The first bubble – or bulb – that burst
What role do investment advisers and private bankers have to play in a world where most investors have lost a lot of money? Is the traditional client investment advice role a relic of the past? Should individuals even be investing at all?
Although it is understandably difficult for investors who are struggling to come to terms with the reduced value of their wealth to contemplate the future, there is, in reality, no better or more appropriate time in which to do so. Many investors have been seduced in the recent past by historical performances produced by individual managers. Many of these have now been exposed as no better than mirages – built up solely through debt and financial leverage. It is, in fact, the opaqueness of the investment market that renders the need for wise investment counsel.
Today’s world is very different to that of two years ago. Investors are distressed. Losing money is significant and definitely ratcheting up distress levels quite quickly, but there is more to it than that. Rather, it is that investors have had to come to terms with the assumptions they held to be true, being proven false.
Let me explain further. Traditional (and, by traditional, I mean all that has been taught to students of investing for the past 20 years) investment theory holds a number of fundamental truths. Each of these truths forms the bedrock for ordinary investors, since it is these truths, in various shapes and forms, which have been distilled into ordinary investors through the written, spoken and visual media. Without these truths or these foundational stones, it is almost impossible for investors to make judgments about investing. It is precisely because of these principles that investing has taken off as spectacularly as it has. Yet, if the recent crises have sown the seeds of destruction for traditional theory, what should investors do? Before answering that question, let us revisit, first, the problems with traditional theory and, second, try to understand why it all went so terribly wrong. And so, in no particular order, the problems with tradition:
Markets are rational
A primary tenet of investment theory is that investors are rational individuals not prone to greed or excess and able to make rational decisions about their future.
Following the dot.com boom and subsequent crash, serious professionals began to question the validity of this assumption. After all, according to rationality, bubbles can’t happen. The reaction from the incumbents was furious. Suffice it to say that abandoning the assumption of rationality begets problems for investors, not least because there is no other assumption. Thus, the working hypothesis was that the dot.com boom and bust was an aberration; that really, rationality did exist and that once things had settled down all would return to normal. Ouch. Not only was the internet bubble followed by another bubble but, arguably, followed by the biggest ever bubble. Clearly, notions of rationality have some serious issues to overcome!
Asset allocation is dangerous – buy and hold is the best strategy
Market timing has traditionally been a dirty word. Investors have been told that there are only a few days each year when major gains are achieved. Not being invested on those days means missing out and actually seeing no returns for that year. Also, because markets are rational, it is impossible to time markets effectively. Thus, the rational investment approach is to buy equities and hold them for 10 or 15 years and investors would be assured of strong gains. The problem with this is that traditional theory used as its data-set a period of rising equities. In other words, being invested is obviously the sensible decision when markets are generally rising. This theory need not be entirely invalidated however. A more nuanced version, along the lines of strategic asset allocation is beneficial, but tactical allocation is dangerous may be appropriate. In this instance, strategic is based on a three-to-five-year view whereas tactical is anything shorter. Identifying macro changes in markets is seemingly the only means of avoiding broad market declines.
Equity markets deliver superior performance over the long run
Multiple studies have shown that investing in equities is the best strategy for long-term investing. That is because equities are effectively a claim on the growth of the economy and nothing can grow faster, over the long run, than the economy. This article won’t argue with the premise that equities are the best long-term investment. The problem is with the definition of the long-term.
Is the long-term five, 10, 15 or 20 years? Or is it even longer than that? Ask most people what constitutes the long-term in their investment decision-making and, rightly or wrongly, the majority will probably plump for something in the five-to-ten year bracket. I say rightly or wrongly because, if investors are acting on a five-to-ten year basis but the theory is not consistent with that, then it is more than a philosophical question to ask whether the theory needs refining or investors’ time horizons need to be refined. After all, how useful is a theory if no one applies the principles of it? Figure 1 illustrates this problem.
