Satyajit Das: Adjust your expectations - investing in the new era of low rates and high volatility
Economic View: Success is always 10 per cent skill and 90 per cent luck, but it is still unwise to try it without the quotient of skill
Thursday 21 March 2013
As the global economy resets, the prospects are for lower returns and increased volatility. After 1929 the US stock market took 25 years to regain its highs. Japanese stocks (down 70-plus per cent from their peak) and property markets (down between 50 and 70 per cent) have still not recovered the levels of 1989.
Since 1912, as Pimco's Bill Gross has argued, equities have returned 6.6 per cent a year in real terms, above real GDP growth at 3.5 per cent. This may not be sustainable.
Investment structures compound the investor's dilemma. Traditional funds are structured to generate relative returns, measured against a benchmark.
Unfortunately, beating a benchmark by 5 percentage points provides cold comfort to investors when the investment manager is down 15 per cent and the market by 20 per cent. Only absolute return now counts.
Management fees and fund expenses are a significant drag on returns. Fees and expenses of 2 per cent are tolerable when the returns are 12 per cent, but difficult to bear with returns at 5 per cent or lower.
Investors may even need to consider the comedian Will Rogers' advice: "I'm more concerned about the return of my money than the return on my money." Capital preservation will be the key to survival.
Investment approaches increasingly focus on matching future cash flows, irrespective of whether it is a known future liability or retirement income needs. Products such as annuities targeted at retirees, or specific saving plans that provide a guaranteed lump sum, are growing in popularity.
This favours debt over equity or other risky assets, even though the safety of government debt is increasingly in question. It also favours defensive stocks or hard assets such as commodities.
Investment income (dividends or interest) may be the major source of return. Capital gains will be more difficult as the period of consistent stellar rises in price may be less likely in the future.
In bull markets, investment approaches focus on capital gains, income and capital return, in that order. The current environment requires a reprioritisation.
Investors have increasingly embraced non-traditional investment. There has been strong interest in gold and other precious metals. Gold prices have risen strongly, although in real terms they remain below their 1980 peak.
Hedge funds and private equity funds continue to attract money, despite variable performance. The attraction is a focus on absolute return and greater investment flexibility. Despite well-documented problems, structured products, where investors assume credit risk or fluctuations in interest rates, currencies or equity prices in return for a higher interest rate, are making a comeback.
Disillusioned with financial assets, the ultra-rich are focusing on scarcity – farmland, prime real estate in world cities with desirable properties, and collectibles (fine art, rare cars). Even wine has emerged as an asset class, giving a new meaning to the term "liquidity".
A key element is capturing volatility to take advantage of large price fluctuations. This can be done by allocating a portion of investment capital to instruments which benefit in periods of "irrational exuberance" (typically growth stocks) or "irrational pessimism" (defensive stocks).
High levels of cash allow investors to capture volatility, taking advantage of sharp falls in value. Warren Buffett's Berkshire Hathaway maintained high levels of cash running into the last crisis – about $20bn. This liquid reserve was expensive to maintain as interest rates were close to zero. But it allowed Mr Buffett to make lucrative and very high-yielding strategic investments in Goldman Sachs, GE and, more recently, Bank of America.
"Independent" financial advisers and tipsters tell their clients that decent returns can be still earned during periods of great uncertainty. Unfortunately, few personal investors or investment managers have the required knowledge, resources or skills. Fewer still are likely to adroitly navigate the treacherous environment. As one fund manager said with disarming honesty: "We are being paid to lose money."
Probably the best the average investor can do is to avoid common pitfalls. Successful investors often succumb to what the theologian Reinhold Niebuhr termed "most grievous temptations to self-adulation". Success is always 10 per cent skill and 90 per cent luck, but it is still unwise to try it without the quotient of skill. Hubris has resulted in a greater loss of wealth than market crashes.
Adjusting your expectations is essential. As Samuel Loyd, the 19th-century banker, observed: "No warning can save a people determined to grow suddenly rich."
Satyajit Das is a former banker and the author of 'Extreme Money' and 'Traders Guns & Money'
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