The article below recently appeared in the 2012 Winter edition of Collective Insight, which is published tri-annually by Finweek on behalf of the South African investment community

The current investment environment presents a challenging setting for any investor. Much of the developed world, which represents two-thirds of the global economy, is trying to deal with the problems of spiralling public debt, ageing populations and economic malaise, leaving investors scrambling to avoid risky assets in these markets. By contrast, many emerging markets with large young populations, rising healthcare and improving education levels, are growing quickly, representing an a tempting destination for investors.
In this turbid setting, individuals responsible for managing their own investments will do well to stick to five tenets that will guide them through any economic setting.
1. ANCHOR ASSET ALLOCATION

To start with, a substantial literature exists which shows that asset allocation decisions have a material impact on the behaviour of investment returns. Indeed, it is arguable that the single most important decision an investors will make relates to their strategic long-term asset allocation. To be effective, a strategic asset allocation needs to appropriately reflect an investor’s risk profile, required investment return, life stage and ability to tolerate variability in returns, especially draw downs in portfolios.

The second most important decision an investor will take is to stick with this asset allocation. Whilst moving a portfolio from a “risky” asset class, such as equities, to a more “stable” asset class, such as cash, will dampen a portfolio’s volatility during turbulent market conditions. This gives the illusion of safety as portfolio volatility falls, but risk to the investor has actually increased as they have moved away from the asset class that produces the best long-term returns. If an investor does this often enough, and for long enough, they raise the risk of not achieving their long-term investment objective.

The risk of disappointment is aggravated by the fact that buying at the bottom of the market is difficult from an emotional perspective and almost impossible from a technical perspective. Given this, investors do best by using their strategic asset allocation as a guiding light in managing investments. That said, it has to be recognized that circumstances change, and it would be naïve to suggest that investment strategy is fixed for all time: investors looking after their own funds should revisit the asset allocation strategy at regular intervals. But strategic adjustments should never be a knee-jerk reaction to market “froth” or “noise”.

2. FORGET FORECASTS

Accurate and reliable forecasting is notoriously difficult and bad forecasting leads to poor investment decisions. Figure 1, drawn from James Montier’s (2009) work, shows that analysts struggle to get reliably forecasts returns. In addition, the evidence suggests forecasters are biased; in the current example there is no year in which analysts forecast a negative return, whereas the actual return was negative in four of ten occasions. In short, forecasts are biased and wrong.

forecast1

Figure 2, which is based on work by Russell Lamberti at ETM Analytics (2011), shows a similar poverty of forecasting in the South African case. The solid red line shows the actual path taken by the R/$ rate whilst the black lines indicate analysts’ consensus quarterly forecasts for the next two years. Almost all of the time analysts do not even get direction correct and, similar to Montier’s example, there is clear evidence of bias and behavioural errors that are resident in forecasting.

graph

If we are to benefit from forecasting, we need a high degree of accuracy in the forecasting which, sadly, is not available. Thus, the rules around forecasting are no different for a do-it-yourself investor than for any other investor: given the poverty of forecasting, investors are well equipped if they are able to look past forecasts.

3. GET OFF THE ROCKING HORSE

Investors often confuse action with effectiveness. A clear example comes from the 2000-2002 collapse in technology stocks. As Figure 3 shows, in March 2000, as the technology company-encrusted Nasdaq Composite Index was reaching its all-time high, the largest ever monthly inflow of $53 billion was recorded into Nasdaq stocks. Fast forward two years to July 2002 when the index was bottoming, and investors withdrew $49 billion from the market in that month, effectively five times the earlier inflow as prices had slumped to one fifth their previous levels. Notably, activity in the Nasdaq market was heavily impacted by do-it-yourself day traders.

In each instance – March 2000 and July 2002 – investors were very active. But they were hopelessly unproductive in this trading activity, effectively buying high and selling low, which is the exact opposite requirement to effective investing. Indeed, most of the available evidence shows us that by being active in their portfolios, or “switching”, investors destroy wealth rather than create or protect it. For any do-it-yourself investor, this observation carries tremendous value.

