We are delighted to announce that, as of October 2019, Pacem and Redrock Financial have combined our businesses to provide our clients with a coordinated range of financial planning, taxation and accountancy services. Daniel Glover, Managing Director of Pacem, explained “our shared values and commitment to a client-focussed service have made this partnership possible and we are delighted to be joining forces with Lyn, Alison and the rest of the team. It is an exciting time for our business and our clients.”

Pictured are Directors Tony Glover, Alison Bell, Lyn McMaster and Daniel Glover.

Systematic, evidence-based investing often results in very little activity in a portfolio.  It is wrong to think that this is the result of a ‘set-and-forget’ strategy.  Pacem Glover’s Investment Committee would be aggrieved at such a suggestion!  Considerable effort goes on behind the scenes to allow this state of calm consistency to exist.  The fortitude and discipline to deliver ‘not much needs to be done to your portfolio except for rebalancing’ advice, comes from a rigorous process of ongoing challenge to the status quo.

The broad terms of reference of the Investment Committee are set out below:

Manage risks over time

• The Investment Committee is responsible for the oversight of the risk in portfolios and the wider investment process. Meetings are regular and minutes are taken, which include all action points to be followed up on. Third-party inputs and guest members – such as Albion – provide independent insight and challenge.

Challenge the process

• The investment process at the Pacem Glover is driven by the latest empirical evidence and theory available. It is always open to challenge. If new evidence suggests that doing things differently would be in our clients’ best interests, then we will revise our approach. The investment process is evolutionary, but change is most likely to be slow and incremental.

Review the portfolio structure

• The underlying characteristics of Pacem Glover’s client portfolios are reviewed, including performance and risk level attributes. Risks (asset class exposures) and their allocations within a portfolio are evaluated. Any issues are raised and resolved. Existing asset classes are reviewed alongside asset classes and risk factors that currently sit outside the portfolios. Areas of interest are placed on a longer-term ‘watch’ list.

Review the incumbent ‘best-in-class’ investment products

• The incumbent products are ‘best-in-class’ choices seeking to deliver the returns due to investors for taking specific market risks. Each product has a role to play in a portfolio and its ability to deliver against this objective is regularly reviewed. Any product-related issues are raised and resolved.

Screen for new products and undertake appropriate due diligence

• Although the incumbent products were recommended as ‘best-in-class’, new products are regularly being launched. Tough screening criteria are in place against which new funds are judged. New, potential ‘best-in-class’ products face detailed due diligence and approval. They are included only when they make the grade.  Given the quality of the products already in portfolios, the threshold for replacement is high, but not insurmountable for newer products.

Reaffirm or revise the investment process

• The Investment Committee is accountable for reaffirming or revising the structure of client portfolios. Risk (asset) allocations and product changes are approved by the Investment Committee. Any actions arising from portfolio revisions will be undertaken, after discussion with and agreement by clients.

The next time you open you latest valuation report, remember that despite the lack of activity on the surface, the Investment Committee continues to paddle furiously behind the scenes to allow this be the case.  In the immortal words of the investment legend and author Charles Ellis:

‘In investing, activity is almost always in surplus.’

Perhaps we should amend this slightly to:

‘In investing, activity is – except for the Investment Committee – almost always in surplus.’

Other notes and risk warnings

 

Use of Morningstar Direct data

Morningstar Direct © 2019. All rights reserved. Use of this content requires expert knowledge. It is to be used by specialist institutions only. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied, adapted or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction. Past financial performance is no guarantee of future results.’

Use of this document

This document may be provided to a client of Pacem Glover either in hard copy or as a PDF.  It may not be in any circumstances be placed on any website or any form of social media.

Risk warnings

This article is distributed for educational purposes only and must not be considered to be investment advice or an offer of any security for sale. The reference to any products is made only to make educational points and must, in no circumstances, be deemed to be any form of product recommendation.

This article contains the opinions of the author and does not represent a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

Errors and omissions excepted.

Politics and portfolios

‘May you live in interesting times’

Old Chinese curse.

