Investment leadership is needed now

Investment leadership needs to step up. It needs to project confidence that it can crack through this crisis. It then needs to re-group with the benefits of extraordinary lessons learned through extraordinary times and morph into something better. While this crisis is rightly producing stories of heroes in scrubs and gowns, the investment industry will be discovering its own heroes. They are likely to be T-shaped leaders: both sure-footed in strategy and steeped in humanity.

This is the conclusion of Roger Irwin in his recent article, the hour for leadership is now, appearing on Top1000funds.com.

 

T-shaped leadership involves having deep expertise in your field and a greater awareness of societal and business issues.

As he notes, investment leaders have the opportunity to make life-changing differences for people’s savings and investments. “They will do so by drawing from the widest range of leadership skills to manoeuvre through the epic challenges this crisis presents and by emerging with stronger, fairer and more sustainable businesses.”

I couldn’t agree more.

 

The article has a wide ranging discussion on leadership, and what will be valued in the current situation. A mix of leadership approaches is required, it is not a case of either / or but and.

 

As he quite rightly points out, in the current environment, safety will be high on everyone’s needs.

“This suggests that the empathy shown to workers through this period of vulnerability will be preciously valued. For example, in the choice of what’s right to do now when family issues arise while working from home; this is the time to choose to do the family thing. For the best organisations, it’s not even close.” Quite right.

 

There is no doubt the current environment presents a unique set of challenges.

Irwin suggests the best stories will come from “organisations where leadership and culture are strongest. They will have a few things in common: a balance in the craft of exercising dominant and serving leadership styles; a purposeful culture as a north star; clarity that profit play a supporting role in that purpose; and a culture that accommodates this ‘it’s all about the people’ moment.”

 

He expects a number of disruptions to organisations, the following observations are made:

  • Good leaders always manage to stay in touch.
  • There will be a growing need for emotional intelligence among investment leadership. “Employees increasingly expect work and life to be integrated and this is central to good employee experiences where well-being, purpose and personal growth rank highly and intrinsic motivations are more lasting than extrinsic forms like pay.”
  • There needs to be a culture of openness in the workplace. The hoarding of information is old school. “Now the open-cultured organisations can create the positive state of psychological safety at all levels with everyone feeling included. This plays to better decision making all round and helps people with their resilience during tough times.”

 

As mentioned above, the current environment requires leaders to be T-shaped.

The vertical bar in the T constitutes deep expertise in their field.

The horizontal bar is about having greater awareness of societal and business issues. Being more in touch. The article provides a number of examples, including: a greater understanding of stress and fight or flight responses in brain science; and the balancing of dominant and serving leadership in management science.

He suggests, we build the vertical bar in the T through being in-touch with a wider network and other disciplines.

 

Good luck, stay healthy and safe.

 

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

 

The psychology of Portfolio Diversification

In a well-diversified portfolio, when one asset class is performing extremely well (like global equity markets), the diversified portfolio is unlikely to keep pace.

In these instances, the investor is likely to regret that they had reduced their exposure to that asset class in favour of greater portfolio diversification.

This is a key characteristic of having a well-diversified portfolio. On many occasions, some part of the portfolio will be “underperforming” (particularly relative to the asset class that is performing strongly).

Nevertheless, stay the course, over any given period, diversification will have won or lost but as that period gets longer diversification is more and more likely to win.

True diversification comes from introducing new risks into a portfolio. This can appear counter-intuitive. These new risks have their own risk and return profile that is largely independent of other investment strategies within the Portfolio. These new risks will perform well in some market environments and poorly in others.

Nevertheless, overtime the sum is greater than the parts.

 

The majority of the above insights are from a recent Willis Tower Watson (WTW) article on Diversification, Keep Calm and Diversify.

The article provides a clear and precise account of portfolio diversification.  It is a great resource for those new to the topic and for those more familiar.

 

WTW conclude with the view “that true diversification is the best way to achieve strong risk adjusted returns and that portfolios with these characteristics will fare better than equities and diversified growth funds with high exposures to traditional asset classes in the years to come.”

 

Playing with our minds – Recent History

As the WTW article highlights the last ten-twenty years has been very unusual for both equity and bond markets have delivered excellent returns.

This is illustrated in the following chart they provide, the last two rolling 10-year periods have been periods of exceptional performance for a Balanced Portfolio (60%/40% equity/fixed income portfolio).

WTW Balance Fund Performance

 

WTW made the following observations:

  • The last ten years has tested the patience of investors when it comes to diversification;
  • For those running truly diversified portfolios, this may be the worst time to change approach (the death of portfolio diversification is greatly exaggerated);
  • Diversification offers ‘insurance’ against getting it wrong e.g. market timing; and
  • Diversification has a positive return outcome, unlike most insurance.

 

WTW are not alone on their view of diversification, for example a AQR article from 2018 highlighted that diversification was the best way to manage periods of severe sharemarket declines, as recently experienced.  I covered this paper in a recent Post: Sharemarket crashes – what works best in minimising losses, market timing or diversification.

 

WTW also note that it is difficult to believe that the next 10-year period will look like the period that has just gone.

There is no doubt we are in for a challenging investment environment based on many forecasted investment returns.

 

What is diversification?

WTW believe investors will be better served going forwards by building robust portfolios that exploit a range of return drivers such that no single risk dominates performance. (In a Balanced Portfolio of 60% equities, equities account for over 90% of portfolio risk.)

They argue true portfolio diversification is achieved by investing in a range of strategies that have low and varying levels of sensitivity (correlation) to traditional asset classes and in some instances have none at all.

Other sources of return, and risks, include investing in investment strategies with low levels of liquidity, accessing manager skill e.g. active returns above a market benchmark are a source of return diversification, and diversifying strategies that access return sources independent of traditional equity and fixed income returns. These strategies are also lowly correlated to traditional market returns.

 

Sources of Portfolio Diversification

Hedge Funds and Liquid Alternatives

Hedge Funds and Liquid Alternatives are an example of diversifying strategies mentioned above. As outlined in this Post, covering a paper by Vanguard, they both bring diversifying benefits to a traditional portfolio.

Access to the Vanguard paper can be found here.

 

It is worth highlighting that hedge fund and liquid alternative strategies do not provide a “hedge” to equity and fixed income markets.

Therefore they do not always provide a positive return when equity markets fall. Albeit, they do not decline as much at times of market crisis, as we have recently witnesses. Technically speaking their drawdowns (losses) are smaller relative to equity markets.

