Something you must know about 2010
December 23, 2009
PORTFOLIO POINT: As we head for a new year, investors should take a contrarian approach (and consider some international shares).
As we sit here stunned by the near-death experience of investing in the markets over the past year, most Eureka Report subscribers most likely feel relieved that, as it turned out, the ASX rebounded.
In fact "rebounded" is an under-statement, it roared from a rock-bottom level of 3030 set in March to about 4700 at year end. Still, for most, there will also be a sense of disappointment over a "downsized" portfolio, which is probably yet to regain the heights reached more than a year ago.
Where to from here?
It could be highly instructive to go back all the way to the 1970s because this has been the toughest time for Australian investors since that era. Stockmarket falls of this magnitude were not seen even during the Great Depression of the 1930s, when the Australian market fell by about 46%; at the same time that Wall Street fell by more than 80%.
Not only have we experienced a dramatic fall in company values, but many investors have been hit through the collapse of once-fashionable "alternative assets" such as tax-driven agricultural assets, mortgage trusts linked with property developers, aggressive double gearing share investment strategies such as Storm Financial, hedge funds (Basis Capital and Macquarie Fortress Notes) as well as individual company collapses such as ABC Learning, MFS, Allco and Babcock & Brown.
Even listed property trusts or A-REITS, so long the standout investment class with strong yields, good overall performance and what seemed at the time like less volatility than equities, lost their shine as they collapsed in value.
Looking back on it the greatest damage from collapsed investment schemes (mortgage funds, MFS, hedge fund, listed property trusts and listed, unrated fixed interest investments) was done to the (minority) of people who included these investments in the "defensive" parts of their portfolios. Categorising these investments as defensive was a big mistake.
In the middle of all this, even the safe haven of cash seemed unreliable.
On one talkback segment I did for ABC radio during the crisis, the first two questions were from callers wondering if their cash was safe in bank accounts, such was the measure of concern about the crisis.
Treasurer Wayne Swan must have tuned in, because the following week he introduced the bank guarantee to quell people's understandable nervousness. On top of all this the Reserve Bank target cash rate was reduced to a 40-year low of 3%, meaning the pre-tax earnings from cash accounts barely kept pace with inflation.
But its not just the end of the year, it's the end of the decade: And it's through looking back on what investors have experienced over the past 10 years that some lessons really shine through.
With compulsory superannuation celebrating its first full decade in existence (it began in the early 1990s), it is ironic that over the past 10 years, as more people than ever before have relied on returns from investments through their superannuation, these returns have been below average (some might say "subprime").
Over the past 10 years, the average annual return (total return: growth in value plus dividends) to the end of November 2009 from various key asset classes has been:
||5.7% a year|
|Australian Shares (ASX300)
||8.7% a year|
|US Shares (S+P 500)
||-0.15% a year (without currency hedging)|
Although the return from Australian shares may look relatively attractive, it is less than the long term average return from investing in Australian shares of about 12-14% a year, although people argue that in a lower inflation environment a return of 7% above inflation - say 9-10% in a 2-3% inflation environment - is a more reasonable expectation.
Cash, as I said earlier, was offering very low rates during the recent crisis but over the longer term it has returned 5.5% a year and that has been effectively risk free, a point not missed by most serious investors during the depths of the crisis.
US shares generally make up the largest portion of overseas share holdings, so the fact that there has been a negative return in this asset class is significant in many diversified portfolios. It is also significant because it debunks the wisdom about investing in growth assets is "in five to seven years you will be OK". The largest sharemarket in the world has provided a negative return over a decade.
At an anecdotal level many people will remember the Dow Jones going through 10,000 point level (March 1999) and then through 11,000 later that year. More than a decade on it stands at about 10,500 points. This is not the first time that this has happened, with the Dow basically standing still between 1967 and 1981.
What does history tell us?
The first lesson from history is that as investors we have a tendency to overreact to recent data. Earlier this year two American academics wrote a very interesting paper: Malmendier (UC Berkeley) and Nagal (Stanford University) wrote a thesis entitled Depression Babies: Do MacroEconomic Experiences Affect Risk Taking? The study considered 40 years (1964-2004) of consumer finances, to look at what appeared to influence investors to choose their mix of share and fixed interest investments.
There are a number of findings that are worth considering in the current context of the global financial crisis including:
- Economic events, especially recent events, are more important than historical facts in influencing investment decisions.
- Investors who have experienced high stockmarket returns are more likely to participate in the stockmarket and own a greater proportion of shares in their portfolio.
- When actual returns are looked at, investors tend to destroy wealth by having too much of their assets in shares after good times, and too few after difficult periods. It's fair to say at the end of a shocking year, at the end of a worse-than-average decade, this evidence is likely to be reasonably relevant.
The authors note that after the volatility of the 1970s, people tended to own less shares leading into the 1980s. Of course, the 1980s and 1990s witnessed one of the greatest bull markets of all time.
Conversely, by the end of the 1990s, as the markets inched towards the dotcom downturn (which started in March 2000), households tended to have greater exposure to shares. Both of these approaches (underweight shares in the 1980s and overweight shares in the 2000s) tended to be wealth-destroying for households, which makes this an ideal time to introduce an observation from the world's greatest living investor, Warren Buffett of the Berkshire Hathaway group.
Buffett repeatedly advises investors "to be fearful when others are greedy, and only be greedy when others are fearful". This time last year, as most investors pulled out of the markets Buffett was putting money into the market, especially at Goldman Sachs and GE. Buffett was something of a lone voice talking about the amount of fear in the air, and encouraging investors to think of it as a time to invest in shares. That advice looks more than sound now.
He also warned about the riskiness of holding too much cash/fixed interest investments in a time of potentially rising inflation and low interest rates. In 2009 one of the challenges for investors was to build the balance between cash (a good short-term but terrible long-term investment) and shares (a terrible short term but good long term investment) keeping in mind that we have to be careful not to overreact to recent events when building this mix.
Another challenge specific to the Australian investor is the role of international shares in a portfolio; after 10 years of poor performance from international shares it would seem that the smart decision is to ignore them; however at some stage international shares will outperform Australian shares, so some exposure might be wise.
Keep in mind that the Malmendier and Nagal suggested investors tended to ignore an asset class just prior to it providing strong returns. Don't invest on the basis of what's just happened, or even what happened over the past decade.
Rather, you should stay in the market, thinking carefully about the asset classes you wish to expose your capital to, and about how you apportion your capital between asset classes.
Scott Francis' articles in the Eureka Report