Amongst others, Jeffrey Brown, Nellie Liang and Scott Weisbenner (2007) and Bob Haugen (2010), show that active switching costs a portfolio an average of 1.5 percent per annum in charges and performance. This leads to a substantially reduced return over time. Invested for a period of 25 years, a capital sum growing at 6 percent a year will grow to just over R400. If this return is eroded by 1.5 percent per annum because of switching the result is R287 – a figure that is 30 percent lower, all else equal.

This “rocking horse” method of investing involves riding furiously on a horse that represents energetic activity but gets you absolutely nowhere. Rocking horse investing gives the impression of activity, but in reality consumes energy and erodes returns.

4. AVOID HYPED ASSET CLASSES

Although what an investor acquires is a key consideration, equally critical is how much is paid for the asset. Buying a good business or a good property is one thing, but overpaying for that asset will result in a poor investment. So too with different investment markets: fast-growing emerging markets or fast-growing industries are not necessarily great investment cases. Just because a country or industry is showing rapid economic growth, it does not follow that its financial markets will perform well. An investor needs to seek value in making a purchasing decision; to ask “is the price right?”

Examples of overpriced assets at present are companies that operate in the social network space, such as Facebook, Groupon and LinkedIn. Similarly, many fast-growing economies are richly priced in the current setting. Another overpriced asset class in the current environment is advanced country government bonds which are looking dangerously expensive relative to the poor financial health of their governments. The price of cash at present is also very high, given the extremely low interest rates in the advanced world (well below inflation) and thereby guaranteeing a negative real return for investors.

In the case of all asset classes, investors need to seek assets – whether companies, properties, cash or debt instruments – that offer excellent value. These investments are characterised by two aspects. First, they are great assets but, second, this quality is not reflected in their price which has been marked down or overlooked by other investors.

5. HUG ATTRACTIVE ASSETS THAT ARE WELL MANAGED

If the fourth tenet is to avoid overpaying for hyped assets, the fifth tenet urges investors to seek out assets that are well managed and offer value by being underpriced as a consequence of being unloved or overlooked. Such assets exist in all market environments, and current examples abound within the equity environment in the local and offshore markets given investors’ anxiety about world economic growth.

For instance, the global motor industry is populated by a number of well-managed companies, including VW, Toyota, Hyundai, BMW and Daimler-Chrysler. These companies have come under pressure as the motor industry has fallen out of favour in the aftermath of the global financial crisis. Yet, each of these companies represents a potentially good investment as they are quality assets that have come under price pressure. By doing a bit of homework on these companies, a do-it-yourself investors can identify desirable aspects and identify a company worth investing in. Amongst other things, attributes to look for could include the strength of the company’s balance sheet, the stability and quality of earnings and the capacity of the company to return profits to investors in the form of dividends. Each of the companies in the above set arguably represents such a case in the current setting.

6. PUTTING IT ALL TOGETHER

Any investor will appreciate that buying assets in tough times is hard, and staying with the investment can get even harder if times get tougher and a rocking horse is in sight. However, effective do-it-yourself investing embraces five key tenets of investing: buy good assets in the right quantities at good prices, avoid hype and park the rocking horse. When put together in this way, do-it-yourself investing is straightforward, but the discipline required means that whilst investing may be simple, it is not easy.

7 References

Montier, J. (2009) Value Investing: Tools and Techniques for Intelligent Investment. Wiley: Chichester, West Sussex.
Brown, J.R., Liang, N. and Weisbenner, S. (2007) Individual Account Investment Options and Portfolio Choice: Behavioral Lessons from 401(k) Plans. NBER Working Paper, No. 13169; issued June 2007.
Haugen, R.A. (2009) The New Finance: Over-Reaction, Complexity and their Consequences (4th Edition). Prentice Hall: Upper Saddle River, New Jersey.