As evidenced in the Graph below provided by Mercer.

Mercer drawdown graph

 

Private Markets

TWT also note there are opportunities within Private Markets to increase portfolio diversification.

There will be increasing opportunities in Private markets because fewer companies are choosing to list and there are greater restrictions on the banking sector’s ability to lend.

This is consistent with key findings of the recently published CAIA Association report, The Next Decade of Alternative Investments: From Adolescence to Responsible Citizenship.

The factors mentioned above, along with the low interest rate environment, the expected shortfall in superannuation accounts to meet future retirement obligations, and the maturing of emerging markets are expected to drive the growth in alternative investments over the decade ahead.

A copy of the CAIA report can be found here. I covered the report in a recent Post: CAIA Survey Results – The attraction of Alternative Investments and future trends.

 

TWT expect to see increasing opportunities across private markets, including a “range from investments in the acquisition, development, and operation of natural resources, infrastructure and real estate assets, fast-growing companies in overlooked parts of capital markets, and innovative early-stage ventures that can benefit from long-term megatrends.”

Continuing the theme of lending where the banks cannot, they also see the opportunity for increasing portfolios with allocations to Private Debt.

WTW provided the following graph, source data from Preqin

WTW Private Market Performance

 

Real Assets

In addition to Hedge Funds, Liquid Alternatives, and Private markets (debt and equity), Real Assets are worthy of special mention.

Real assets such as Farmland, Timberland, Infrastructure, Natural Resources, Real Estate, TIPS (Inflation Protected Fixed Income Securities), Commodities, Foreign Currencies, and Gold offer real diversification benefits relative to equities and fixed income in different macro-economic environments, such as low economic growth, high inflation, stagflation, and stagnation.

These are a conclusive findings of a recent study by PGIM. The PGIM report on Real Assets can be found here. I provided a summary of their analysis in this Post: Real Assets offer real diversification benefits.

 

Conclusion

To diversify a portfolio it is recommended to add risk and return sources that make money on average and have a low correlation to equities.

Diversification should be true both in normal times and when most needed: during tough periods for sharemarkets.

Diversification is not the same thing as a hedge. Although “hedges” make money at times of sharemarket crashes, there is a cost, investments with better hedging characteristics tend to do worse on average over the longer term. Think of this as the cost of “insurance”.

Therefore, alternatives investments, as outlined above, are more compelling relative to the traditional asset classes in diversifying a portfolio, they provide the benefits of diversification and on average over time their returns tend to keep up with sharemarket returns.

Importantly, investing in more and more traditional asset classes does not equal more diversification e.g. listed property.  As outlined in this Post.

 

As outlined above, we want to invest in a combination of lowly correlated asset classes, where returns are largely independent of each other. A combination of investment strategies that have largely different risk and return drivers.

 

Good luck, stay healthy and safe.

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

 

 

Balanced Fund Bear Market and the benefits of Rebalancing

Balanced Funds are on track to experience one of their largest monthly losses on record.

Although this largely reflects the sharp and historical declines in global sharemarkets, fixed income has also not provided the level of portfolio diversification witnessed in previous Bear markets.

In the US, the Balanced Portfolio (60% Shares and 40% Fixed Income) is experiencing declines similar to those during the Global Financial Crisis (GFC) and 1987.

In other parts of the world the declines in the Balance Portfolio are their worst since the   1960s.

As you will be well aware the level of volatility in equity markets has been at historical highs.

After reaching a historical high on 19th February the US sharemarket, as measured by the S&P 500 Index, recorded:

  • Its fastest correction from a peak, a fall of 10% but less than 19%, taking just 6 days; and
  • Its quickest period to fall into a Bear market, a fall of greater than 20%, 22 days.

The S&P 500 entered Bear market territory on March 12th, when the market fell 9.5%, the largest daily drop since Black Monday in October 1987.

The 22 day plunge from 19th February’s historical high into a Bear market was half the time of the previous record set in 1929.

Volatility has also been historical to the upside, including near record highest daily positive returns and the most recent week was the best on record since the 1930s.

 

Volatility is likely to remain elevated for some time. The following is likely needed to be seen before there is a stabilisation of markets:

  • The Policy response from Governments and Central Banks is sufficient to prevent a deepening of the global recessions;
  • Coronavirus infection rates have peaked; and
  • Cheap valuations.

Although currently there are cheap valuations, this is not sufficient to stabilise markets. Nevertheless, for those with a longer term perspective selective and measured investments may well offer attractive opportunities.

Please seek professional investment advice before making any investment decision.

For those interested, my previous Post outlined one reason why it might be the right thing for someone to reduce their sharemarket exposure and three reasons why they might not.

 

The Impact of Market Movements and Benefits of Rebalancing

My previous Post emphasised maintaining a disciplined investment approach.

Key among these is the consideration of continuing to rebalance an investment Portfolio.

Regular rebalancing of an investment portfolio adds value, this has been well documented by the research.  The importance and benefits of Rebalancing was covered in a previous Kiwi Investor Blog Post which may be of interest: The balancing act of the least liked investment activity.

Rebalancing is a key investment discipline of a professional investment manager. A benefit of having your money professionally managed.

Assuming sharemarkets have fallen 25%, and no return from Fixed Income, within a Balanced Portfolio (60% Shares and 40% Fixed Income) the Sharemarket allocation has fallen to 53% of the portfolio.

Therefore, portfolios are less risky currently relative to longer-term investment objectives. A disciplined investment approach would suggest a strategy to address this issue needs to be developed.

 

As an aside, within a New Zealand Balanced Portfolio, if no rebalancing had been undertaken the sharemarket component would have grown from 60% to 67% over the last three years, reflecting the New Zealand Sharemarket has outperformed New Zealand Fixed Income by 10.75% per year over the last three years.

This meant, without rebalancing, Portfolios were running higher risk relative to long-term investment objectives entering the current Bear Market.

Although regular rebalancing would have trimmed portfolio returns on the way up, it would also have reduced Portfolio risk when entering the Bear Market.

As mentioned, the research is compelling on the benefits of rebalancing, it requires investment discipline. In part this reflects the drag on performance from volatility. In simple terms, if markets fall by 25%, they need to return 33% to regain the value lost.

 

Investing in a Challenging Investment Environment

No doubt, you will discuss any current concerns you have with your Trusted Advisor.

In a previous Post I reflected on the tried and true while investing in a Challenging investment environment.

I have summarised below:

 

Seek “True” portfolio Diversification

The following is technical in nature and I will explain below.

