It is becoming clear that investors are currently paralysed by fear and finding it difficult to make rational decisions in the face of unprecedented turmoil in international markets. In this article, I will attempt to explore some of the issues that investors should be considering in the light of recent market volatility as shown below:

Source: Bloomberg

How bad is it?

Writing in the Financial Times on March 17^th, former chairman of the Federal Reserve, Alan Greenspan said “The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the Second World War”. In a speech to the Institute of Economic Affairs on the 27th February 2008, BoE deputy governor Rachel Lomax said the outlook for the UK economy in 2008 and beyond had “changed dramatically”. The Bank of England (BoE) warned inflation was set to “rise sharply” in the near term and there is nothing the Monetary Policy Committee (MPC) can do about it. Lomax believes cost pressures have not yet fed through fully to consumer prices, with higher utility bills at the forefront. While the BoE foresaw some form of correction in financial markets, Lomax said the extent of the recent reverberations was not fully appreciated. “There have been financial and banking crises before, but not on the present global scale, and this must surely be the largest ever peacetime liquidity crisis,” she said. “There may be more shocks to come”. Clearly, we are experiencing an unprecedented global crisis and investors cannot simply sit on the sidelines as passive observers.

Diversification and asset allocation

An investment portfolio, which is well constructed using a wide variety of asset classes, can produce positive returns under both favourable and unfavourable market conditions without relying on expert timing or accurate economic forecasts from a portfolio manager. In recent years, it may have made financial sense to concentrate one’s portfolio into a narrow range of Property and Equity investments. These assets have been generally rising and therefore investors will have made money. However, it is only when markets reverse, that investors see the error of their ways. Now that we are seeing falls in both equity and property prices investors are nervous and are unsure what to do. Our approach is based on the Nobel Prize winning work of financial economists and has been developed from decades of empirical research. This approach, commonly referred to as “asset class investing”, is common within the institutional market but is rarely offered to private clients. The rationale for asset class investing is simple: capital markets work and diversification between asset classes increases return and reduces risk. Over the long run, markets reward investors with positive returns for taking risks and providing capital. If they did not, the capitalist system would have collapsed long ago. Market prices reflect the knowledge and expectations of all investors. Nearly forty years of academic research has shown that traditional managers are unable to outperform the markets by anything more that we would expect by chance. Asset allocation therefore involves dividing an investment portfolio among different asset categories such as commodities, equities, fixed interest, cash and property and the process of establishing which mix of assets to use, is largely determined by investment objectives, time horizon and tolerance to risk. However, we also share the concerns being raised by the Bank of England and echo the warning offered by the Financial Services Authority (FSA) in the UK in 2007 regarding the faith investors and their advisers had in the benefits of asset diversification. In the FSA´s Financial Risk Outlook 2007 the regulator said ´Instruments that have been traditionally used to balance portfolios due to their low or negative correlation may no longer necessarily fulfill this role as effectively, because they now appear to be moving together.´ We argue that in the light of the current problems in International Capital markets that it is now time to fundamentally reappraise investment portfolios, reappraise the correlation of assets to one another and to reappraise systemic risk within the International Banking system. Alan Greenspan again “In line with the time-honoured observation that diversification lowers risk, computers crunched reams of historic data in quest of negative correlations between prices of tradeable asset: correlations that could help insulate investment portfolios from the broad swings in an economy. When such asset prices, rather than offsetting each other’s movements fell in unison, huge losses across virtually all risk-asset classes ensued.” In searching for an explanation as to why “optimised” portfolios performed so badly we can conclude that the use of historic correlation data leads a statistical optimisation model to overweight traditional “asset” classes at the expense of inferior “alternatives”. Indeed with even the most sophisticated statistical optimisation model, if you tell the computer that you trust your assumptions 100%, it will invest 100% into Equities, since in the long-run, these are the best performing asset class. That may be true, but as the economist John Maynard Keynes said; ”in the long-run we are all dead” Until relatively recently, Commercial Property was viewed as an alternative asset class and largely underweighted in professional portfolios. Two factors lead to greater inclusion within optimised portfolios: · The historic lack of correlation with equity investment · The consistently strong returns in the 10 years up to mid 2007 With both of these factors now appearing to be breaking down, Commercial Property is still seen as a core asset class within an optimised portfolio while commodity investments are pushed to the sidelines.