What a mess

It is rare that politics is discussed in our articles about investing, but it is evident when turning on the news that it feels like there is much going on in global politics at the moment that is unsettling, complex and confusing at one end, such as Brexit, to the downright worrying and unpleasant at the other, such as Russian meddling in the democratic process and the use of nerve agents on the streets of Salisbury.  There is much in between that is hard to compute in terms of its impact.  Trump’s populism feels unpleasant to many, but is his call to NATO members, such as Germany, to meet their commitments in full to share more of the financial burden of protecting Europe unfair, given Russian aggression? Is his trade war with China wholly a bad thing?  A recent leader in The Economist[1] supports – at least in part – his tirade against its mercantilism and unfair trade practices.  Let’s not forget climate change…

Issues closer to home such as Brexit and the potential for great political uncertainty in the event of no satisfactory (or any) deal being reached, feel – at least to UK residents – more prominent in our lives at this moment than some of these wider issues.

The Brexit affair

Whichever way one voted, it is hard not to be dismayed by the shambles that is Brexit, concocted by all sides.  Until recently, the UK appeared to have no clearly defined strategy. Its negotiations are led by a PM who wanted to remain, receiving criticism from the right wing of her party for not going far enough, and daily criticism from the opposition party, led by a long-time Eurosceptic, that still has no credible alternative aside from six ‘cake-and-eat-it’ criteria that any deal must meet.  For example, Criteria 2 poses the question ‘Does it deliver the “exact same benefits” as we currently have as members of the Single Market and Customs Union?[2]’, which is an impossibility, unless the deal is to remain. What a mess!  One would laugh if the consequences for our nation were not so great.

The EU has hardly covered itself in glory either with their intransigence and deep-seated, implicit desire to make everything so tough that other EU member states won’t dare to follow suit, or that UK voters might change their minds.  Yanis Varoufakis – the Greek finance minister at the time of their debt crisis – revealed the trap that the EU would set for the UK government, in his book[3] about his own experiences of dealing with it.   Did any of our politicians read it?

In the event that any deal agreed gets voted down in Parliament – or there is no deal – we face a high chance that the Conservative government could fall (but will turkeys vote for Christmas?) to be replaced by a far-left leaning government led by Corbyn and McDonnell.  Whatever your own thoughts and preferences on that, the one certainty is that we would be in for a period of radical change.  Certainly that means higher personal taxation.  In Labour’s 2017 manifesto they gave us a clue: a 45% income tax rate to kick in at £80,000 of income, with a 50% rate above £123,000.  This results in marginal tax rates – taking into account National Insurance and tapering of allowances – of 55% for those earning between £80,000 to £100,000, 73% up to £123,000 and 58% thereafter, according to the Institute for Fiscal Studies.  Even before these changes it is interesting to note that 4 in 10 adults currently pay no income tax and the top 10% of income tax payers pay 60% of all income tax[4] and around 30% of all personal taxes collected.  Corporation tax is set to rise from 19% to 26% and the 10% shareholding held for employees – announced by McDonnell at the Labour Party Conference – is likely to be a large new tax on companies, given the £500 limit per employee on dividend income and with the remainder going to HMRC.  Renationalisation of some industries, possibly without full compensation, is not beyond the realms of possibility.  Wherever you sit in terms of the balance between equity (how the economic pie is sliced up) and efficiency (how big the pie is), there is no doubt that we are living in ‘interesting’ times.

The point of this note is to recognise that the world we live in can be an uncertain and uncomfortable place and it can create anxiety over our future wealth and well-being.  It also sets the context for why and how a sensibly structured portfolio can provide considerable comfort for longer-term investors, and how we can put the uncomfortable noise of what’s going on in perspective.

It is not all bad, in fact, far from it

A recent study by the OECD[5] projects that global (after inflation) growth will rise by 3.7% in both 2018 and 2019, with major European economies growing by 1% to 2%, including the UK (1.3%). Growth in the US is predicted to be around 3% in 2018 and 2019.  In the UK, employment is at a record high and real wage growth (after inflation) has been positive since 2015 and the budget deficit is now around 1% of GDP compared to 10% before the austerity program.  Global growth leads to a growth in global earnings, which, when added to dividends paid, equates to the economic return due to equity investors for providing capital.  That’s good news.

The chart below illustrates that markets weather the multitude of World events they experience, rewarding the patient long-term investor, with growth in their purchasing power.

Figure 1: The relentless growth of purchasing power, despite World events (1/1985-7/2018)

 

 

 

 

 

 

Source: Albion Strategic Consulting[6]

The capitalist spirit continues to drive positive change

Since 2016 alone, 90 million people have been lifted out of extreme poverty[7], something that afflicts 8% (634 million) of the World’s population, most of whom live in Sub-Saharan Africa.  South Asia and East Asia and the Pacific have lifted around 0.5 bn and 1 bn people out of extreme poverty, respectively, since 1990[8].  That is on account of the unleashing of the energy and innovation that capitalism has driven in these regions, including China. In terms of infant mortality, the progress has, again, been staggering.  In 1990, on a global basis, infant mortality stood at 65 deaths per 1,000 live births. Today it is less than half that at below 30[9]. This is due to the reduction in poverty and improvement in healthcare and education around the globe, again driven and funded by the wealth that capitalism delivers[10].