A recent AllAboutAlpha article referenced a Presentation by Deutsche Bank that makes “a very compelling case for building a more diversified portfolio across uncorrelated risk premia rather than asset class silos”.

For the professional Investor this Presentation is well worth reading: Rethinking Portfolio Construction and Risk Management.

The Presentation emphasises “The only insurance against regime shifts, black swans, the peso problem and drawdowns is to seek out multiple sources of risk premia across a host of asset classes and geographies, designed to harvest different features (value, momentum, illiquidity etc.) of the return generating process, via a large number of small, uncorrelated exposures

 

We are currently experiencing a Black Swan, an unexpected event which has a major effect.

In a nutshell, the above comments are about seeking “true” portfolio diversification.

Portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits over the longer term and particularly at time of market crisis.

True portfolio diversification is achieved by investing in different risk factors (also referred to as premia) that drive the asset classes e.g. duration (movements in interest rates), economic growth, low volatility, value, and market momentums by way of example.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market risk (e.g. equities and fixed income), smart beta (e.g. value and momentum factors), alternative, and hedge fund risk premia. And of course, “true alpha” from active management, returns that cannot be explained by the risk exposures just outlined.

There has been a disaggregation of investment returns.

US Endowment Funds and Sovereign Wealth Funds have led the charge on true portfolio diversification, along with the heavy investment into alternative investments and factor exposures.

They are a model of world best investment management practice.

 

Therefore, seek true portfolio diversification this is the best way to protect portfolio outcomes and reduce the reliance on sharemarkets and interest rates to drive portfolio outcomes.  As the Deutsche Bank Presentation says, a truly diversified portfolio provides better protection against large market falls and unexpected events e.g. Black Swans.

True diversification leads to a more robust portfolio.

 

Customised investment solution

Often the next bit of  advice is to make sure your investments are consistent with your risk preference.

Although this is important, it is also fundamentally important that the investment portfolio is customised to your investment objectives and takes into consideration a wider range of issues than risk preference and expected returns and volatility from investment markets.

For example, level of income earned up to retirement, assets outside super, legacies, desired standard of living in retirement, and Sequencing Risk (the period of most vulnerability is either side of the retirement age e.g. 65 here in New Zealand).

Also look to financial planning options to see through difficult market conditions.

 

Think long-term

I think this is a given, and it needs to be balanced with your investment objectives as outlined above.

Try to see through market noise and volatility.

It is all right to do nothing, don’t be compelled to trade, a less traded portfolio is likely more representative of someone taking a longer term view.

Remain disciplined.

 

There are a lot of Investment Behavioural issues to consider at this time to stop people making bad decisions, the idea of the Regret Portfolio approach may resonate, and the Behavioural Tool Kit could be of interest.

 

AllAboutAlpha has a great tagline: “Seek diversification, education, and know your risk tolerance. Investing is for the long term.”

Kiwi Investor Blog is all about education, it does not provide investment advice nor promote any investment, and receives no financial benefits. Please follow the links provided for a greater appreciation of the topic in discussion.

 

And, please, build robust investment portfolios. As Warren Buffet has said: “Predicting rain doesn’t count. Building arks does.” ………………….. Is your portfolio an all-weather portfolio?

 

Stay safe and healthy.

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Navigating through a Bear market – what should I do?

To all Kiwi Investor Blog readers, I hope you are staying safe and healthy. My thoughts are with you from a health perspective and for those facing the economic consequences on businesses and families from the spread of the coronavirus.

 

In the current market environment there is much uncertainty and many are wondering what to do with their investments.

The key questions being asked are should we switch to a more conservative investment or get out the markets all together.

 

One of the best discussions on why to remain invested is provided by FutureSafe in a letter to their client’s 15th March.

FutureSafe provide one reason why it might be the right thing for someone to reduce their sharemarket exposure and three reasons why they might not.

They have reproduced the letter in the hope that it might be helpful and of interest to the broader investing community.

As they emphasis, please consult your advisor or an investment professional before making any investment decisions. In New Zealand, the FMA has also provided recent guidance on this issue, KiwiSaver providers should be providing general (class) advice to members at this time. Their full guidance on Kiwisaver Advice is here.

 

I have provided the main points below of the FutureSafe letter to clients, nevertheless the letter is well worth reading in full.

The first question is do you have too much invested in the market?

As FutureSafe highlight, the average declines of bear markets since WWII have been over 30%, with some declines as large as 60%. It has generally taken on average 2 years to recover.

 

My last Post, What to expect, navigating the current Bear-Market, presented research from Goldman Sachs on the historical analysis of bear markets in US equities going back to the 1800s. At this stage, we are likely experiencing an Event-Driven Bear market.  These Bear markets tend to be less severe, but the speed of the fall in markets is quicker, as is the recover.

However, as Goldman Sachs note none of the previous Event-Driven Bear markets were triggered by the outbreak of a virus, nor were interest rates so low at the start of the market decline.

Historically Event-Driven bear markets on average see falls of 29%, last 9 months and recover within 15 months. Nevertheless, the current Bear could transform into a cyclical bear market if containment efforts lead to a larger global recession than anticipated.

 

Back to FutureSafe. You should only take the risk you can stomach, or technically speaking, is aligned with your “risk appetite”. Which is a level of risk that does not keep you awake at night.  Unfortunately, we often don’t know our risk appetite until we experience significant market events like we are experiencing currently. We are often over-confident as to the level of market volatility we can tolerate.

FurtureSafe conclude “Now that we are in a downturn, if you have come to the conclusion that your risk appetite is not what you thought it was, it’s perfectly OK to acknowledge that and change your safety net accordingly.”

However, before you do anything, FutureSafe ask you to read through and consider a few reasons why not to do anything at this time might be appropriate.

Reason 1

If management of risk appetite is not your motivation, perhaps you are planning on selling now, with the conviction markets will continue to fall, and you plan on buying back in later.

You are essentially making an active investment decision and attempting to time markets.

Timing markets is very hard to do. Professional Investors are not very good at it.

The data on the average mutual fund investor is also not very complimentary. As FutureSafe note the “the average mutual fund investor has not stayed invested for a long enough period of time to reap the rewards that the market can offer more disciplined investors. The data also shows that when investors react, they generally make the wrong decision.”  A mutual Fund is like a Unit Trust or KiwiSaver Fund in New Zealand.

I depart from the FutureSafe article and provide the graph below from PIMCO.