If individuals’ long-term horizon is, indeed, five-to-ten years, then that is what it is. The problem is that since 1948, there have been 427 weeks when an investor putting money to work in the US stock market (the S&P 500) would have lost money on a five-year view. Perhaps, then ten years? Similar problem this time – 153 weeks when a ten-year investment would have lost money. One-hundred-and-fifty-three weeks may not seem like such a long time but it is worth noting that the recent past has seen an increasing preponderance of these loss experiences. It is only if investors lock their money away for 15 years that theory can show that equities will make money. Remember, this is the actual return of the stock market and says nothing about the opportunity costs – such as simply buying US government treasury bills. Fifteen years, though, is a long time. John Maynard Keynes once remarked that “in the long run we are all dead” and a lot of investors would probably share that sentiment if told that equity markets are the right long-term investment but, for that to work, you need to invest for 15 years.
Those who cannot remember the past are condemned to repeat it
“Progress, far from consisting in change, depends on retentiveness. When change is absolute there remains no being to improve and no direction is set for possible improvement and, when experience is not retained, as among savages, infancy is perpetual. Those who cannot remember the past are condemned to repeat it.” (George Santayana: “The Life of Reason” 1905-1906)
Whether the problem is one of outdated theories, incorrect theories or investors who have time horizons that are too short doesn’t matter at this juncture. Of course, it matters a great deal for the future but really all investors care about is delivering positive returns on their money. How can they achieve that?
In an uncertain world – and there can be little more discomforting than the very foundations of one’s belief being washed away, experience is vital and so is a level head. My argument, therefore, is that in times of crisis there is nothing more important than having wise counsel. Now, working as a private banker, I might be expected to exhibit a degree of bias, but allow me, if you will, to present my rationale.
So many investors today describe themselves as shell-shocked, dazed, confused or discombobulated even. Investors are so concerned about their wealth that many are thinking of giving up, buying gold or pursuing some other the-end- is-nigh type of strategy.
Is this the right approach? Let me use a metaphor to describe my view on this. A child, when he or she learns to ride a bike, is inevitably going to fall off the bike. The child is going to be bruised, have cuts and probably be in pain. The last thing on the child’s mind is learning to ride. If the child had its way the bike would very probably get some serious abuse. And yet how many parents stop there? Don’t all parents encourage – perhaps persuade may be more apt – their child to get back on, give it another go, try again? Of course they do. They do this because the child is incapable of looking beyond the short-term pain and recognising the more long-term opportunities.
Investors similarly are irrational beings (this article has explained why rationality is a somewhat quaint concept). Humans have a genuinely puzzling inability to rate events in the more distant past as highly as events in the recent past. Housing is a great example of this. If you had asked someone two years ago what they though the price of their house would have been worth twelve months ago, it is reasonably likely they would have said about ten per cent more than it is today. That isn’t because they knew or even had reason to know. Rather, it is because that is roughly how much their house went up the previous year. How quickly we forget though. Back in the early 1980s, there was a housing boom, which led, inevitably, to a housing bust. In the US, an entity called Resolution Trust was set up to help solve the resulting problems.
Here we are today, experiencing a housing bust. How many people, though, are reminding themselves that this happened once before? It seems almost as though today’s troubles were an entirely unpredictable event. Of course they weren’t, but no one looks back far enough. That is precisely why investors need wise counsel. The best counsel would be someone who lived through the Great Depression but, it is sad, not many people from that era who can properly remember it are alive today. The next best is a dispassionate adviser who can be distanced from the financial pain – or joy at financial success when that occurs – of the client and give honest comments. It may not be what the client wants to hear. And yet, much like the child being told to get back on the bike, the most unpleasant advice is very often the most important. Whether the adviser gives that advice of course is a very different matter. It is very easy for people to mock those who foretell impending doom as a market surges or who advise investing when all around are panicking and yet that is precisely what investors need to hear. The value of investment advice and experienced private bankers is no greater than today.