Trying to forecast market movements is fraught with danger.  There is overwhelming evidence, academic and otherwise, that predicting market movements simply cannot be done.

As an example, a recent Eureka Report edition focused on the expected returns from the Australian sharemarket.  The Eureka Report is an online magazine that I have a lot of respect for, and am a regular contributor to.  The headlines were as follows:

When we see the studies of investment performance, it is clear that active managed funds on average fail to beat the lower cost and simpler investment strategy of investing in an index fund.

However there remains another factor lurking behind these reports, in the form of 'survivorship bias'.  Survivorship bias works like this.  If you are measuring investment returns over a period, say 10 years, then over that time some managed funds would collapse.  These managed funds are generally not included in the research.  However, the fact that they tend to fail suggests that their performance is poor, and therefore overlooked.

A study by some professors from the University of Massachussets, which looked at hedge funds, provided some interested statistics on this topic.  Hedge funds were divided into 6 categories.  For those funds that failed, their returns were more than 10% lower than the successful funds in 4 out of the 6 categories.  The other two categories had differences of 8.9% and 5%.  This is a massive difference in performance, with the bad performance hidden from the public by the fact that the funds went out of business.

This makes it hard for consumers to know what is happening in any part of the managed funds industry, as they are only hearing the story of the good funds, rather than the funds that have gone out of business and let investors down.

I am not a fan of hedge funds at all.  They are basically trading funds, that rely on the skill of the expensive investment manager.  The fact that they are trading funds makes them tax ineffective.  I remain unconvinced of the existence of publicly available trading skill that will result in superior 10 year hedge fund returns against investing in traditional asset classes.  Hedge funds often sell themselves on the fact that the returns are 'uncorrelated' with other investment classes.  Betting on horse 2, race 3 is also uncorrelated with other investment classes, however I would not advise it.

My thoughts: if you want to get rich start a hedge fund, don't invest in one.

An article in today's Courier Mail (September 13) written by John McCarthy showed some of the seedy side of financial planning.

The article related to complaints by financial planners who had advised clients to invest in Westpoint investments.  As we now know the 12% return offered from these investments was unsustainable, and the scheme collapsed. 

Investors are seeking compensation from these financial planners through FICS (Financial Industry Complaints Scheme).  However the planners are complaining that this should not happen as the Westpoint investments were 'promissory notes' rather than financial products.

What rubbish.  Financial planners let clients know about the FICS scheme as a way of settling disputes and, at the first sign of trouble try to wiggle out of it. 

The investors came to the financial planners looking for advice on financial products, and the advisors decided that the Westpoint investments were suitable.  I am sure it was not the client who decided that they were passionate about investing in promissory notes.  Moreover financial planners should have nothing to fear provided that:

• They explained to clients the high fees that they were receiving from Westpoint for the recommendations
• They explained the risks related to investing in promissory notes related to mezzanine finance (a high risk bridging finance) so that clients were aware of the risks
• The only invested a moderate amount of the investors capital into the notes, say 5%

Of course, if the media articles are correct, any financial planner who represented the Westpoint investment as being 'safe' and 'like investing in a bank' should be in serious trouble for dishonest or incompetent advice.

A little while ago I mentioned that the secret of compound interest was time.  That is, the effect of compound interest becomes more and more pronounced over time.  That is because compound interest is effectively the investment earnings on investment earnings.  And it takes time for the level of investment earnings in a portfolio to increase.

It was great to see this in action when I came across this blog here.  This blog shows the people in question aiming to accumulate $1 million of wealth by the year 2016.  There is a lot of interesting discussion on their financial journey.

What I found particularly interesting was the length of time taken to reach each financial goal.  Their first $100,000 took 5 years to accumulate, although at that time they were not as focused on financial goals.  The next $100,000 19 months, the following 11 months and the most recent 8 months.  They also received $100,000 as a capital gain from the sale of their house, taking their net wealth to above $500,000 currently.

Each $100,000 became progressively quicker, at least in part because of the help that 'compound interest' was giving them.

Last night Channel Seven ran an interesting article on the way cars lose value over time.  The results were interesting.  Basically cars fall in value by about 50% over the first three years of their life.  Some fall by a little less, some by quite a bit more.  In fact, of the big cars the best performer was the Chrysler 300c which fell in value by 53.9%.  Remember, that was the BEST performer in that class, the class that includes the traditional aussie six's.

