Investment: volatility gains
As the global economy resets, the prospects are for lower returns and increased volatility. The US stock market took 25 years to regain its highs after 1929. Japanese stocks (down 75 per cent from their peak) and property markets (down between 50 per cent and 70 per cent) have still not recovered 1989 levels.
Good returns can be earned during periods of uncertainty, but require different investment approaches. Investment theory may fall short in this respect.
Governments bonds are no longer risk-free safe havens. The risk of default or loss of purchasing power through currency devaluation or diminished purchasing power is a concern. To borrow Jim Grant's phrase of Grant's Interest Rate Observer , government bonds now offer "return-free risk".
Risk premiums are frequently negative as investors flock to safe assets or the latest best investment - US and German bonds, high yield corporate bonds or high dividend stocks.
Diversification to mitigate risk is problematic as the correlation between different investment assets has become volatile. The fundamental risk of domestic shares, international shares and property is similar in the current economic environment. Even returns on cash are positively correlated to risky assets as interest rates have fallen in the recession. Tail risk - the chance of large and frequent increases and decreases in prices - is also a factor.
Investment structures also compound the dilemma. Mutual funds generate relative returns measured against a benchmark. But beating a benchmark by 5 per cent is cold comfort to investors when the market falls by 20 per cent. Only absolute return counts.
Management fees and fund expenses are a significant drag on returns. Fees and expenses of 2 per cent are fine when returns are 12 per cent, but rough when returns are 5 per cent or lower.
In choppy markets, rapid changes to a portfolio including switches between assets and instruments are required. Long periods of staying uninvested, even holding cash, or other defensive assets, may be necessary. Investment mandates require investment in a single asset class or limit switching, constraining the type of instruments used and forcing the fund to stay substantially invested at all time. This restricts the ability to generate positive returns.
Traditional investment styles may not work. Value investing - buying stocks based on fundamentals when they look cheap - has historically been successful since the days of legendary US economist, investor and Columbia Business School professor Benjamin Graham. (Warren Buffett was one of his students). The hidden value can be released through cash flow, dividends or acquisition in the long run. But since 2008, value investing has performed indifferently. Arbitrage strategies, such as relative-value trading and long-short equity or equity pairs trading, have also performed poorly. The failures reflect uncertainty about correct values, risk-on/risk-off trading, risk aversion, illiquidity and the lack of convergence to theoretical values.
Investors may now need to follow US comedian Will Rogers' advice: "I'm more concerned about the return of my money than the return on my money." Capital preservation will be key to survival. A large sustained loss of capital is currently the major investment risk. This favours debt over equity or other risky assets. 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 consistent price rises may be less likely in future.
In bull markets, investment approaches focus on capital gains, income and capital return. The current situation calls for re-prioritisation.
Investors have increasingly embraced non-traditional investment. There has been strong interest in gold - prices have risen steeply - and precious metals. Gold prices remained below their 1980 peak for 26 years.
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 higher interest rates - are making a comeback, driven by low interest rates. Disillusioned with financial assets, the ultra rich seek scarcity - farmland, prime real estate in world cities with desirable properties, and collectibles (fine arts, rare cars).
Increasingly, investment approaches focus on matching future cash flows, regardless of whether it is a known future liability or retirement income needs. Products such as annuities targeted at retirees, or specific savings plans that provide a guaranteed lump sum, are growing in popularity.
A key element is capturing volatility to take advantage of large price fluctuations. This can be done by buying out-of-the-money options which provide the investor unlimited gains from tail risk for a known fee. Alternatively, volatility can be captured by allocating a portion of investment capital to either stock which benefits in periods of "irrational exuberance" (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 crisis - about US$20 billion. This liquid reserve was expensive to maintain as interest rates were close to zero. But it let Buffett make lucrative and very high yielding strategic investments in Goldman Sachs and General Electric in 2008, and last year's US$5 billion in Bank of America.
Success also requires avoiding common pitfalls; it is always 10 per cent skill and 90 per cent luck but it is unwise to try without the skill quotient. Hubris has caused greater loss of wealth than market crashes.
Adjusting return expectations to more modest levels is essential. As Samuel Loyd, 19th-century British banker and politician, said: "No warning can save a people determined to grow suddenly rich."
Satyajit Das is a former banker and author of Extreme Money and Traders, Guns & Money