When I admit to not knowing, people become disappointed.  It seems to be beyond belief that we wouldn’t know something.   It doesn’t help that some myths are perpetuated by an investment world that wants you to believe in secrets and mercurial talent.   So I want to tell a short story, a true story, about how hard it is to forecast the future.

Many people will have heard of Anthony Bolton, arguably one of the UK’s best fund managers.   He used to run the Fidelity Special Situations Fund from 1979 until 2007 – 28 years in total.  Over this period his fund achieved an average annual return of 19.5%.  An impressive return, though as Mr Bolton points out, very few investors in the fund got anything like that kind of return.  Too many bought close to the top, and sold near to the bottom.  But that’s a different story altogether.

The story I want to tell is about what happened when Bolton decided he wanted to retire.  In 2006 it was decided to split his fund into two because it had grown so large. By now it was the UK’s largest fund with almost £3 billion under management.  It was decided to split it into a Global Special Situations Fund and a UK Special Situations Fund.

The Global Fund was passed over to a younger manager, Jorma Korhonen, and the UK fund continued under Bolton’s stewardship for another year. Then in January 2008 management of the UK Fund passed to Sanjeev Shah. I imagine Bolton and the chiefs at Fidelity were able to choose from the cream of crop when deciding who should manage the funds. In short, they had the time, the resources, and the contact list to find and appoint the best fund managers for the job. All they had to do was appoint someone to manage the Global fund, and someone else to manage the UK fund.   How hard could that be?

Well the investment results for Bolton’s hand-picked replacements suggest it’s a lot harder than it appears.  5 years after being personally chosen by Bolton, Jorma Korhonen has been replaced as manager of the Global Fund. He underperformed the market and underperformed his peers.  He didn’t even deliver average returns, so bad was his performance. For all his promise, Korhonen chose to bet on struggling investment banks in 2008, and the fund lost over one third of its value.

Sanjeev Shah hasn’t found it easy either, though he’s still in the job. He also bet on the banking sector and has had a disastrous last year. The result is that over his tenure his fund has also turned in a below average performance.

The message is, trying to select the best fund managers in the hope of superior investment performance is a flawed strategy.  If Anthony Bolton and the other ‘experts’ at Fidelity couldn’t pick the right people, what hope is there for a financial adviser? Not only that, we’re expected to pick the right people across a wider range of funds and sectors.  It’s a mug’s game.

Far better to concentrate on the things we have more control over, like fund charges, investor behaviour and matching the right asset allocation to someone’s capacity for investment risk. That way there are fewer disappointments and more expectations met.

A year ago the Barclays Capital Global Macro Survey asked more than two thousand institutional investors to predict the top performing asset class.  Their pick for 2011 was shares (with 40% support), followed by commodities (34%) and bonds (less than 10%). On top of this they were asked to predict the gain in the US S&P 500, an index used to measure the performance of the US stock market.  The consensus prediction was for a 15% gain for the S&P 500 this year.

A year later we can see how well these two thousand professional investors did – not very. To the beginning of December, diversified fixed income was the best performing asset class of the year, followed by government bonds.  The returns on commodities and shares (the most popular choices among these professionals) were both negative, and the year-to-date return for the S&P 500 was close to zero.

Meanwhile, one investment magazine was telling readers this time last year that smart investors were “looking eastward” in 2011.  According to them, the year would be dominated by fast growth and rising inflation and the smart thing was to reweight toward China and other tigers.
That didn’t really turn out to be such a good idea, as China had another bad year.  The Hong Kong Hang Seng index was down nearly 17% to early December. The Shanghai Composite was down by a similar amount.

Conversely, the majority of professional investors were gloomy around bonds in late 2010.  One survey of 10 top strategists and investment managers found nearly all expected shares to outperform bonds in 2011.

Their logic might have been impeccable, but the strategy wasn’t. Bond yields might have been seen as unusually low a year ago, but they have fallen even further since driving up bond prices. Those who tried to profit by market timing or making concentrated bets elsewhere have paid a heavy price for doing so.
So if the experts can’t get the broad asset class movements right, what chance on earth have they of correctly and consistently predicting individual stock or commodity performances?  But year after year, that doesn’t stop them from trying.