So what does that mean for our financial wellbeing?  First of all we should never, ever think that buying a standard car is an investment.  And secondly we should decide whether we want to buy a car before it falls in value over the next three years, or as a three year old car that is suddenly 50% (or more) cheaper than when it was bought.

One emphasis that I have is that we should look at money as being a unit or work.  That is, if I am paid $15 a hour after tax then a purchase of $30 is equal to 2 hours of work.  That way we can decide as to whether we really think that we are going to get the benefit from our purchase that will justify the work that we have to put in.  Let us say that we want to buy a new car costing $24,000.  We now know that we can buy the three year old second hand equivalent for $12,000 (and three years old is still pretty new).  The difference is equal to 800 hours of work - or 20 full time weeks of work.  That is a lot or work just for that new car smell!  Of course, some people really into cars will say that is worth it, and fair enough too.  For me, I'd rather drive a second hand car and do 20 weeks less work.

For more information on second hand car prices, the pre-eminent guide in Australia is redbook.com.au. 

Over the 5 years to the end of June 2006 International shares investments have been poor.  Really, really poor.  They have returned around -2% a year for the past 5 years. 

As investors, how should we react to this poor performance?  At A Clear Direction Financial Planning we expect that over the long term all growth asset classes will return around 10% to investors.  About 7% above the inflation rate of 3%.  There are three growth asset classes that we invest in: Australian Shares, international shares and listed property trusts.  By investing in three asset classes with similar average returns we don't change the expected returns from growth asset classes, still around 10%, however we reduce the volatility of the portfolio - because being exposed to three asset classes with the same expected return will smooth the ups and downs of the portfolio. 

Here's the kicker.  The same average return, with less volatility, results in a greater compounding effect in your portfolio - meaning a higher ending portfolio value.  So, regardless of poor returns over 5 years, we are more focused on the fact that international shares are an asset classes that historically has produced good long run returns, and there is no reason that they will not in the future.  They are an important part of our portfolios, and play an important role in providing diversification.

Another underlying reality is this.  No-one knows what investment markets will do tomorrow, this year, next year and going forward.  If we were to decide to have no international share exposure just because it has performed badly in the last 5 year period then we would be trying to guess which market to be in at which time.  And history has shown that this simply does not work! 

One very last comment.  The accepted financial planning wisdom is that a 5 year investment in any asset class is 'long term enough' to ride out the ups and downs due to market volatility.  A five year investment in a fund like the BT international fund has returned -4.08% annually for the five years to the 30th of June 2006.  A 5 year investment timeframe in a growth asset class simply does not guarantee a successful investment experience, and there is the proof!

At its highest Telstra traded at well over $9.00.  Today I read a columnist who suggested the final sale price of the $8 billion of Telstra to be sold in November could be as low as $3.15.

So what should prospective investors do or be thinking about right now?  The answer is not much - there will be plenty of time to gather more information about Telstra between now and the time when you have to put forward your money.

Telstra remains a huge producer of cash flow for investors.  Indeed, the dividend payments to investors are often regarded as the one thing that keeps the share price from falling even further.  The government are going to use 'installment receipts' to sell the Telstra shares.  This means that for each share about $2.00 will have to be paid up front and the rest, say $1.20, will have to be paid 18 months later.  One tactic used to support the sale will be the fact that there will be a 28 cent dividend over the first 12 months.  28 cents on a $2.00 first installment will be enthusiastically described as a '14% yield'.  How could you go wrong when the average sharemarket dividend yield is 4%?

The number one way that you can go wrong will be if they cut the dividend.  Management can and do cut dividends that are paid to shareholders.  This is not likely to happen over the first year or two, however can happen after that.  The second way that you can go wrong is that you don't take the time to understand the company and its prospects.  You need to form an opinion about the ability of the company to grow its future earnings.  I think that it is almost as simple as this:  If you think Telstra is capable of growth of 5% a year in the future, buy the company.  If you don't think it is, don't buy the company.  There is a lot of information that we will need before we can make that judgement.