Please take the time to view an amazing data visualisation of the World’s progress since 1810 by Hans Rosling[11], a renowned global health academic, to lift your spirits (see footnote 8). It’s a great way to spend four minutes.

We, as humans, tend to hold many misperceptions around important issues, overestimating guesses when an issue worries us and underestimating those that do not.  In part, this is because we rely on the fast thinking part of our brains, which are often not over-ridden by slower, more measured, reasoning[12].  For example in the UK we guess that 37% of the population is over 65, when in fact it is 17%.   We believe that the top 1% of wealthiest people own 59% of the wealth, when in fact it is 23%.  Only 13% of the UK’s population are immigrants, yet we guess at 25%[13].   One can begin to see how polarised political system can use facts and misperceptions to their advantage.

So where does all this leave investors and their portfolios?

You may well be asking yourself whether what is going on in the World affects how your money is invested and if any changes need to be made to your portfolio.  The question implicitly suggests that we can look into the future and know what is going to happen.  If it were that easy, all investors would know what to do and prices would already have moved.  Remember that you are not the only person thinking about these global challenges and all scenarios are reflected in current prices.  As a consequence, we need to rely on the structure of our portfolios to see us through.

We set out three key risks relating to Brexit and how sensible portfolio structures can mitigate them.

Risk 1: Greater volatility in the UK and possibly other equity markets

In the event of a poorly received deal – or no deal – it is certainly possible that the UK equity market could suffer a market fall as it tries to come to terms with what this means for the UK economy and the impact on the wider global economy.  A collapse of the Conservative government and a Labour victory would add further uncertainty.

Risk 2: A fall in Sterling against other currencies

In 2016, after the referendum, Sterling fell against the major currencies including the US dollar and the Euro.  There is certainly a risk that Sterling could fall further in the event of a poor/no deal.

Risk 3: A rise in UK bond yields (and thus a fall in bond prices)

The economic impact of a poor/no deal and/or a high spending socialist government could put pressure on the cost of borrowing, with investors in bonds issued by the UK Government (and UK corporations) demanding higher yields on these bonds in compensation for the greater perceived risks. Bond yield rises mean bond price falls, which will take time to recoup through the higher yields on offer.

Looked at in isolation, these may appear to be significant risks.  Owning a well-diversified and sensibly constructed portfolio, however, can greatly reduce these risks.

Mitigant 1: Global diversification of equity exposure

Although it is the World’s sixth largest economy (depending on how you measure it), the UK produces 3% to 4% of global GDP, and its equity market is around 6% of global market capitalisation.  Many of the companies listed on the London Stock Exchange derive much of their revenue from outside of the UK (around 70% to 80%).  For example, HSBC, even though it is often thought of as a British bank, generates over 90% of its revenues from overseas.  Well-structured portfolios hold diversified exposure to many markets and companies.

Figure 2: Global market capitalisation (developed and emerging markets) – 2018

 

 

 

 

Source: Albion Strategic Consulting using data from iShares – August 2018 (MSCI ACWI ETF).

Equity markets are always volatile, responding – sometimes materially – to new information.  Despite this, changing your mix between bonds and equities would be ill-advised.  Timing when to get in and out of markets is notoriously difficult. Markets move with speed and magnitude and missing out on the best days in the markets can have material long-term return impacts.  Provided you do not need the money today, you should hold your nerve and stick with your strategy.

Mitigant 2: Owning non-Sterling assets and currencies in the growth assets

In the event that Sterling is hit hard, it is worth remembering that the overseas equities that you own come with the currency exposure linked to those assets.  For example, owning US equities comes with US dollar exposure, as this exposure is not hedged out.  In short, a fall in Sterling has a positive effect on non-UK assets that are unhedged.  The chart below illustrates the impact that currency in unhedged non-UK assets has had over the past decade.  As you can see, at times of market crisis, the Pound has fallen against other safe-haven currencies such as the US dollar.

Figure 3: A falling pound is a positive contributor to portfolio returns

Source: Morningstar Direct© 2018.  All rights reserved.  Data derived from MSCI World Index in GBP, MSCI World Index in Local Currency and MSCI UK Index.