As PIMCO highlight, “Through no fault of their own – and especially when market volatility strikes – investors tend to be their own worst enemy.”

The graph below highlights that investors do not capture all of the returns from the market, which can be attributed to behavioural biases that leads to inappropriate timing of  buying and selling.

This investor behavioural gap is well documented.

In reference to market timing and in one short sentence, FutureSafe say “We’re probably not as good at these active calls as we think we are, and it might hurt more than help.”

PIMOC Behaviour gap

Reason 2

A large portion of returns are earned on days markets make large gains.

Although the extreme volatility being witnessed currently is very painful to watch, amongst them are explosive up days. Attempting to time markets might cause you to miss these valuable up days.

The research on this is also very clear.

As outlined in the Table below, if you had missed the top 15 biggest return days your yearly return would have been 3.6% compared to 7% per year if you had remained fully invested (this is over the period January 1990 to March 2020 and being invested in the US S&P 500 Index).

Missing large daily returns

Of course, the same can be said if you missed the largest down days. Nevertheless, good luck at avoiding these days and still being able to fully capture the returns from equity markets.  The down days represent the risk of investing in shares.

Most important is having a disciplined investment approach and an investment portfolio consistent with your risk appetite and is truly diversified so as to limit the impact of the poor periods of performance in sharemarkets.

In summary, FutureSafe note, “Missing just a few of the top up days, can cost you a large chunk of the market’s returns.”

 

Reason 3

Take a long-term perspective.

Overtime, and with hindsight, large market declines look like minor setbacks over the longer term, the very long term.

This is quite evident from the following graph.

Remember, the stock market fell by 20% over one day in 1987, the dot-com crash of 2000 or even the Great Financial Crisis of 2008 don’t look to bad with a longer term perspective.

Take a longer term perspective

As FutureSafe conclude “If you really don’t need the money for a long period of time (e.g. 10 or 15 years) these are best to ride out because they look a lot better in the rear view mirror than when you are going through it.”

“If you have a long enough horizon (10 to 15 years or more), the chances of doing well in the stock market is still quite good.”

 

Therefore, the key points to consider are:

  • Risk Appetite should primarily drive your allocation to sharemarkets, not the current market environment;
  • We can’t time markets, not even the professionals;
  • Be disciplined and maintain a well-diversified investment portfolio, this is the best way to limit market declines, rather than trying to time markets;
  • Take a longer-term view; and
  • Seek out professional investment advice

 

Keep safe and healthy.

 

Happy investing.

 

Please read my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Time to move away from the Balanced Portfolio. They are riskier than you think.

GMO, a US based value investor, has concluded “now is the time to be moving away from 60/40” Portfolio.  Which is a Balanced Portfolio consisting of 60% US equities and 40% US fixed income.

Being a “contrarian investor”, recent market returns and GMO’s outlook for future market returns are driving their conclusions.

I covered their 7-year forecasts in an earlier Post. GMO provide a brief summary of their medium term returns in the recently published article: Now is the Time to be Contrarian

 

The GMO article makes the following key observations to back up their contrarian call:

  • The last time they saw such a wide “spread” in expected returns between a traditional 60/40 portfolio and a non-traditional one was back in the late 1990s, this was just prior to the Tech bubble bursting.
  • The traditional 60/40 portfolio went on to have a “Lost Decade” in the 2000s making essentially no money, in real terms, for ten years. Starting in late 1999, the 60/40 portfolio delivered a cumulative real return over the next ten years of -3.9%.

 

As outlined in the GMO chart below, Lost Decades for a Balanced Portfolio have happened with alarming and surprising frequency, all preceded by expensive stocks or expensive bonds.

GMO note that both US equities and fixed income are expensive today. As observed by the high CAPE and negative real yield at the bottom of the Chart.

They are of course not alone with this observation, as highlighted by a recent CFA Institute article. I summarised this article in the Post: Past Decade of strong returns are unlikely to be repeated.

lost-decades_12-31-19

 

 

The Balance Portfolio is riskier than you think.

The GMO chart is consistent with the analysis undertaken by Deutsche Bank in 2012, Rethinking Portfolio Construction and Risk Management.

This analysis highlights that the Balanced Portfolio is risker than many think. This is quite evident in the following Table. The Performance period is from 1900 – 2010.

Real Returns

(after inflation)

Compound Annual Return per annum 3.8%
Volatility (standard deviation of returns) 9.8%
Maximum Drawdown (peak to bottom) -66%
% up years 67%
Best Year 51%
Worst Year -31%
% time negative returns over 10 years 22%

The Deutsche Bank analysis highlights:

  • The, 60/40 Portfolio has generated negative real returns over a rolling 10 year period for almost a quarter of the time (22%).
  • In the worst year the Portfolio lost 31%.
  • On an annual basis, real negative returns occur 1 in three years, and returns worse than -10% 1 in every six years
  • Equities dominate risk of a 60/40 Portfolio, accounting for over 90% of the risk in most countries.

 

The 4% average return, comes with volatility, much higher than people appreciate, as outlined in the Table above. The losses (drawdowns) can be large and lengthy.

This is evident the following Table of Decade returns, which line up with the GMO Chart above.

Decade Per annum return
1900s 6.3%
1910s -4.7%
1920s 12.7%
1930s -2.3%
1940s 1.1%
1950s 9.1%
1960s 4.5%
1970s -0.3%
1980s 11.7%
1990s 11.7%
2000s 0.5%

 

We know the 2010s was a great decade for the Balanced Portfolio.  A 10 year period in which the US sharemarket did not experience a bear market (a decline of 20% or more). This is the first time in history this has occurred.

Interestingly, Deutsche Bank highlight the 1920s and 1950s where post war gains, while the 1980s and 1990s were wind-full gains.

The best 4 decades returned 11.3% p.a. and the 7 others 0.7% p.a.

 

As outlined in my last Post, the case for diversifying away from traditional equity and fixed income is arguably stronger than ever before.

 

Happy investing.

 Please read my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Sobering low return estimates

AQR has updated their estimates of medium-term (5- to 10-year) expected returns for the major asset classes.

Their expected real return for the traditional U.S. 60/40 portfolio (60% Equities / 40% Bonds) is just 2.4%, around half its long-term average of nearly 5% (since 1900).

It is also down from 2.9% estimated last year.

 

AQR conclude that medium term expected returns are “sobering low”. Their return estimates are after inflation (real returns) and are compounded per annum returns.

