New Year's Resolution

New Year’s Resolutions

Equity investors around the world had a disappointing year in 2011 as 37 out of 45 global markets posted negative returns. In Australia, 2011 marked the end of a particularly volatile decade. The table below shows the annual 10 year performance of the Australian stockmarket[1] to the end of 2011:

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The average annualised return of 6.4% is appreciably lower than the long term average of 11.3% over the past 30 years. In contrast, our Australian share Asset Class strategy would have returned 8.4% per annum over the past 10 years[2], which is a healthier return for the risk of being invested in the stockmarket. Today, our Asset Class portfolio would be worth 23% more than a portfolio that matched the returns of the market portfolio.

Our results were achieved without spending a large amount of time or effort trying to pick the stocks expected to outperform, or trawling through broker or newspaper reports.

Nevertheless, some people remain convinced that there are errors or mispricing of securities in the market that they can identify and benefit from. Indeed, it is probable that there will always be mispricing of securities; however, there is no academic evidence to suggest there is a methodology available to allow individuals to identify these errors and consistently benefit as a result. So why do many investors still attempt to time markets or pick stocks?

There have been some very interesting articles by psychologists such as Daniel Kahneman and Amos Tversky on the ways human judgment may be distorted when we make decisions in uncertain times. Despite not being finance academics, they were actually awarded the 2002 Nobel Prize in Economics for their research.

What is most interesting when you read their work is that the undoubted anarchy of the human mind is actually consistent and supportive of our evidence based Asset Class investment approach.

People often make the mistake of thinking that if stockmarkets are falling, everyone is getting out and if they don’t act, they’ll be left behind. But in order for someone to sell a share, someone must be willing to buy that share at an agreed price. Clearly, someone thinks it is good value to buy when someone else is selling. This is the anarchy of the human mind at work.

Against this backdrop, if investors want to believe they can accurately predict the direction of markets in 2012 and beyond, you can only question the evidence or basis they use for their conclusions.

Three years ago many investors were keen to distance themselves from the U.S stockmarket. But over the three years to the end of 2011, the largest 500 companies in the U.S returned 14.1% pa compared to 7.7% pa for the Australian stockmarket. You won’t find too many people who predicted this outcome at the end of 2008 amid the GFC and collapse of Lehman Brothers.

Indeed, the largest companies in the US last year produced a positive return of 2.1% against the pervasive negative results globally. Even the darlings of China and India lost 21% and 16% respectively! This is why we place little value on forecasting.

Investors can achieve relatively strong returns from their portfolio without needing to spend time trying to predict the future – time that can be spent on far more meaningful and productive pursuits.

So for investors who haven’t yet found a better way to invest or don’t have an investment philosophy, here are five suggested New Year’s resolutions:

1. Have a clear, documented plan – many have heard the saying that what gets measured gets managed. If you don’t have a plan to achieve what’s important to you, and don’t periodically measure your progress against that plan, then how do you know if an annual return of 7% or 10% is a good outcome for you? In isolation, performance returns are meaningless in the pursuit of a meaningful life.

The most important thing about an investment philosophy is that you have one.

2. Focus on asset allocation – your portfolio weighting towards the major asset classes of cash, fixed interest, shares and property is by far the biggest determinant of how your portfolio will perform over time. If you don’t have a clear target weighting to each of these asset classes based on what is important to you, it is important that you develop one.

3. Don’t favour short term emotional needs over long term goals – one human tendency is to judge the effectiveness of our investment strategies by looking at one, two or three year horizons. We do this because we are wired to be more sensitive to short term losses than to long term gains. The result of this short-term mindset is that investors end up ‘following the herd’ and seeking safety when good opportunities are plentiful and seeking risk when good opportunities are few.

Focusing exclusively on returns can lead to rude awakenings when risk shows up and returns are low. Focusing exclusively on risk can lead to disappointment when returns are high.

Remember that money is just an enabler, rather than an end in itself. Portfolios should be designed to provide investors with a stream of cashflow over a typically long period of time. Ensuring this cashflow will be there when needed should be the focus, rather than zealously trying to protect your portfolio value on a day to day basis.

4. Break your addiction to the financial media – on Friday, 25 November 2011, the newspapers quoted Ralph Norris (Commonwealth Bank’s former CEO) that GFC 2 ‘could’ be on its way. This headline understandably spooked many investors, and some may have acted to sell down their shares. However, over the next six trading days, the market rose by 8.4%.The financial industry and media continually makes forecasts and continually gets them wrong. But because people have an in-built desire to know the future, we continue to be attracted to predictions on the future, particularly from those who are passionate about their forecasts even if we don’t understand the basis or reason for their forecast.

Remember that commercial media is a business selling audiences to advertisers. Their understandable goal is to get you to buy newspapers or watch their shows – it is not to impart wise counsel tailored to your situation. We recommend you spend more time reading novels.

5. Don’t chase performance – typically stockbrokers attempt to find the ‘next big thing’ or think they have a special ability to forecast returns. We often hear that the best time to work with a stockbroker is when markets are volatile, as that’s when experience and research really ‘pays off’. There is much evidence in Australia and overseas to demonstrate that this is definitely not the case.

In the U.S in early 2009, the market had fallen by 41% over the previous two years. The market was supposedly ripe for stockbrokers but their stock recommendations failed to deliver satisfactory returns for their clients over the next 18 months as shown below[3]:

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Not only did the stockbrokers best tips underperform the market, but the stocks they didn’t like did better than the stocks they did like. So rather than chasing performance, work out what asset allocation and investment returns you need to live your ideal life, and then create a plan to target those results and measure the outcomes over time.

In 2011, some investors (as well as some allegedly professional advisers) apparently decided to switch from a buy-and-hold philosophy to a market timing strategy in the midst of an unusually stressful and volatile period in financial markets. We suspect few of those adopting the change would have been able to clearly articulate their investing beliefs and why they had shifted.

Legendary investor Benjamin Graham offered the following observation nearly 40 years ago: “There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he himself is a part.”

Good advice then, good advice now.

In 2012, anarchy and common sense will continue to co-exist, but our clients remain well placed to endure volatility and enjoy expected returns far higher than most investors achieve by embracing an “evidence based approach” to investing.


[1] ASX 300 Accumulation Index used as a proxy for the Australian stockmarket. Source: Returns Program.

[2] Source: Returns Program. Calculation assumes clients had invested their portfolio in 40% large, 40% value and 20% small stocks over the past decade

[3] Equity Analysts Prove Hazardous to Returns as Contrarian Stocks Rise 165%’, Matt Walcoff and Lynn Thomasson, Bloomberg, 10 January 2011. Returns are averages for stocks

 

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