The bond element of your portfolio should have little or no non-Sterling currency exposure to avoid mixing the higher volatility of currency movements with the lower volatility of shorter-dated bonds.

Mitigant 3: Owning short-dated, high quality and globally diversified bonds

Any bonds you own should be predominantly high quality to act as a strong defensive position against falls in equity markets.  Avoiding over-exposure to lower quality (e.g. high yield, sub-investment grade) bonds makes sense as they tend to act more like equities at times of economic and equity market crisis.  Your bond holdings should be diversified across a number of different global bond markets, which mitigates the risk of a rise in UK yields (and thus falling prices), as the cost of borrowing in other markets may not be impacted in the same way, at the same time.

Some thoughts to leave you with

Even if you cannot avoid watching, hearing or reading the news, it is important to keep things in perspective.  The UK is a strong economy with a strong democracy.  It will survive Brexit, whatever the short-term consequences that we will have to bear, and so will your portfolio.  Keeping faith with both global capitalism and the structure of your portfolio and holding your nerve, accompanied by periodic rebalancing is key.  Lean on your adviser if you need support. That is what we are here for.

Perhaps try to catch up on the news only once a week and use the extra time to read about some of the exciting and positive things that are happening in the World.

‘This too shall pass’ as the investment legend Jack Bogle likes to say.

 

Other notes and risk warnings

Use of Morningstar Direct© data

© Morningstar 2018. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied, adapted or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction. Past financial performance is no guarantee of future results.

Risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

Other notes and risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

[1]     The Economist, September 22^nd – 28^th edition, ‘Hunker down’, page 12.

[2]     www.labourlist.org (2017) Keir Starmer: Labour has six tests for Brexit – if they’re not met we won’t back the final deal in parliament. 27^th March 2016.

[3]     Yannis Varoufakis (2016), And the weak suffer what they must The Weak Suffer What They Must? Europe’s Crisis and America’s Economic Future, New York: Nation Books, 2016

[4]     IFS (2017) www.ifs.org.uk/publications/10038 Note also that an income of a little over £50,000 put one in the top 10%.

[5]     OECD Economic Outlook and Interim Economic Outlook (September 2018) http://www.oecd.org/eco/outlook/economic-outlook/

[6]     Global balanced portfolio: 36% MSCI World Index (net div.), 26% Dimensional Global Targeted Value Index, 40% Citi World Government Bond Index 1-5 Years (hedged to GBP) – no costs deducted, for illustrative purposes only. Data source: Morningstar Direct © All rights reserved, Dimensional Fund Advisers. Past performance is not indicative of future performance.

[7]     World Poverty Clock www.worldpoverty.io (worth a look at how poverty is reducing).

[8]     The Economist, September 22^nd – 28^th edition, ‘Poverty estimates’, page 65.

[9]     World Bank (2017) https://data.worldbank.org/indicator/SP.DYN.IMRT.IN?end=2017&start=1990

[10]    For any reader interested in a more positive outlook, Matt Ridley’s book ‘The Rational Optimist’ is a good read

[11]    Hans Rosling’s data visualisation. https://www.youtube.com/watch?v=jbkSRLYSojo – a brilliant four minutes!

[12]    Nobel Prize winner, Daniel Kahneman’s book ‘Thinking fast and slow’ is a great read on this subject.

[13]    Data source: Bobby Duffy (2018), ‘The Perils of Perception: why we are wrong about nearly everything’.  Bell & Bain Ltd. Glasgow.  A great read on the subject.

Pacem Glover’s Kevin Kelly and Lizzy Crossan, along with other members of TeamBigDanny, were delighted to hand over a cheque for £10,635 to the Friends of the Cancer Centre Charity at Belfast City Hospital. The money was raised as part of a charity cycle from the most southerly point in Ireland to the most northerly and was in memory of our good friend and client Danny Gallagher who passed away at Christmas.

The cycle was organised by Pacem Glover Partner Kevin Kelly who talked three of his friends into undertaking the challenge. Kevin explains ”We are not great cyclists, in fact we only bought bikes in February, and we’re not a pretty sight in lycra so it was always going to be an interesting 400+ miles up the west coast of Ireland”!

The core cycling team, which consisted of Kevin, Brian Rainey and Gerard Hughes and Gavin Brown set out from Mizen Head in County Cork and, following stops in Kenmare, Kilrush, Oranmore, Drumshambo and Irvinestown, they rolled into Malin Head in County Donegal to a heroes’ welcome six days later.