“They suggest that over the next decade, many investors may struggle to meet return objectives anchored to a rosier past”.

“We again emphasize that our return estimates for all asset classes are highly uncertain. The estimates in this report do not in themselves warrant aggressive tactical allocation responses — but they may warrant other kinds of responses. For example, investment objectives may need to be reassessed, even if this necessitates higher contribution rates and lower expected payouts. And the case for diversifying away from traditional equity and term premia is arguably stronger than ever.”

 

The AQR estimate for a Balance Fund return are similar to those published recently in a CFA Institute article of 3.1%.

 

AQR update their estimates annually.  They manage over US$186 billion in investment assets.

 

Return Estimates

Reflecting the strong returns experienced in 2019 across all markets, particularly US equities, future returns estimates are now lower compared to last year.

This is Highlighted in the Table below.

Medium-Term Expected Real Returns

Market

2019 Estimate

2020 Estimate

US Equities

4.3%

4.0%

Non-US Developed Equities

5.1%

4.7%

Emerging Markets

5.4%

5.1%

US 10-year Government Bonds

0.8%

0.0%

Non US-10 Year Government Bonds

-0.3%

-0.6%

US Investment Grade Credit

1.6%

0.9%

 

Bloomberg have a nice summary of the key results:

  • Anticipated returns for U.S. equities dropped to 4% from 4.3% a year earlier.
  • U.S. Treasuries tracked the move, with AQR predicting buyers will merely break even.
  • Non-U.S. sovereigns slipped deeper into negative territory, with a projected loss of 0.6% a year.
  • Emerging-market equities will lead the way, the firm projects, with a return of 5.1%.

 

This article by Institutional Investor also provides a good run down of AQR’s latest return estimates.

More detail of return estimates can be found within the following document, which I accessed from LinkedIn.

 

Lastly, AQR provide the following guidance in relation to the market return estimates:

  • For shorter horizons, returns are largely unpredictable and any predictability has tended to mainly reflect momentum and the macro environment.
  • Our estimates are intended to assist investors with their strategic allocation and planning decisions, and, in particular, with setting appropriate medium-term expectations.
  • They are highly uncertain, and not intended for market timing.

 

In addition to the CFA Article mentioned above, AQRs estimates are consistent with consensus expected returns I covered in a previous Post.

 

Although AQR’s guidance to diversify away from traditional equity and fixed income might be like asking a barber whether you need a haircut, surely from a risk management perspective the diversification away from the traditional asset classes should be considered in line with the prudent management of investment portfolios and consistency with industry best practice?

In my Post, Investing in a Challenging Investment Environment, suggested changes to current investment approaches are covered.

Finally, Global Economic and Market outlook provides a shorter term outlook for those interested.

 

Happy Investing

Please read my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Investing in a Challenging Investment Environment

The Global financial backdrop can be summarised as:

  1. Late Cycle
    • The US economy is into its longest period of uninterrupted growth, it has been over ten years since the Global Financial Crisis (GFC) and the US experiencing a recession.
    • Likewise, the US sharemarket is into it longest period without incurring a 20% or more fall (which would be a bear market).
  2. Exceptionally low interest rates. As you will be aware over $14 trillion of European and Japanese fixed income securities are trading on negative interest rates.
  3. Central Banks around the world are reducing short-term interest. By way of example, the US Federal Reserve has undertaken a mid-cycle adjustment, with more to come, the European Central Bank recently cut interest rates, as has China’s Central Bank. The Reserve Bank of Australia and the Reserve Bank of New Zealand have reduced cash rates very aggressively in recent months. It appears that interest rates will remain lower for longer.
  4. Rising geo-political risk, namely an ongoing and escalating trade dispute between the US and China, while Brexit has a cameo role on the global stage, and there are rising tensions in the middle-east.
  5. Global growth has slowed. The pace of economic activity has slowed around the world, this is most noticeable in Europe, Japan, and China, and is concentrated within the manufacturing sector. The service sectors have largely been unaffected.

 

Against this backdrop the US sharemarket has outperformed, continually reaching all-time highs, likewise for the New Zealand sharemarket.

Value stocks have underperformed high growth momentum stocks. The performance differential between value and growth is at historical extremes.

Lastly emerging Markets have underperformed the developed world.

 

A good assessment of the current environment is provided in this article by Byron Wien. It is a must read, Plenty to worry about but not much to do.

 

It is not all gloom and doom

The US consumer is in very good shape, reflecting record low unemployment, rising wages, and a sound property market. The US consumer is as bigger share of the global economy as is China. Although it is not growing as fast as China, a solid pace of growth is being recorded.

Overall, economic data in the US has beaten expectations over recent weeks (e.g. retail sales).

Globally the manufacturing sectors are expected to recover over the second half of this year, leading to a rebound in global growth. Low interest rates will also help global growth.  Nevertheless, growth will remain modest and inflation absent.

Globally, in most countries, Sharemarket’s dividend yields are higher than interest rates. This means that sharemarkets can fall in value over the next 5-10 years and still outperform fixed income.

 

How to invest in current environment

Recently there has been #TINA movement: There Is No Alternative to Equities.

Certainly equities have performed strongly on a year to date basis, so have fixed income securities (their value increases as interest rates fall).

The traditional 60/40 portfolio, 60% Equities and 40% Fixed Income, has performed very strongly over the last 6-9 months, this comes after a difficult 2018.

#TINA and the longer term performance of the 60/40 portfolio is covered in this AllAboutAlpha Article, which is well worth reading.

The 60/40 portfolio has performed well over the last 10 years, and has been a strong performer over the longer term.

This performance needs to be put into the context that interest rates have been falling for the last 35 years, this has boosted the returns from the Fixed Income component of the portfolio.  Needless to say, this tail wind may not be so strong in the next 35 years.

This indicates that future returns from a 60/40 portfolio will be lower than those experienced in more recent history.

There are lots of suggestions as to what one should do in the current market environment.  This article on Livewire Markets provides some flavour.

No doubt, you will discuss any concerns you have with your Trusted Advisor.

 

At a time like this, reflect on the tried and true:

Seek “True” portfolio Diversification

The AllAboutAlpha article references a Presentation by Deutsche Bank that makes “a very compelling case for building a more diversified portfolio across uncorrelated risk premia rather than asset class silos”.

The Presentation emphasises “The only insurance against regime shifts, black swans, the peso problem and drawdowns is to seek out multiple sources of risk premia across a host of asset classes and geographies, designed to harvest different features (value, momentum, illiquidity etc.) of the return generating process, via a large number of small, uncorrelated exposures

The above comments are technical in nature and I will explain below. Albeit, the Presentation is well worth reading: Rethinking Portfolio Construction and Risk Management.