If you want an example of dividends being used to prop up a float you need go no further than Australian Magnesium Corporation.  This was a start up company that many people were 'suckered' into investing in because the Government had underwritted 'pretend' dividends - that is dividends that had not come from earnings.  While Telstra is different from this, it is a massive company with a long corporate history, it is a company under pressure from regulators and competitors within the industry.

What are we most looking for over the next 3 months?  An understanding of how the regulators (the Government) and Telstra are going to be able to work together in the future.  If they can settle their differences, and form a reasonable relationship that will allow Telstra to benefit from its capital expenditure programs, the the upcoming sale of Telstra at less than $3.50 a share is worth a look.

An interesting piece of research was presented on today's ABC lunchtime news show.  Dr Karl was talking about some recent research that showed that companies that listed on the stock exchange performed better if they had a simple and easy to remember name.  It was presented as light hearted research, however it provides a reminder as to some of the folly of 'active management', that is spending time and money to try and identify which companies are going to perform better than any other.

It reminds me of some research that said companies that start with the letter 'W' had outperformed over a period.  In fact, I would think that over the last 10 years this might still hold true - there are not that many companies that start with the letter W the biggest such as Woolworths (25.7% a year average for last 10 years), Wesfamers (23.2% a year average for last 10 years), Westfield (had a merger about 3 years ago so there are no combined results), Westpac (19% a year average for last 10 years) and Woodside (23.1% a year average for last 10 years) are all strong performers over this time.  All these companies beat the average sharemarket return be some margin.

So the moral of the story is that we should invest in shares that start with 'W' or have easy to remember names.  Or, for a lay down winner, easy to remember shares that start with the letter W.  No rational person would be, or should be, comfortable with either of these strategies as a basis for a long term investment strategy.  Therein lies the problem with 'active management', trying to pick and choose which shares are going to outperform.  There is so much information already priced into each share that it is really difficult to pick any that will outperform.  And, when patterns or outperformance are identified, who says that it is just not luck driving the higher returns - such as the letter 'W'. 

At the end of the day the market does a good job of rewarding long term investors who focus on a long term, well diversified, buy and hold approach to investment. 

Investment Markets have been a little bit up and down lately.  And a lot of the commentary in the media has been whether it was time to get out of investment markets for a while, have they now bottomed, and it is the right time to buy back in.

In the long term sharemarkets - both Australian and International - have provided returns of around 11-14% a year on average.  They are respectable returns, so why add extra pressure and expenses assocated with trying to buy and sell investments.

The 'Miracle of Compound Interest' refers to the way that, over time, investment earnings increases as there are investment earnings on investment earnings.  For example, let us assume that I have $1,000 in a bank account earning 10% interest (a little bit unreasonable give current cash earning rates, however it makes the maths easier).  In the first year the $1,000 earns $100 interest.  However, if this $100 is not spend the 10% interest on $1,100 in the second year is $110.  And so on. The key is not to be impatient.  The benefits of compound interest will take some time to show through.  Set up an investment portfolio.  Invest regularly into in.  In time, the investment earnings on investment earnings (compound interest) will help push you towards your financial goals.

Financial services is a funny industry.  It is an industry where the participants somehow decide that they are smarter than the great thinkers - the Nobel prize winners - in financial economics.

Merton Miller (Nobel prize winner) explained why the expected return of an investment has to be linked to risk; why there are no free lunches.  And yet many people in the industry still promote low risk ways of earning a high return.  They simply don't exist, people are too selfish to give away a return higher than they need to - so the return will always be related to the risk.

William (Bill) Sharpe (Nobel prize winner) explained that they best way to earn a return above the cash rate was to expose some percentage of your portfolio to the sharemarket, in a broad and diversified way.  The sharemarket provided a 'market risk premium', that is a higher rate of return over the long term for people who invested in it.

Markowitz (Nobel prize winner - do you notice any pattern?) said that an investor should use diversification to minimise the amount of volatility (ups and downs) in their portfolio, to try and get a smoother return over time.

So there you have it.  The fundamentals of investment success from some of the great thinkers:

• If you want a higher return than a cash investment, expose some of your wealth to higher risk, higher return sharemarket investments.
• Don't look for shortcuts - risk and return are related, so high return must mean high risk.
• Diversification is an investors friend - use it to minimise the ups and downs of your portfolio.