One example – a prominent investment bank team was quoted by The Australian Financial Review last January as saying that platinum was the metal to back in 2011.  As of early December, the spot platinum price was down nearly 14% for the year.  On the Australian stock exchange, platinum stocks Platinum Australia and Aquarius Platinum – both recommended by the bank – had delivered total returns to the end of November of minus 83% and minus 53% respectively. Ouch!

It’s a tough business isn’t it? And remember these are major financial institutions with armies of expert analysts, mountains of data and sophisticated forecasting tools. So what is an ordinary investor supposed to do?

The first lesson might be that forecasting is hard, particularly about the future!  You can do all the analysis you want, but events have a way of messing with your assumptions.

The second lesson is you don’t really need forecasts to succeed as an investor.  Yes, shares were rocky again this past year.  However, a portfolio of good quality bonds would have provided excellent returns. Therefore, an investment portfolio diversified across different assets, and within asset classes, provides a cushion in down times, and ensures you are still positioned to reap returns when riskier assets come back into demand.

It’s human to feel anxious about bad news because we fear loss more than we like gains.  But in this case, the loss isn’t real unless you realise it.

The final lesson is that nothing lasts forever. In fact, of all the forecasts ever made, the only one really worth counting on is that things change.  What’s more they often change in ways we least expect.

Listening to the media, 2011 started as a catastrophe waiting to happen! Even before the year began the global financial system was on its last legs, and the eurozone was within a few weeks of a melt-down – it still is, and has been for the last couple of years! The initial problem was the potential for Greece to default on its debt obligations. This shouldn’t come as a surprise, Greece has been defaulting on its external sovereign debt obligations since the fourth century BC (back then they defaulted on the funds borrowed to build the Temple of Delos).

Let’s put this into perspective; the Gross Domestic Product (GDP) of Greece is only twice the size of Kazakhstan’s.  To put a number on it, it represents barely 2% of the entire European Union GDP (GDP represents the total market value of all goods and services produced in a country in a given year). So how does such a small economy threaten to bring down the financial system of the entire world? Well, we’re told that if Greece fails it would set off a chain reaction, like the first domino to fall.

Journalists and commentators like this because it keeps them busy. Once Greece has been sorted the story simply moves on to the next sick economy. Italy, Spain and Portugal are already in the spotlight. Bad news sells papers; and there’s every incentive to keep these stories running. Heaven forbid that there should be any good news out there.

But whilst we’ve been focused on Europe, the rest of the world has been managing their exposure to the eurozone. They’ve been putting their efforts into more promising economies like China, India, and Brazil. There are some great stories out there but they’re not being told.

Now we’re being told to watch for a double dip recession, not just in Europe but in America too. Journalists on both sides of the Atlantic frequently remind us that it’s all doom and gloom, whilst Warren Buffett invests billions in stocks and corporate bonds. Nobody thought to mention that America has never had a double dip recession. In fact, industrial production accelerated sharply in 2011 – that sounds like good news.

We’ve been told that the economy would drop like a stone, markets would freefall, and Western currencies like the Pound and the Dollar would become worthless (whilst gold became the only true repository of value). If we’re only ever exposed to this type of news it stands to reason that we’ll believe this is the only story out there – it isn’t.

We thrive on bad news, it’s almost masochistic! In some ways it’s hard wired into our psyche – look at how popular bad news stories are. But with our focus on all the bad news out there, are we missing any good news of any consequence? I think we are; large global companies have seen earnings, cash flows and balance sheets climb steadily upward throughout 2011 – and many have reached new all time high levels. Investors reliant on dividends (which were cut back in 2008 and 2009) have seen their income levels bounce back (though they are not yet back to previous highs).

Admittedly we have witnessed some very volatile markets the past 12 months, and yet despite all the bad news we’ve been exposed to, the FTSE 100 share index is down by less than 4% over the past year. From everything I have been reading I would not have been surprised if markets had halved. In fact, having read nothing other than doom and gloom it is a surprise that markets have been so resilient.