 

In a nutshell, the above comments are about seeking “true” portfolio diversification.

Portfolio diversification does not come from investing in more and more asset classes i.e. asset class silos. This has diminishing diversification benefits over the longer term and particularly at the time of market crisis e.g. adding global listed property or infrastructure to a multi-asset portfolio that already includes global equities.

True portfolio diversification is achieved by investing in different risk factors (i.e. premia) that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth by way of example.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market beta (e.g. equities and fixed income), smart beta (e.g. value and momentum factors), alternative and hedge fund risk premia, illiquidity e.g. Private Equity, Direct Property, and unlisted infrastructure. And of course, true alpha from active management, returns that cannot be explained by the risk exposures just outlined. There has been a disaggregation of returns.

US Endowment Funds and Sovereign Wealth Funds have led the charge on true portfolio diversification, along with the heavy investment into alternative investments and factor exposures. They are a model of world best investment management practice.

Therefore, seek true portfolio diversification, this is best way to protect portfolio outcomes and reduce the reliance on sharemarkets and interest rates driving portfolio outcomes.

As the Presentation says, a truly diversified portfolio provides better protection against large market falls and unexpected events i.e. Black Swans.

True diversification leads to a more robust portfolio.

(I have written a number of Post on Alternatives and the expected growth in institutions investing in alternatives globally.)

 

Customised investment solution

Often the next bit advice is to make sure your investments are consistent with your risk preference.

Although this is important, it is also fundamentally important that the investment portfolio is customised to your investment objectives and takes into consideration a wider range of issues than risk preference and expected returns and volatility from capital markets.

For example, income earned up to and after retirement, assets outside super, legacies, desired standard of living in retirement, and Sequencing Risk (the period of most vulnerability is either side of the retirement age e.g. 65 here in New Zealand).

 

Think long-term

I think this is a given, and it needs to be balanced with your customised investment objectives as outlined above. Try to see through market noise, don’t over trade and don’t take on more risk to chase returns.

It is all right to do nothing, don’t be compelled to trade, a less traded portfolio is likely more representative of someone taking a longer term view.

Also look to financial planning options to see through difficult market conditions.

 

There are a lot of Investment Behavioural issues to consider, the idea of the Regret Portfolio approach may resonate, and the Behavioural Tool Kit could be of interest.

 

AllAboutAlpha has a great tagline: “Seek diversification, education, and know your risk tolerance. Investing is for the long term.”

Kiwiinvestorblog is all about education, it does not provide investment advice nor promote any investment and receives no payments. Please follow the links provided for a greater appreciation of the topic in discussion.

 

And, please, build robust investment portfolios. As Warren Buffet has said: “Predicting rain doesn’t count. Building arks does.” ………………….. Is your portfolio an all weather portfolio?

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

The balancing act of the least liked investment activity

A recent Research Affiliates article on rebalancing noted: “Regularly rebalancing a portfolio to its target asset mix is necessary to maintain desired risk exposure over the portfolio’s lifetime. But getting investors to do it is another matter entirely—many would rather sit in rush-hour traffic! “

“A systematic rebalancing approach can be effective in keeping investors on the road of timely rebalancing, headed toward their destination of achieving their financial goals and improving long-term risk-adjusted returns.”

Research Affiliates are referencing a Wells Fargo/ Gallup Survey, based on this survey “31% of investors would opt to spend an hour stuck in traffic rather than spend that time rebalancing their portfolios. Why would we subject ourselves to gridlock instead of performing a simple task such as rebalancing a portfolio?

 

I can’t understand why rebalancing of an investment portfolio is one of least liked investment activity, it adds value to a portfolio overtime, is a simple risk management exercise, and is easy to implement.

It is important to regularly rebalance a Portfolio so that it continues to be invested as intended to be.

 

A recent article in Plansponsor highlighted the importance of rebalancing. This article also noted the reluctance of investors to rebalance their portfolio.

As the article noted, once an appropriate asset allocation (investment strategy) has been determined, based on achieving certain investment goals, the portfolio needs to be regularly rebalanced to remain aligned with these goals.

By not rebalancing, risks within the Portfolio will develop that may not be consistent with achieving desired investment goals. As expressed in the article “Participants need to make sure the risk they want to take is actually the risk they are taking,” …………..“Certain asset classes can become over- or under-weight over time.”

Based on research undertaken by BCA Research and presented in the article “Rebalancing is definitely recommended for all investors, perhaps more so for retirement plan participants than others, as they are more likely to be concerned with capital preservation than capital appreciation.”

The following observation is also made “While a portfolio that is not rebalanced will have a greater allocation to equities during a bull market and, therefore, outperform a rebalanced portfolio, all rebalanced portfolios outperformed an unbalanced portfolio during periods leading up to market corrections and recessions,” Hanafy says, citing a BCA Research study which looked at three main rebalancing scenarios of a simple 60/40 portfolio since 1973.

The potential risks outlined above is very relevant for New Zealand and USA investors currently given the great run in the respective sharemarkets over the last 10 years.

When was last time your investment fiduciary rebalanced your investment portfolio?

 

Rebalancing becomes more important as you get closer to retirement and once in retirement:

“There are two main components to retirement plans: returns and the risk you take,” …… “When you do not rebalance your portfolio, a participant could inadvertently take on too much risk, which would expose them to a market correction. This is important because, statistically, as participants reach age 40 to 45, how much risk they take on is far more important than how much they save. When you are young, the most important thing is how much you save.”

Rebalancing Policy

As the article notes, you can systematically set up a Portfolio rebalancing approach based on time e.g. rebalance the portfolio every Quarter, six-months or yearly intervals.

It is not difficult!

Alternatively, investment ranges could be set up which trigger a rebalancing of the portfolio e.g. +/- 3% of a target portfolio allocation.

Higher level issues to consider when developing a rebalancing policy include:

  • Cost, the more regularly the portfolio is rebalanced the higher the cost on the portfolio and the drag on performance. This especially needs to be considered where less liquid markets are involved;
  • Tax may also be a consideration;
  • The volatility of the asset involved;
  • Rebalancing Policy allows for market momentum. This is about letting the winners run and not buying into falling markets too soon. To be clear this is not about market timing. For example, it could include a mechanism such as not rebalancing all the way back to target when trimming market exposures.

