlations rise. That is unavoidable, but what one can do at least is to invest in quality fixed-income assets (government bonds and highest grade corporate bonds) where liquidity and solvency of the asset will not be in question.

 

 

High-risk fixed income assets are not worth it

 

In principle, by investing in fixed income assets one is diversifying one’s overall portfolio risk. The problem is that when investing in lower quality, high-yielding assets one is not really diversifying one’s risk, since the rapid decline in the value of such assets in troubled times more than offsets the higher yields. 

 

Do not confuse the familiar with the safe

 

You may be very familiar with a particular company because you or a relative may be an employee of this company. Hence you are likely to trust such a company with your financial assets, but it is never a sound idea to concentrate labour capital and financial assets in the same basket. Unfortunately, many employees of once great companies not only lost their jobs, but also a substantial part of their financial assets invested in such companies. 

 

Uncertainties are not equal to risk

 

Investors must always prefer risky bets to uncertain bets. In the former the odds of events occurring can be measured while in the latter the odds cannot be measured. Since we cannot calculate the odds of a bear market, like the one starting in 2008, investors should require a large equity risk premium relative to other asset classes. Only then we will see equity investments outperforming other asset classes by considerable margins, otherwise disappointing returns are most likely to follow. 

 

Differentiate between the unlikely and impossible or likely versus certain

 

Treat neither the unlikely as impossible (property prices will fall sharply) nor the likely as certain (equities will outperform fixed income investments over the long term).

 

Then, if something may not have happened in the past, this does not mean it cannot or will not do so in future. Surely, we live in an uncertain world where we based our investment decisions and advice on the best possible estimate of probabilities, but ultimately no certainties or guarantees exist.

 

 

Invest in regulated products

 

Do not invest in unregulated, non-transparent investment products. Very often fantastic performances and promises together, with social reputations and connections à la Madoff and Stanford, are used to lure investors to such investment opportunities.

 

When one is confronted with such investments, check first for audited financial statements, the independency of custodians, etcetera. Otherwise, simply avoid such investments altogether and stick to well-regulated collective investments (unit trusts).

 

 

 

Based on an article written by:

Larry Swedroe, 2009. “Lessons From 2008”. IndexUniverse.com, January 2.