So, what are we to believe? One idea is that the market is wrong i.e. that a crash is on its way and has only been delayed. The other is that much of the gloom and doom is misplaced, and that markets are right after all.  The earnings, cash flows and balance sheets of great companies are telling the truth.

Yes, there are significant macroeconomic problems within Europe and the United States and we face several years of austerity measures. Nor have large multinational companies escaped unscathed – share prices are still below their all time highs and the wider economic problems are also reflected in their share prices. It’s not all good news, and it’s not all bad news.

As we approach the year end, why not reflect on your wise decision not to resort to panic given all the bad news you’ve been exposed. We’re not out of the woods yet, but a well diversified portfolio constructed with the long term in mind is the best approach you can take in the current conditions.

If anything the news sounds worse rather than better. I’ve been receiving some emails about what is happening so I thought it would be worth looking at this again.
Truthfully, nobody really knows what the short term holds. This isn’t unusual. People generally don’t know what’s happening until long after it’s happened – which is when the books are written telling us what we should have done to avoid it all – hindsight is perfect vision. Everything seems so obvious when we’re looking back.

I don’t know whether the current market conditions will continue, or whether the next movement will be up or down. But I’ve spent a lot of time listening to, and reading the thoughts of the wisest sages I know. The thing is, stock market investments are looking reasonably priced when compared to the long term average. There’s no reason for markets to go down, but sentiment – greed and fear – are strong drivers of behaviour.

Even if markets continue to go down (as they did in 2009) they will eventually recover. In our experience once markets do recover the upswing is usually quite quick. If you’ve got out of the market what will be the trigger to return to the market? Behavioural Psychology suggests that people will wait on the sidelines too long. Fear breeds inertia, and my worry is that people will find it difficult to reinvest because they won’t know where the bottom or the top is.

In fact, what I believe we are seeing is greater volatility. In simple terms this is the amount stock markets move up and down. Theoretically it shouldn’t matter how far up or how far down the markets swing, so long as they are up when you need the money. Volatility then, isn’t a true measure of risk because it doesn’t tell you the likelihood losing your money – it simply tells you how bumpy the ride is.

The problem is we are able to see volatility fairly easily – the market goes up by 3% it goes down by 3% – and the papers and TV are full of it. We experience volatility and we equate it to risk. It’s like sailing across the channel to France – we’re comfortable when the waters are smooth, and we get sea-sick when we hit big waves. We’re experiencing more big waves these days and sometimes it’s a scary journey, but we’ll reach the other side.

We know that companies are still producing goods, they have less debt, and they’re leaner and fitter as a result of the past few years. We’ve been through storms like this before, and the best advice then, as it is now, is not to make any rash decisions. The markets are a long way off the lows experienced in 2009 and anyway, most of our investors have a split between shares and bonds.  They are already cushioned against the worst of the market wobbles. In my opinion having diversity in your portfolio is the best defense for when in markets are like they are today.

The increase in market volatility is an expression of uncertainty. The concerns over sovereign debt in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading investors to discount riskier assets.

So share prices on the developed world’s stock markets, oil and industrial commodities, emerging markets and commodity-related currencies like the Australian dollar are weakening as risk aversion drives investors to the perceived safe havens of government bonds, gold and Swiss francs.

Whilst this feels reminiscent of the events of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction, the focus of concern this time has turned from private-sector to public-sector balance sheets.

As to what happens next, no one knows for sure. That is the nature of risk. But there are a few points individual investors can keep in mind to make living with this volatility more bearable.

• Remember that markets are unpredictable and do not always react the way the experts predict they will. The recent downgrade by Standard & Poor’s of the US government’s credit rating should have caused US Treasury bond prices to fall.  Unexpectedly their prices rose.

• Quitting the equity market at a time like this is like running away from a sale. While prices have been discounted to reflect higher risk, that’s another way of saying expected returns are higher. And while the media headlines proclaim that “investors are dumping stocks”, remember someone is buying them. Those people are often the long-term investors.

• Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009 – when market sentiment was last this bad – the S&P 500 turned and put in seven consecutive months of gains of almost 80 percent. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.

• Remember the power of diversification. While equity markets have had a rocky time in 2011, fixed interest markets have flourished–making the overall losses to balanced fund investors a little more bearable. Diversification spreads risk and can lessen the bumps in the road. All of our clients have diversified portfolios.

• Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. As the IMF noted recently, while advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving, and a globally diversified portfolio takes account of these shifts.

• Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

The market volatility is worrisome, no doubt. The feelings being generated are completely understandable. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value will re-emerge, risk appetites will re-awaken, and for those who acknowledged their emotions without acting on them, relief will replace anxiety.

As a method it is as valid as using astrology. Using astrology all Librans would invest in balanced portfolios, and someone born under Taurus would be permanently bullish. It is of course ridiculous.  What would happen if Leo moved into Ursa Major?

The Financial Services Authority have also taken a recent interest in risk profiling tools, so we were pleased to discover that our risk profiling methodology is about as good as it gets. We didn’t expect anything else.  The research behind the tool we use is thorough and there is a continuous testing and validation process that goes on behind the scenes.

Assessing risk tolerance has been an Achilles heel of the advising industry for many years.  However the use of psychometric testing helps determine risk in more robust manner. Psychometrics is a mix of psychology and statistics, and was developed by psychologists in the late 19th century. Psychometrics underlies all testing of personality, skills, aptitudes, IQ, etc.

The system we employ is a scientifically validated tool for assessing risk tolerance.  It is used by a lot of leading advisers, from across 15 countries, and in seven languages. More than 400,000 risk profiles have been completed, and the results of these are regularly fed back into the system to ensure the accuracy of the conclusions.

Until recently the Financial Services Authority gave no guidance on how an investor’s risk profile should be measured, hence perhaps the bank adviser’s impersonation of Paul McKenna, the TV hypnotist. However, in January, the Financial Services Authority did release a detailed guidance paper. By and large, the FSA did a very good job. As it was, the FSA was very critical of industry standards and the paper is going to force most in the industry to rethink their current practices.

So are all psychometric financial risk profiling tests good tests? Unfortunately the answer is no. Most that we know of are OK but some would not meet international psychometric standards. Anyone who provides this type of psychometric test should publish a technical manual independently verified by a third party with expertise in the field. We believe that FinaMetrica is the world standard for risk profiling psychometrics.

Risk tolerance is often thought of as being a tick-box exercise.  However, a good psychometric test will provide you with a better understanding of, and commitment to, your investment decisions as part of your personal financial planning.

Just a few years back, people lined up for investments known as “structured” products. These were promoted as funds where investors could ‘have their cake and eat it’, seemingly earning an investor high returns without any risk. Yet in a post-crisis report by the Financial Services Authority it was pointed out that many of these products used terms like “safe”, “secure”, “protected” or “guaranteed” whilst hiding substantial risks.

In that period of investment hubris before the financial Armageddon, financial product makers also marketed created financial products that actively encouraged more risk taking in the belief that markets were ‘on a roll’. The problem was that these investments were based on the faulty assumption that market risk always remains the same. Many people are now living with the consequences.

These days, investors are more risk averse. The focus has turned to preserving capital and ensuring a “guaranteed” minimum return above what could be obtained from risk free deposits. So the financial services industry has come up with “absolute return” funds.

Sometimes called “all weather” funds, absolute return funds suggest they can deliver reliable returns in rising or falling markets. Describing themselves as highly diversified funds they bring together a dizzying range of asset classes – including commodity futures, swaps of various kinds, mortgages, currencies and other exotic financial instruments. They are a far cry from a traditional equity and bond portfolio.

Many add leverage, borrowing money to increase returns. They also use shorting, that is selling investments they don’t own, hoping to benefit from a drop in price of the investments – a speculative practice.

The intention with these products is to use a range of investments that are “uncorrelated” – meaning they behave differently at different points in the economic cycle – to traditional stocks and bonds. Consequently, they are supposed to lower your risk of a negative return by increasing the diversification in your portfolio.

