Investment decisions are made in situations of uncertainty, and so risk is involved. Whilst the future is uncertain, past and particularly current circumstances are not. Indeed, these current circumstances provide the well-researched and informed investor with a better understanding of probable long-term outcomes. Less informed investors are more vulnerable to poor decision making, which may work well in the short term, but can cause very poor long-term outcomes. From our experience of reading, listening to and talking with other professional investors, we believe that many:-
• Were unable to identify the possibility of a global financial crisis in 2008/9.
• Are unaware of the full extent of the current global debt problem and its potential consequences.
• Are unaware of the potentially significant generational losses that may occur in conventional stock, bond and property markets from currently excessively elevated valuation levels.
• Misunderstand the causes and consequences of high rates of inflation.
• Are unaware of how to appropriately invest through an inflationary period
These inabilities, misunderstandings and/or poor knowledge often come from a commercial and/or behavioural bias, as well as from an unwillingness to commit time and resources towards undertaking necessary research. By maintaining a high level of research, a professional investor can achieve greater ability, knowledge and understanding. Whilst better ability, knowledge and understanding do not guarantee improved longer-term investment outcomes, it does considerably improve the probability of improved longer-term investment outcomes.
Different people are comfortable with different levels of risk. A person’s risk tolerance is the level of risk with which he or she is comfortable.
The financial services industry is preoccupied with volatility as the only method of measuring risk and hence meeting the attitude to risk of their clients. Unfortunately, the volatility of any particular investment changes as economic; credit and valuation risks change. For example, the volatility of zero dividend preference shares increased 3.6 times between 2000 and 2002 (source: Money Management) going from a low volatility to a high volatility investment, and between December 2007 and December 2009 the volatility of the UK Stock Market more than doubled (source: Money management). Some believe that investing and holding one particular asset and disregarding its valuation will produce successful returns. Every asset class becomes over valued at some point in time and it is important to ensure that investments are not purchased near this point of over valuation. For example:-
•The Herengracht district in Amsterdam is the only part of the world that has retained detailed property and inflation data going back to 1628. This data demonstrates that property prices can fall by as much as 66% adjusted for inflation within thirty years and by around 80% over the longer term. Source: Eicholtz Piet M A 1997;
•Cash lost 2.6% per annum adjusted for inflation between 1934 and 1955 and 3.3% per annum adjusted for inflation between 1969 and 1979 (source: BZW Gilt Equity Study);
•Gilts lost 17.2% per annum (121.1%) adjusted for inflation between 1915 and 1920 (source: BZW Gilt Equity Study);
•The UK stock market lost 73% adjusted for inflation between 1972 and 1974 (source: BZW Gilt Equity Study) and
•Technology stocks lost 90% adjusted for inflation between 2000 and 2002 (source: Money Management).
Many advisers, having lost money for clients with the fall in stock markets between 2000 and 2003, have attempted to appease the anxiety of their clients by diversifying into Stock markets and Property only to see both fall heavily in 2007/2008. Consequently they are now creating balanced or diversified portfolios. They tend to include a mixture of assets such as shares, property and bonds. Each of these investments is sensitive to a rise in interest rates. According to the BZW Gilt Equity Study 2005, the demographics of the UK suggest that we will go through a period of rising inflation and interest rates over the next ten years which in our opinion is likely to require a negative capital revaluation of these investments as the costs of funding them is increased. Another possible problem of balanced or diversified portfolios is that investments that perform poorly tend to negate or reduce the returns achieved in positive areas.
Others are turning to more sophisticated methods of supposedly reducing risk such as hedge funds and credit derivatives. The real risk being that the organisation with whom a contract is held may not be able to settle the contract that has been placed with them. That would be very painful if an investment had been called correctly but could not be collected because of the poor credit worthiness of the counterparty. Do not suppose that the large banks are exempt as they are currently exposed to a huge amount of credit risk from many sources.