 

My preference is to use rebalancing ranges and develop an approach that takes into consideration the above higher level issues. As with many activities in investing, trade-offs will need to be made, this requires judgement.

 

As noted above, it appears that rebalancing is an un-liked investment activity, if not an over looked and underappreciated investment activity. This seems crazy to me as there is plenty of evidence that a rebalancing policy can add value to a naïve monitoring and “wait and see” approach.

I think the key point is to have a documented Rebalancing Policy and be disciplined in implementing the Policy.

 

This also means that those implementing the Rebalancing Policy have the correct systems in place to efficiently carry out the Portfolio rebalancing so as to minimise transaction costs involved.

Be sure, that those responsible for your investment portfolio can efficiently and easily rebalance your portfolio. Importantly, make sure the rebalancing process is not a big expense on your portfolio e.g. trading commissions and the crossing of market spreads (e.g. difference between buy and sell price), and how close to the “market price” are the trades being undertaken?

These are all hidden costs to the unsuspecting.

 

A couple of last points:

  • It was noted in the recent Kiwi Investor Blog on Behaviour Finance that rebalancing of the portfolio was an import tool in the kit in helping to reduce the negative impact on our decision making from behavioural bias. It is difficult to implement a rebalancing policy when markets are behaving badly, discipline is required.
  • The automatic rebalancing nature of Target Date Funds is an attractive feature of these investment solutions.

 

To conclude, as Research Affiliates sums up:

  1. Systemic rebalancing raises the likelihood of improving longer-term risk-adjusted investment returns
  2. The benefits of rebalancing result from opportunistically capitalising on human behavioural tendencies and long-horizon mean reversion in asset class prices.
  3. Investors who “institutionalise contrarian investment behaviour” by relying on a systematic rebalancing approach increase their odds of reaping the rewards of rebalancing.

 

It is not hard to do.

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Technology focus that will transform the Wealth Management Industry – Robo Advice alone won’t be enough

The Professional Wealth Magazine (PWM) argues that Private Banks must take “goaled-based tech to heart”.

In their recent article they see technology assisting Wealth Managers in the following areas:

  1. Customer facing;
  2. Client relationship management; and
  3. Goals-Based wealth management Investment Solutions.

The first two are well known, the third, as PWM note, is flying under the radar. Combined they are the future of a successful wealth management business.

Quite obviously Robo Advice models use technology. Nevertheless, Goals-Based wealth management provides the opportunity for greater customisation and a more robust investment solution that better meets the needs of the customer.

Therefore, technology will play a major role in delivering more customised Investment Solutions to a wider range of people.

 

Technology is going to play a major role in the industry’s transformation.

As has been argued: “In order to be part of the fourth industrial revolution, the people-centric industry of wealth management must transform the production, customisation and distribution of retirement solutions, …..”

(See my first Kiwi Investor Blog Post, Advancements in Portfolio Management, for an article written by Lionel Martellini, of EDHEC Risk Institute, that appeared in the Journal of Investment Management in 2016: Mass Customization versus Mass Production – How an Industrial Revolution is about to take place in money management and why it involves a shift from investment products to investment solutions.)

 

The PWM article covered a recent symposium held in Paris focusing on fintech, quantitative management and big data, the technologically-led trends transforming the global industry.

The participants at the symposium gathered to consider: what should be the role of technology in client acquisition and servicing, data analysis, and portfolio management?

With regards to technology in general PWM note, “Private banks need to put technological solutions at the heart of their operations if they are to meet the demands raised by clients and relationship managers, though there will always be a need for human interaction”

However, having acknowledged that technology is critical for a successful Wealth Management business of the future, it appears to be a difficult issue to address. PWM “calculate that of the 150 global private banks we monitor closely for technological, business, customer-facing and portfolio management trends, less than one third have implemented a serious technological solution to the challenges encountered by their clients and relationship managers.”

“Many have only devised client-interfaces such as online forms, apps and screens allowing choices of services. But a handful have gone much further…….”

 

Under the radar

PWM noted that “…there is probably one technology-led sphere which is totally under-appreciated by the industry, which was highlighted at the summit. This is that of goals-driven wealth management (GDWM), ….”

 

Goals-Based investing is an improvement on the generic industry approach. Rather than viewing your investments as one single diversified portfolio, where the allocations are primarily based on your risk tolerance and the concept of risk is measured by volatility or standard deviation of returns, Goals-Based investing creates distinct milestones (goals) that are closely aligned with the priorities in your life.

Goals-Based investing closely matches your investment assets with your unique goals and objectives (customisation). It is the Wealth Management counterpart to Liability Driven Investing (LDI), which is implemented by pensions and insurance companies where their investment problems are reflected in the terms of their future liabilities (expected future insurance claims), much like a Wealth Management client’s future priorities (goals). LDI is also implemented by Pension Funds, particularly those with Defined Benefits, which are known future liabilities/cashflows.

Goals-Based Investing offers a more robust investment solution, provides a closer alignment of retirement goals and investment assets. It will also help investors avoid some common behavioural biases, such as regret and hindsight bias.

The benefits of Goals-Based Investing are a:

  1. More stable level of income in retirement;
  2. More efficient use of capital – potentially need less retirement savings;
  3. Better framework to make trade-off between allocations to equities and fixed income; and
  4. Improved likelihood of reaching desired standard of living in retirement.

In summary, a Goals-Based investment strategy increases the likelihood of reaching a customer’s retirement income objectives. It can also achieve this with a more efficient allocation of capital. This additional capital could be used for current consumption or invested in growth assets to potentially fund a higher standard of living in retirement, or used for other investment goals e.g. endowments and legacies.

 

As the PWM article points out, technology is allowing “wealth managers to use institutional tools, helping clients to prepare for key life events….. Length of investment terms, risk tolerances, prices, taxes, depreciation levels can all be plugged into a model by relationship managers. Optimal asset allocations can then be arrived at and modified to plan for specific goals.“

“While few private banks currently approach this topic seriously, it surely must become the wealth management paradigm for the future. It will still require human wealth managers to advise clients and shepherd them through the process, but it will put an algorithmic system at the centre of the asset allocation decision. There is no substitute for this and it will most likely steal the very soul of wealth management.”

The Bold is mine, LDI is an institutional tool implemented to meet specific goals.

 

This is beyond a straight forward Robo Advice model and the filling out of a generic risk profile questionnaire. Technology is being applied to determine more customised investment solutions, taking into consideration a greater array of personal information and then implementing an investment solution using more advanced portfolio techniques, such as LDI.