According to Kevin “It was a fantastic experience and one that will live long in the memory. It was tiring and sore at times but the encouragement and scenery and hospitality (!!) that we enjoyed along the way gave us a great boost”. The team of 4 became 54 when they arrived in Danny Gallagher’s birthplace of Tummery in County Tyrone. Many of Danny’s family and friends from years gone by turned out to see the team off for the final leg and over 50 cyclists made the journey from Mahons Hotel in Irvinestown to the Gallagher Farm in Tummery.  Some 15 cyclists completed the 86 mile final leg from Irvinestown to Malin Head including Danny’s daughter Caitriona and son Daniel neither of whom had ever cycled more than 20 miles on a bike.

Pacem Glover was honoured to sponsor TeamBigDanny and remember our good friend and client Danny Gallagher. Indeed it is in Danny’s memory that we are supporting a host of cancer-related causes during 2018.  Well over 200 people made donations for what is a fantastic cause. Kevin explained that “The Cancer Centre at Belfast City Hospital will touch many of our lives in one way or another. The Friends of the Cancer Centre charity funds life-saving and life-changing projects that make a real and lasting difference to the lives of thousands of local people affected by cancer. During his short illness Danny spoke so highly of the Cancer Centre and the work they do. It has been an honour for us to raise £10,635 for this charity and all of the money will go directly towards patient care, patient comfort and research in the fight against cancer. It is even more of an honour to do it in memory of a great man”.

Modern life provides us – some would say swamps us – with so much news, information and punditry, which focuses on the here-and-now, that it is easy to be overwhelmed with the feeling of doom and gloom.  The list of things to concern us is long and worrisome; Donald Trump leading the free world, a nuclear-armed North Korea; an increasingly fractious Brexit process and looming cliff-edge, to name a few.

The natural extension of this is to worry about what the impact of all this uncertainty will have on your portfolio and in turn, on your future wealth and expenditure goals.  The first mistake is to believe that the world is falling apart around our ears.  It most certainly is not.  The second mistake is to think that the portfolio needs to be repositioned to mitigate these events. There are five key reasons why portfolio tinkering is unlikely to be a sensible course of action.

Reason 1: today’s ‘unprecedented’ turmoil is no different to how it’s always been

Today’s worries dominate our thinking; but can you remember what you were worrying about a year ago, or two years ago? Probably not.  It has ever been thus.  Take a look at the chart below. The overwhelming take-away is to acknowledge the relentless upward trajectory of purchasing power for those patient enough, and disciplined enough, to stay the course.

Figure 1: The relentless growth of purchasing power, despite World events

Source: Albion Strategic Consulting[1]

Reason 2: bad news sells – so don’t ignore the underreported good news

We are all aware that bad news sells.  For example, the Office for Budget Responsibility (OBR) delivered a ‘gloomy’ forecast for growth of ‘only’ 1.4% for 2018.  Yet, the UK economy is still growing; remember too that this slow down comes after a period of growth that has outstripped much of the developed world – particularly the rest of the EU – for the past few years.  It is not all bad news.

Reason 3: the danger of conflation of ‘what ifs’

The human mind likes stories and in themselves these stories may lead to what appear to be rational outcomes on which some action, or another, could or should be taken.  What we often fail to realise is that the seemingly logical outcome is highly unlikely; we have failed to multiply the probabilities of each sequential outcome together.  Think hard about the stories you read and hear.

Reason 4: the futility of futurology

Futurology is the financial markets’ version of astrology.  There is a huge industry out there from the IMF and the UK’s Office for Budget Responsibility (OBR) to investment banks, academics and BBC reporters all peddling their own view of the future.  These futurologists have one thing in common; they are nearly always wrong in their predictions, and are rarely held to account for their poor forecasts. Take forecasts with a pinch of salt.

Reason 5: the framing of data

As we all know, data is used to score points in support of the data-user’s viewpoint. Be aware that simple statements of fact can be both very influential and misleading.

Reason 5: the news is already in market prices

It is normal to be worried about the potential impact of what is going on in the world and how this will affect markets.  The reality is that you are not alone; in fact, all active investors have some view on how Trump, Brexit, Merkel’s problems in Germany, or the Federal Reserve in the US – to name a few – will impact bond and equity prices.  These global, diversified view-points are already reflected in the equilibrium price of securities, agreed freely between buyers and sellers.