That’s the theory. But there are a few problems in practice. For one thing, as we saw in the financial crisis, the past isn’t a good guide to what will happen in the future. During extreme stress, the markets tend to punish all risky assets, with prices dropping across the board. Distinctions are not made no matter how uncorrelated they are.

Secondly, investors are mistaken if they think volatility and correlations are the only measures of risk. Extreme events can occur. Some of those events can be blamed on the financial system; others not. Who would have thought, for instance, that Japan would suffer a catastrophic earthquake, a hugely destructive tsunami and a terrifying nuclear crisis at the same time?

A third issue is that a supposedly risk-free investment should really only expect the risk free rate of return, something like the return you can receive on a bond issued by the UK government.  That they don’t – and we shall see evidence of that in a moment – highlights the contrast between simulated track records and reality.

Despite all of this, the moniker ‘absolute return’ is a great marketing strategy. And it appears to have worked. In the UK, for instance, the absolute return sector was the second most popular among retail investors in 2009 and the third most popular last year, according to the Investment Management Association.

The sheer complexity of these funds and the vast differences in their underlying investments make comparisons difficult.

In the UK, research has found that 13 absolute return funds were set up in 2009 in the wake of the financial crisis. Only two were around in 2007. Far from offering returns uncorrelated to the stock market, by the end of 2010, the absolute return sector had moved in the same direction as the FTSE-100 in 29 of the previous 36 months. And in 34 out of 36 months, the absolute return funds had moved in the same direction as the balanced managed sector (funds with a maximum of 60 per cent in shares).

So it’s not clear from all of this that absolute return funds are living up to their names: In the meantime they have opaque strategies, a reliance on simulated returns, a large variation in fees, and returns that do not differ greatly from what can be achieved in underlying shares and bonds – so why invest in all the smoke and mirrors?

When risk appears again on the horizon and these “all weather” portfolios do not live up to expectations (and they won’t) their defenders may blame “the black swan”, the “six sigma” event or the once-in-a-century storm. What they’re really saying is that they couldn’t predict the markets. 

For everyone else, here’s the story. In September 2010 Dr Juliane Kokott, an Advocate General in the European Court of Justice argued that using a person’s gender when underwriting insurance policies was actually sex discrimination, and therefore did not comply with the provisions contained within the Charter for Fundamental Rights.

I’ll go back a couple of steps just to show how significant this is. When an insurance company wants to calculate how to charge for a life insurance policy, it will take into consideration a variety of different things, the age of the person, the medical history and the gender. The same happens when working out how much income to pay someone in exchange for their pension fund.

The older a person is the shorter their remaining lifespan, this means that a higher level of income can be paid. Likewise, if someone is in poor health they have a shorter lifespan, and consequently the more income that can be paid. Finally, because men are statistically likely to die at a younger age than a woman, they too receive a higher income because the pension fund does not need to last so long.

Age, health and gender have been legitimate factors in the calculation of insurance, risk and annuity returns but now an unintended consequence of the Treaty of Rome will mean the majority of people will be worse off.

Nature has little regard for the Treaty of Lisbon so unfortunately men, we’re still more likely to die at a lower age than women. This means that if insurance companies are compelled to offer same sex annuity rates, the age expectancy for men will rise, and their annuity income will decrease. That will hit their pockets with a reduction in income of around 5% being talked about, though some commentators have suggested there will be a 13% difference. Put another way, a £100 income payment could fall to between £87 and £95, neither of them a favourable outcome.

The ruling will be announced on March 1st, but many insurance companies have already started to withdraw their current annuity rates in favour of unisex rates. This is because the 14 day acceptance period for annuities would take them beyond the 1st March.

Savings accounts topping the best buy tables in the newspapers and paying the highest rate of interest may seem attractive.  Many of these accounts offer enticing interest using a high bonus rate for a period of time, typically up to a year.  But maintaining the accounts can be a lot of work.