 

The article covers other technology related issues in relation to wealth management, such as increasing competition from the likes of Google, Facebook, Alibabas and Tencents.

Importantly, PWM see room for a human element in all of this.

 

PWM conclude we are at the beginning of the industry’s “revolution”, technology will play a part in the success of the modern wealth manager and in capturing the next generation of investors:

“The battle for the hearts and minds of the next generation and for the soul of wealth management has yet to be fought and won. But the opening salvos have been fired.”

“Private banks have interesting weapons in their armouries. Some still need to be modernised for effectiveness. But at the moment, those that appear to be vital for future success appear to be GDWM (goals-driven wealth management) tools, networking apps and screens for impact and ethics.

“The private bank of the future will manage, introduce and evaluate, as well as working closely with the next generation. These disciplines require a raft of technological systems and an army of relationship managers, not just to operate them, but to take the output which they deliver and use this to help build a long-term relationship with families of the future.”

Again bold is mine.

 

The future, according to PWM, is a raft of technology solutions with Goals-Based investing as the underlying investment solution.

The appropriate use of technology and the mass production of customised investment solutions will be the Uber moment for the Wealth Management industry. The technology and investment knowledge is available now.

The customisation of investment solutions involves a Goals-Based investment approach, based on the principles of LDI.

A winning outcome will be the combination of smart technology and the mass production of customised investment solutions that more directly meet the needs of the customer in achieving their retirement goals.

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

 

Improve investment decisions – Behavioural Finance

Behavioural finance is the branch of behavioural economics that focuses on finance and investment. It encompasses elements of psychology, economics, and sociology.

Behavioural finance has gained increased prominence since Daniel Kahneman was awarded the Nobel Prize for economics in 2002. (Kahneman was recently involved in analysis of the regret-proof Portfolio.)

Kahneman is best known for identifying a range of cognitive biases in his work with the late Amos Tversky. These biases, and heuristic (which are mental shortcuts we take to solve problems and make judgments quickly), are consistent deviations away from rational behaviour (as assumed by classical economics).

Richard Thaler, also awarded a Nobel Prize, has made a large contribution to Behavioural Economics, his work has had a lasting and positive impact within Wealth Management.

There is a continued drive to better understand how our behaviour affects the decisions we make.

From an investing perspective, failing to understand our behaviour can come with a cost.  By way of example, the cost could be the difference between the returns on an underlying investment and the returns received by the investor.

 

In short, we have behavioural biases and are prone to making poor decisions, investment related or otherwise. Therefore, it is important to understand our behavioural biases. Behavioural Finance can help us make better investment decisions.

There are lots of good sources on Behavioural Finance, none other than from Joe Wiggins, whose blog, Behavioural Investment, provides clear and practical access to the concepts of Behavioural Finance.

 

By way of example, Joe has recently published “A Behavioural Finance Toolkit”. This is well worth reading (Behavioural Finance Toolkit).

The Toolkit helps us understand what Behavioural Finance is and then identifies the major impediments to making effective investment decisions.

These impediments are captured in the “MIRRORS” checklist outlined below:

As the Toolkit outlines: “An understanding of our own behaviour should be at the forefront of every decision we make. We exhibit a number of biases in our decision making. While we cannot remove these biases, we can seek to better understand them. We can build more systematic processes that prevent these biases adversely influencing the decisions we make.

Investors should focus on those biases that are most likely to impact their investment decisions – and those supported by robust evidence. We have developed a checklist to reduce errors from the key behaviours that affect our investment decisions – ‘MIRRORS’.”

 

M Myopic Loss Aversion We are more sensitive to losses than gains, and overly influenced by short-term considerations.
I Integration We seek to conform to group behaviour and prevailing norms.
R Recency We overweight the importance of recent events.
R Risk Perception We are poor at assessing risks and gauging probabilities.
O Overconfidence We over-estimate our own abilities.
R Results We focus on outcomes – the results of our decisions – when assessing their quality.
S Stories We are often persuaded by captivating stories.

The Toolkit provides detail on each of these impediments.

 

Risk Perception is the big one for me, particularly the ability to gauge probabilities and to effectively probability weight risks.

This is vitally important for investors and for those that sit on Investment committees.

Identifying risks is relatively easy, we tend to focus on what could go wrong.

As this The Motley Fool article highlights, being pessimistic appears to sound smart, and being optimistic as naïve. As quoted in the article: John Steward Mill wrote 150 years ago “I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.”

 

Albeit, in truth, assigning a probability to a risk, the likelihood of an event occurring, but also its impact, is a lot more difficult than merely stating a “potential” risk.

Remember, “more things can happen than will happen” – attributed to Elroy Dimson who also said “So you manage risks by comparing them to potential returns, and through diversification. Remember, just because more things can happen than will happen doesn’t mean bad things will happen.”

 

The Toolkit highlights that Noise affects our decision making.

“Our decisions are affected by noise; random fluctuations in irrelevant factors. This leads to inconsistent judgement. Investors can reduce the effects of noise and bias through the consistent application of simple rules.”

 As quoted “Where there is judgement, there is noise, and usually more of it than you think” – Kahneman

 

Accordingly, the Toolkit offers six simple steps to improve our decision making; three dos and three don’ts.

  • Do have a long-term investment plan.
  • Do automate your saving.
  • Do rebalance your portfolio.
  • Don’t check your portfolio too frequently.
  • Don’t make emotional decisions.
  • Don’t trade! Make doing nothing the default.

The central point: “These six steps seem simple but are not easy. We cannot remove our biases, or ignore the noise. Instead, we must build an investment process that helps us overcome them.”

There is a lot of common sense in the six steps outlined above.

 

Finally the Toolkit outlines four books that have changed the way we think about thinking!

I’d like to suggest a couple of books that I value highly, which are on topic, and with a risk focus angle as well:

  1. The Undoing Project, A Friendship That Changed Our Mind, Michael Lewis, this book outlines the relationship between Kahneman and Tversky, and the collaboration they had in developing their theories, including highlighting the different experiments they undertook. In doing so, Lewis provides practical insights into the types of biases we have in making decisions.
  2. Against the Gods, The Remarkable Story of Risk, Peter L. Bernstein. True to its label this book provides a history of the perception of risk and its management over time, right up to modern times, emphasising: more things can happen than will happen!

 

Both books provide fascinating accounts of history.

 

Happy investing.

 

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.