Your portfolio is already structured to manage uncertainty

Today’s concerns such as Brexit, Sterling’s weakness, potential tax rises in the event of a Labour government, and Donald Trump in general, are endlessly recycled through the 24/7 media soundbite process, alarming some who are invested in the markets.  Well-structured investment portfolios seek to ensure that any market conditions can be weathered in the future, whatever drives these storms.  Your highly diversified portfolio, balancing global equity assets with high-quality shorter-dated bonds, is well positioned to do so.  Try not to worry.  Start by watching the news less.

If you are feeling concerned, please feel free to get in touch to talk further.

 

[1]     Global balanced portfolio: 36% MSCI World Index (net div.), 26% Dimensional Global Targeted Value Index, 40% Citi World Government Bond Index 1-5 Years (hedged to GBP) – no costs deducted, for illustrative purposes only. Data source: Morningstar Direct © All rights reserved, Dimensional Fund Advisers.

All investors know that they need to take risks in order to achieve returns higher than cash.   If you asked ten investors if equities were more risky than cash, most would agree; but that depends on how one understands risk.  The investment industry has done a poor job of explaining risk as it relates to an investor and tends to equate risk with return volatility.  William Bernstein – a neurosurgeon-turned-adviser and prolific investment writer – wrote a great, short booklet on risk[1], where he explained the different risks that equity investors face, as follows:

‘Risk, then, comes in two flavors: “shallow risk,” a loss of real capital that recovers relatively quickly, say within several years; and “deep risk,” a permanent loss of real capital.’

Shallow risk – precipitous equity market crashes that recover relatively quickly

This first level of risk is the one that most investors focus on, yet is perhaps the least relevant, particularly for those with long investment horizons.  These are the scary and emotionally fraught times when equity markets fall dramatically, the latest example of which was the Credit Crisis of 2007 to 2009.  We illustrate below, the five largest equity market falls in the US market, since 1927 (in US$ terms).

Figure 3: Five largest falls in the US equity markets between 1927 and 2017

Data source: Ibbotson SBBI US Large Stock TR, Jan-25 to Apr-17. Morningstar © All rights reserved.

Deep risk – a permanent loss of wealth

Bernstein defines deep risk as the permanent loss of purchasing power on account of four events: hyperinflation, such as that of the Weimar Republic, where from 1921 to 1924 bonds and cash lost nearly all their value; prolonged deflation causing a depression and high unemployment; devastation i.e. wars and geopolitical events, such as the Bolshevik revolution (almost 100 years ago to the day) resulting in the closure of the Russian stock market and default on Tsarist government debt; and finally confiscation, which still happens today e.g. the Argentinian government’s expropriation of the Spanish oil company Repsol’s assets in the country in 2012.

There are two investment behaviours that translate shallow risk into deep risk. Being shaken out of the market by a precipitous rapid fall (shallow risk) and then failing to get back in again – as there never seems to be a good time to do so – crystallises a real loss (deep risk).  Owning concentrated stock portfolios can do the same; a recent study[2] in the US shows that 26,000 listed companies have been in and out of the US equity exchanges since 1926, with a mean life of only seven years.  Only 36 companies have made it through from 1936.  Owning high exposures to stocks that fail is deep risk.

The best mitigants of deep risk are to own a globally diversified portfolio of several thousand stocks distributed predominantly across developed equity markets of democratic countries with a sound legal frameworks.  Equities provide the prospect of strong, long-term inflation-plus returns.

In conclusion

Investors know that placing money in the bond and equity markets carries risk.  Yet the way in which many look at, and measure, risk is disconnected from investors actual longer-term investment horizons, focusing on shallow risk, rather than deep risk.  Unless one understands the probability of an adverse event (hazard) happening and the effect of this exposure, due to a specific hazard on the individual investor, then it is likely that the real risks faced by an investor are masked by the shallow risks that have more emotional impact.  Owning more ‘low risk’ bonds (or cash) is not necessarily always the right answer when trying to avoid the deep risks that investors face.

Other notes and risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

[1] Bernstein, W.J., (2013), Deep Risk: How History Informs Portfolio Design. Available at www.amazon.co.uk

[2] Bessembinder, Hendrik, Do Stocks Outperform Treasury Bills? (May 22, 2017). Available at SSRN: https://ssrn.com/abstract=2900447

Gold has always held a certain appeal for humans. Its lustre, due to a lack of oxidation, makes it pleasing to look at and to handle.  Yet, it is simply a lump of metal that generates no income and will only be worth what someone else wants to pay for it at any point in time.  Given the lack of cash flow, common valuation models are not useful. Warren Buffett is not a big fan:

“Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

Gold has suffered prolonged, negative real returns over periods as long as 20 years and delivered an annualised return of just 1.5% p.a. after inflation – around 5% lower than equities – between 1987 and 2017, yet with comparable volatility.  In its favour, gold prices are uncorrelated to equity markets.  Yet many investors seem enamoured by its fabled investment properties.  Do these claims tack up?

