Which Country? All of them

April 25, 2012

Dear readers,

We are proud to see our blog back online after a period of downtime. Some misbehaving servers over with our web providers seem to finally have been tamed. Apologies if you came by and were greeted with Internal Error 500, hopefully we won’t see it again.

So back to your planning…

Interestingly the topic of exactly which countries to invest in has come up a few times recently, and as usual with investment, there is a myriad of ideas and more than a little ‘market noise.’ As followers of this blog will know, we do not buy into ‘hot tips’ or speculation, and firmly believe diversification and long term planning is the only justifiable approach.

Some actually quite artisitic diagrams will now follow to help explain why.

The first, World Market Capitilisation, is a cartogram depicting the world by the size of each country’s stock market relative to the world’s total market value (free-float adjusted). Please click to enlarge.

Diagram 1

The cartogram brings into sharp relief the investible opportunity of each country relative to the world. It avoids distortions that may be created or implied by attention to economic or fundamental statistics, such as population, consumption, trade balances or GDP.

By focusing on an investment metric rather than on economic reports, the chart further reinforces the need for a disciplined, strategic approach to global asset allocation. Of course, the investment world is in motion, and these proportions will change over time as capital flows to markets offering the most attractive returns.

Viewing the world map by relative market capitalisation illustrates the importance of building a globally diversified portfolio and avoiding a home market bias.

The second and third diagrams below serve to make the point further.

This table in diagram 2 ranks annual stock market performance in US dollar terms for eighteen different global markets (from highest to lowest) over the last twenty-five years. The colours correspond to the countries featured on the next slide, and the patchwork dispersion of colours shows no predictable pattern.

Diagram 2

Investors who follow a structured, diversified strategy are more likely to capture the returns wherever they happen to occur. Investing in securities markets outside the UK helps build more extensive diversification into a portfolio.

The chart in diagram 3 shows annual performance in US dollar terms of eighteen developed-country stock markets for the last twenty-five years, highlighting the top performer in each calendar year. Over this period, the UK market was only the top performer once.

Diagram 3

Although many investors prefer to keep their capital close to home, they may pay a high price in terms of lower diversification and missed opportunity.

Next time you hear geographically related speculation, try to imagine predicting the the next line of colours in diagram 2…

Malcolm Stewart

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Wealth Modelling – Historical Simulation

February 22, 2012

Wealth Modelling – Historic simulation.

Past performance is not indicative of future results. You will notice this disclaimer, albeit with minutely different wording, on every single piece of investment literature available. However we can use the past to see what kind of turbulence investors in times gone by have had to face, and think about how prepared we can be as market volatility continues into the future.

Using our wealth modelling system we can bring history into focus and actually use it to model what really would have happened to you if you had been one of these earlier investors. In other words we can answer the following question:

  • If you first invested with this asset allocation many years ago, how would it have performed?

With historical market data, we project forward how your wealth would fluctuate if the market behaved in the same way.

Take our client Mr Example(i), Chart 1 below shows the normal projection for his net worth from today until mortality. His chosen portfolio grows at an average of 6.85% (ii). The chart has been displayed in real terms to allow us to take the inflation growth out of the equation and see how the actual monetary growth of his assets fluctuated over time.

Mr Example is 41 with a projected mortality of 90 so he potentially has 49 years of investing ahead. Taking the most recent 49 years of market information and using this to be the background market data for the next 49 years we can show his projections modelled on the historical data and this is reflected in Chart 2. Chart 3 displays the historical selection we are making.

In essence the system projects forward as though we are living from 1961 to 2010. It thus includes all the booms and busts in between, and we can see how Mr Example was affected in this period.

 

So what does this tell us? Firstly from the calculated growth of £1,000 display in Chart 3 and the significantly higher numbers Mr Example hits in Chart 2, this was a fine long term period to be invested.

Secondly, Chart 2 also lets us consider how Mr Example might have felt at age 53, 81 and 88 (the 70s, 2001 and 2008 recessions). Not good I suspect. This is where would be vital for him to have the investment discipline to ignore market noise that is integral to our investment philosophy. He must think about the long term picture, and he is rewarded for doing so: not even the deepest recessions in recent times hold back his growth for long.

This is just one of the many tools we have at our disposal to model potential losses for our clients. It is something we can all relate to, and for that reason it is a particularly interesting exercise.

Past performance doesn’t indicate future performance, but it can let us know the kind of turbulence we will always have to face as investors.

For more information on this or anything else, please get in touch.

Malcolm Stewart

22 Feb 2012

i Mr Example has been kept relatively simple for illustration purposes. He has an income of £75,000, cash savings of £20,000 (unaffected by simulation), and ISA & Portfolio investments of £150,000 in total in a ‘Cautious Growth’ portfolio (40% fixed interest, 60% equities). His total expenses per year is £35,000. He is 41 currently and is going travelling for 5 years in retirement

ii Novia Financial Plc Market Assumptions

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5th August 2011 – response to market conditions

August 5, 2011

In the uncertainty surrounding North America and Europe lately, and the sharp fall in the markets that has come with it, it is easy to both feel panicked and miss out on the good news in the global markets.