Constant portfolio re-balancing

Another question I am regularly asked is “if I had held Gold in my portfolio back in the 1980s, then surely I would have lost money?” First let’s be clear: We do not advocate investing 100% of a portfolio in Gold or indeed any other asset class. Our standard weighting to Gold being in the order of 10% to 20% of a portfolio. Let’s look at an example using two asset classes Gold and the Dow Jones. The following chart shows the price of gold and the Dow Jones Stock index from the period 1976 to 2001. Clearly, if you had kept your holding of gold at a constant 10% of your portfolio, you would have been selling gold from 1977 to 1980 and buying Dow Jones. Equally, from 1982 to 2001, you would have been gradually selling Dow Jones and buying Gold. What happened in the period 2001 to 2008? Gold appreciated from around $300 to around $1000 now. Compared to the Dow Jones Industrial Average which, in 2001, fell 7.1%. In 2002, the industrial average lost 18.8%, its worst loss since 1977. The Dow Jones Industrial Average hit a five-year closing low of 7286.27 on October 9, 2002 By constant rebalancing to your optimum portfolio, you will be selling assets at a high and buying assets at a low. The lack of a correlation between to the two asset classes works to the advantage of the investor and reduces risk and, crucially, increases returns when markets are at their most volatile.

Inflation

All Investors are susceptible to unanticipated inflation, which may result from what economists call “externalities” or shocks to the financial system such as short-term wars (Gulf Oil War of 1990-1991), inclement weather (periodic droughts, floods and frosts), and currency devaluations (Asia in 1997 and Russia in 1998). Through much to the 1990’s, developed economies appeared to have moved into what was described in the USA as a “Goldilocks” state, i.e. the economy was not too hot and not too cold. It seemed as if the authorities had somehow managed to remove both “boom and bust” from the economic cycle and maintained a low and stable level of inflation. In these conditions, investment in financial instruments (cash/bonds/equities) made perfect sense. Generally falling interest rates from the peak reached in the early 1990s, meant that Bonds represented a sound investment for much of the 1990s. Equally, many years of uninterrupted growth in the developed economies resulted in generally consistent Stock market returns at around a 20%pa return. At the same time, the returns from raw materials and commodities were not in the same league as either stocks or bonds. Indeed, it is possible, if not probable, that the declining prices of raw materials in real-terms may have benefited the bond market and supported stock market valuations in the last decade. Consequently, commodity investments both hard (precious metals such as Gold and Silver) and soft (grain, oil etc) were largely ignored by fund managers through much of the 1990s and early part of this Century. An investment in a commodity is not a financial instrument and therefore does not feature in the basket of traditional asset classes for a modern fund manager or financial adviser. Indeed, today financial advisers are told in their training manuals that commodity investments are “alternative asset classes” and that they do not provide an income and need to be stored and possibly insured. It is hardly surprising that an investment is a commodity is viewed as “risky”. Compared to other forms of financial instrument, commodity investments are not seen as a realistic option for the private investor.

Marc Westlake Dip PFS, QFA 20^th March 2008

INVESTMENT WARNING The information available through this Website is for your general information and use and is not intended to address your particular requirements. We do not, nor are we authorised to, offer advice on specific investments in the UK. In particular, the information does not constitute any form of advice or recommendation by Gold Investments and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision. For your information we would also like to draw your attention to the following general investment warnings. The price of shares and investments, and the income derived from them, can go down as well as up. Investors may not get back the amount they invested. Past performance should not be regarded as indicative of future performance.