Claim 1: gold is a good defensive asset at times of global equity market crisis

In the period under review, there were three substantial equity market crashes.

Figure 1: Gold as a defensive asset from 1/1979 to 6/2017

Peak date	Global Equity Fall	Trough date	Gold	Short-dated bonds
Jan-00	-48%	Jan-03	18%	17%
Nov-07	-41%	Feb-09	90%	12%
Oct-87	-29%	Nov-87	-7%	2.5%

Data source: MSCI World Index (net div.), Citi WGBI (1-5) hedged GBP from Morningstar © All rights reserved.

The spectacular return of gold during the credit crisis was perhaps driven by fear, pushing up the price of gold.  If you are able to guess how others are going to behave in the future, you would be able to take advantage of gold’s hedge against fear, buying and selling it at appropriate times.  Market timing is exceptionally hard to do, without the luxury of hindsight.  Holding gold as a strategic diversifier in a portfolio carries with it a punitive, long-run zero real return assumption. Gold may be a good hedge against fear, but it is hard to exploit in practice.

Claim 2: gold is a good inflation hedge

Perhaps one of the most quoted properties of gold is its supposed ability to provide a hedge against inflation.  The evidence does not support the assertion, at least over normal investment horizons.  Over the long-term gold keeps up with inflation; A US army private gets paid almost the same – in terms of gold – as a Roman legionary did 2,000 years ago!

The belief that gold is a good inflation hedge is anchored on its performance during the late 1970s when gold prices and high inflation rose in tandem.  James Montier of GMO undertook an analysis that demonstrated the 10-year inflation for each decade and the gold price return were uncorrelated except for the 1970s[1].   In terms of an inflation hedge, stocks and index-linked gilts provide better opportunities to achieve this objective.

 

 

Figure 2: The real price of gold and underlying annual inflation 1/1979 to 6/2017

Data source: www.gold.org.  UK Retail Price Index – Bank of England

Claim 3: gold is useful store of wealth in an Armageddon scenario

A case can perhaps be made for holding some physical gold in the form of coins or ingots, in the liquidity reserves of those who fear the breakdown of fiat (paper) currencies at times of extreme market events, such as those surrounding the collapse of Lehman Brothers or even greater global calamity such as another world war.   In the extreme collapse of the financial system, paper gold (e.g. via a gold fund or ETF) would be less favourable given the risk of counterparty failure and the potential inability to access the underlying gold when it is truly needed.  Don’t forget that gold is very heavy and if you bury it, you need to be able to find it again; our museums are full of gold Roman coins, buried and lost two thousand years ago!

Conclusion

Enjoy your gold jewellery, perhaps hide a few Krugerands in the airing cupboard, but don’t believe that owning gold will improve the structure of your portfolio.  From an investment perspective, all that glistens is not gold. 

 

Other notes and risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

[1]      Montier, J., (2013) No Silver Bullets in Investing (just old snake oil in new bottles), GMO White Paper, December 2013

As investors, we have to contend not only with the erratic and unpredictable nature of markets but also the erratic and irrational way in which we think and behave.  A lack of knowledge, combined with a number of illusions and biases can lead to errors in making decisions that can turn out to be very costly.  Some of the common behavioural traps – and how to avoid them – are set out below:

Trap 1: Believing you are better than average

Human beings tend to be overconfident in their abilities. For example, out of 600 professional fund managers asked in a study almost three quarters said they were better than average.

Mitigation strategy: Have some humility – plenty of very clever people get beaten-up by the markets.

Trap 2: Mistaking random noise for patterns

A rational gambler playing roulette knows that the chance of any number coming up is the same as any other number.  Yet, a sequence of three red ‘9s’ in a row, can create quite a stir at the table.

Mitigation strategy: If you detect a pattern in shorter-term data it is probably meaningless.

Trap 3: Problems with probability (and maths in general)

For example, many people are willing to pay more for something that improves the probability from 95% to 99% than from 45% to 49%, despite the financial benefit being the same.  Virtually no one can compound in their heads.