It is fitting to refer you to pages 8 and 9 of our Informed Investor brochure (see the link above) to understand the emotional ride you must take with investment, and why panicking now is the very worst thing you can do.

It is also fitting to mention these lesser headlines that you may well not have been exposed to, but your well diversified portfolio will have: –

  • Robust Growth in Germany Pushes Prices—Analysts see a strong chance that German inflation will head towards 3 per cent by the end of the year against a backdrop of robust growth in Europe’s biggest economy. (Reuters, July, 27, 2011)
  • Brazil Domestic Demand Still Strong—The Economist Intelligence Unit says economic growth in Brazil surprisingly picked up speed in the first quarter, challenging the government’s efforts to cool the expansion. (EIU, July 6, 2011)
  • Japan Retail Sales Top Estimates—Japan’s retail sales rose 1.1 per cent in June, exceeding all economists’ forecasts and adding to signs the economy is bouncing back from an initial post-disaster plunge. (Bloomberg, July 28, 2011)
  • No Fear in China—Traders betting on gains in China’s biggest companies are pushing options prices to the most bullish level in two years. The Chinese economy is projected to grow by 9.4 per cent in 2011. (Bloomberg, July 28, 2011)
  • Southeast Asia Booms—Southeast Asian markets are the world’s top performers in 2011 thanks to strong economic and corporate fundamentals. Thailand’s index hit a 15-year high in July and Indonesia’s a record high. (Reuters, July 22, 2011)
  • Australian Boom Keeps Rate Rise on the Agenda—The Australian dollar hit its highest level in 30 years in late July as traders looked to the prospect of another rise in interest rates on the back of a resource investment boom. (WSJ, July 27, 2011)
  • NZ Bounces Back—The New Zealand economy has grown more strongly than expected after the Christchurch earthquake, helped by improving terms of trade. The Reserve Bank signals it may raise interest rates soon. (Bloomberg, July 28, 2011)

Roland Oliver

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The long term futility of active management

June 15, 2011

A couple of weeks ago Roland mentioned a few reasons why we strongly believe in asset class investing – buying a complete representation of the market in each asset class and staying away from the two key features of active management: market timing and stock picking.
A lot of research has taken place in academic economics into the true cost of active investing and whether, on average, active managers can consistently beat the average market return after transaction and management costs are taken into account.
We believe this academic evidence, coupled with some solid figures from Standard and Poor’s Indices Versus Active (SPIVA) research, explains why even the most successful active managers of recent times, Warren Buffett and Peter Lynch, stated that passive management is best for most investors.
Using the small space a blog article allows, I will briefly go into more depth below.
This excerpt from The Cost of Active Investing by Prof Kenneth R French explains the futility of the average active manager’s task:
“Whether fund of fund investors break even or not, a passive market portfolio produces a higher return than the aggregate of all active portfolios. Why do active investors continue to play a negative sum game? Perhaps the dominant reason is a general misperception about investment opportunities. Many are unaware that the average active investor would increase his return if he switched to a passive strategy.
Financial firms certainly contribute to this confusion. Although a few occasionally promote index funds as a better alternative, the general message from Wall Street is that active investing is easy and profitable.
This message is reinforced by the financial press, which offers a steady flow of stories about undervalued stocks and successful fund managers.
Overconfidence is probably the other major reason investors are willing to incur the extra fees, expenses, and transaction costs of active strategies. There is evidence that overconfidence leads to active trading. (See, for example, Odean (1998), Barber and Odean (2001), and Statman, Thorley, and Vorkink (2006).) Investors who are overconfident about their ability to produce superior returns are unlikely to be discouraged by the knowledge that the average active trader must lose.”
According to Fama’s efficient market hypothesis, all information is already factored into a stock’s price. The very existence of active management makes this so. When we include the higher fees, expenses, and trading costs, it is clear that active investors are playing a negative sum game.
Mr French concludes thus: ‘If a representative investor switched to a passive market portfolio, he would increase his average annual return by 67 basis points over the 1980 to 2006 period.”

The figures taken from the SPIVA research show that in the US and Australia over a 5 year horizon well over half of the active managers fail to outperform indices. Not only this, the inconsistency of fund performance makes it hard to anyone to pick a winning manager. In the US, over the five years ending March 2011, only 0.96% of large cap funds, 1.14% of mid-cap funds and 2.59% of small cap funds maintained a top half ranking over five consecutive 12 month periods.

I must clarify that we do not believe that there are no active managers who can perform well. But the task of picking the few that do perform consistently better than the market over a long investment horizon is futile.
Some investors do trade actively because they really are able to produce superior returns.
The existence of superior investors, however, does not explain the behaviour of the average investor. Active investing is still a negative sum game. Every pound a superior investor earns must increase the aggregate losses of all other active investors.
We do not accept that the City or Wall Street can predict the future, and we certainly would not bet ours or your money on it.

Malcolm Stewart

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