One good thing about these bonus accounts, especially where the bonus makes up a large chunk of the overall interest rate, is you know the interest rate won’t fall very far.  Don’t rely on the banks to let you know when it’s time to move your money because the bonus has expired though. Make sure you make a note to start looking for alternatives a month before the end of the bonus.  At that time you’ll have to be prepared to move your money to an account paying a better interest rate.

If you don’t want the work of keeping on top of the best buy savings accounts another strategy is to open accounts with a bank or building society that pays consistently good rates.  Moneyfacts regularly run a consistency survey which shows building societies offering the most stable interest rates.  Over the long-term most savers probably end up with more interest earned this way than by chasing the best rate.

Once you’ve chosen a good account you probably want to be able to safely deposit a large amount of money.  From 31 December this will get a little easier.  The compensation payable under the Financial Services Compensation Scheme, or ‘FSCS’, is going up from the current £50,000 to £85,000 per person, per authorised firm.  This means joint account holders can put £170,000 into one institution and still be fully protected under the scheme.

The FSCS would pay out if a UK regulated financial services firm is unable to pay claims against it. We never recommend clients put more than the compensation limit with one institution.  You can check if your savings account is covered under the scheme by asking the institution or looking at the list provided on the FSA website.

The bottom line is there are a few things you can do to make sure your money is safe and earning a good rate of interest.  The least hassle do-it-yourself method is to find an account paying a consistent rate of interest rather than a best buy.  Use a joint account to take advantage of the higher amount that will be protected by the FSCS.

I’m not surprised by the questions given the challenges facing our economy and the focus of the commentary in the press. ‘Double dip recession’ news story anyone?

We were invited to participate in a survey by the Economist Intelligence Unit on our perceptions on the economy, and how the press report on it. I was able to tell from some of the questions that the press is aware that they can come across as a little bit negative sometimes.

For example, question 3: Do you agree or disagree with the statement ‘I mainly see negative stories in the financial press’?

There wasn’t an option for me to choose ‘very strongly agree’.

Given the tsunami of negativity, you may have missed the positive comments from leaders of some of the world’s largest organisations which we have the pleasure of sharing with you below.

It’s the Economy

The economy was one of the major themes at a meeting of business leaders, academics and policy makers at the 2010 Montana Economic Development Summit.  Given the attendees and their comments one of the striking things was the lack of in depth media coverage.

Here are some of the comments from famed investor Warren Buffett, and the chief executives of two of America’s largest companies, Steve Ballmer of Microsoft and GE’s Jeff Immelt at the conference.  Their comments give a different perspective on the positives for the global economy and its’ engine, the US economy.

Jeff Immelt, GE

“Angry political rhetoric is not helpful and headlines are too focused on finding negative indicators.”

“Business at GE is improving. Signs across the world show growth improving as evidenced by a rise in GE’s orders.”

Warren Buffett

“I’ve seen sentiment turn sour in the last three months or so, generally in the media. I don’t see that in our businesses. I see we’re employing more people than a month ago, two months ago.”
 
“The things that worked for the country through a century of two world wars, a depression and more — all while increasing the standard of living — will work again.” 

“I’m a huge bull on this country…we won’t have a double dip recession. I see our businesses coming back almost across the board…it’s night and day from a year ago.”

Steve Ballmer, Microsoft

“There soon will be more technological advancement and invention than there was during the Internet era and that will help drive business growth.”

“I am very enthusiastic what the future holds for our industry and what our industry will mean for growth in other industries.”

“We will see new technologies that move beyond the Internet to tie together computers, phones, televisions and data centers to create amazing new products. And the pace of innovation will increase as technology makes workers more productive.”

Their comments are backed up by the recent quarterly Economic Conditions survey from McKinsey, the consulting firm.  McKinsey surveyed 2,000 executives around the world and their responses show 58 percent say the economy in their countries is recovering, and 38 percent expect to hire by the end of the year, the greatest share expecting to hire in the near term since before the crisis.

It’s unrealistic to suggest there won’t be challenges ahead for the economy.  Of course there will.  But we believe it’s important to keep things a little more balanced and stay optimistic for the long-term.   It’s very easy to pay attention only to the views of those that are the most negative, especially as they seem to be shouting the loudest right now.