Mitigation strategy: Do not ignore the maths.  Sit down and spend a little time teasing out the numbers.

Trap 4: The Monday morning quarter-back – hindsight delusion

With hindsight we often honestly think we could have predicted what has happened, such as a fall in the markets.  The evidence suggests that we cannot.

Mitigation strategy: Do not believe that you have predictive powers – it is unlikely that you do.

Trap 5: I will throw my anchor out here thanks

The human mind really likes to use mental ‘anchors’ when forming opinions, which in many cases leads to extraordinarily inaccurate estimates of outcomes.  The level of the FTSE 100 is a common investment anchor for clients, even if their investment portfolio is very different.

Mitigation strategy: Do not allow yourself to get hooked on meaningless anchors.

Trap 6: It is more familiar to me, and I get it

Humans tend to make spontaneous generalisations, based on how they are influenced by recent events, press coverage, their own experiences, and the vividness with which a situation is portrayed.

Mitigation strategy: Stand back and seek a broader perspective.

Trap 7: I like a good story

We all love a good story and there are few better story-tellers than fund managers.  The danger is that the narrative of a plausible sounding script, often full of contingent probabilities, tends to persuade us to assign a higher likelihood to the story coming true than is realistic.

Mitigation strategy: Be a sceptic – take everything you hear or read from the industry with a pinch of salt.

Trap 8: Short-termism and obsessive portfolio monitoring

Many investors find it difficult to see the long-term wood for the short-term trees. Their focus tends to be on the effects of recent market conditions on their wealth and this affects their ability to make good decisions for the long-term success in meeting their lifetime purchasing power needs.

Mitigation strategy: Given the 2:1 ratio of pain to gain, the longer the period between peeks at a portfolio the better!

The solution: process, process, process.

Investing using a well thought-out, evidence-based and systematic investment process helps to take much of the emotion out of investing.  A good process won’t always deliver a good outcome, but over time it raises the chances of one.  While investing is simple, it is never easy, largely because of how we behave.

 

Other notes and risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

We tend to regard wealth as financial assets, large houses, and nice cars accumulated through a life of hard work.  Yet that is to view wealth in narrow terms; on the very day we are born we are wealthy in terms of our human capital, or in other words, the present value of all the future earnings that we will generate over our working lives.  This needs to be reflected in how we invest during the accumulation phase of investing.

As younger people have a long time to go before they will need the money, the advice they receive is often that excess earnings should be invested predominantly in equities.  A subtler approach takes into account the attributes of each person’s human capital, which ranges from bond-like to equity-like in nature.  Take for example a university professor and a fin-tech entrepreneur; the former has stable income, linked to inflation and job security; the latter has little income stability and, most likely, a high correlation to the equity markets. The professor’s human capital acts like a bond, the entrepreneur’s as an equity.

So, if they are both 40 years old and have the same level of financial capital, should they invest in the same way?  Intuitively, the answer is no.

Human capital should be treated like any other asset class; it has its own risk and return properties and its own correlation with other financial asset classes.

Ibbotson, Milevsky, Chen and Zhu (2007)[1]

Those with more bond-like human capital could well take on more risk and those with more equity-like human capital should, perhaps, take on less risk with their financial capital.  Ironically, it is also possible that those who choose steady, stable jobs may have lower tolerance to losses than the entrepreneur, and vice versa.  One can see the risk of this scenario.  Additionally, two partners may also have different levels of risk in their human capital. Imagine a professor married to an entrepreneur; together they form a balanced portfolio between bonds and equities and their investable portfolio of financial capital should reflect this.

Figure 1: How human capital attributes influence asset allocation

Lower equity content in portfolio	Higher equity content in portfolio
Low job and earnings stability	High job and earnings stability
Low earning flexibility	High earning flexibility
High correlation of earnings to equities	Low correlation of earnings to equities
Low earning capability	High earning capability (replenish losses quickly)

Source: Albion Strategic Consulting

Cash-flow modelling can help those in the accumulation phase of investing to understand the financial impact of changes to their human capital.  Owning sufficient life cover to protect the outstanding human capital should be an important part of the discussion.  It is difficult to see how a stockbroker or investment manager can structure a portfolio sensibly, particularly where the investor still has substantial human capital, without the insight into, and modelling of, the client’s total asset picture.  No financial portfolio is an island.

[1]      Ibbotson, Milevsky, Chen and Zhu (2007), Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance, Research Foundation of CFA Institute publication.

Other Notes and Risk Warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.