How to protect the money you've made

By Tim Price Jun 18, 2007

Tim Price

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As Warren Buffett, the world’s most successful investor, once said, it’s only when the tide goes out that you learn who’s been swimming naked. Over recent weeks, the tide in the US subprime mortgage market has most definitely retreated.

Only time will tell whether the beaches will be littered with naked swimmers. Certainly, fears of the carnage spreading have affected equity markets and high-yield credit markets alike. But the market volatility that erupted in February has also reminded the market that investing is never a one-way bet – it just seems that way when investor complacency abounds, as it did just before the sell-off. Still, if recent losses prove a more general reminder of some defensive principles, those billions of dollars, pounds and euros will not have evaporated in vain.

To quote Buffett again, “Rule Number One: never lose money. Rule Number Two: never forget Rule Number One.” This isn’t as trite as it sounds. Not only is losing money contrary to the basic aim of investing, but we find it disproportionally upsetting. Cognitive scientists Amos Tversky and Daniel Kahneman have led ground-breaking studies into human loss-aversion, essentially showing that we feel the emotional impact of losing money at least twice as profoundly as that of making money. For many investors interested in sleeping soundly at night, therefore, avoidance of loss is key to building a portfolio. This doesn’t mean just putting your money in a saving account and leaving it there; it means developing a nuanced understanding of market volatility, calculated risk, and our own deficiencies.

Investment risk: how much should you diversify?

Every investor must think about how much risk he is prepared to take on. Your response to the sudden market slides in the last few weeks should have given you some clues about how much you can cope with and hence how to construct your portfolio. For most private investors, equities remain the asset class of choice for longer-term capital growth. We’re told to believe in “stocks for the long run”. But is this a low-risk strategy? I don’t think so. The problem is that the virtual certainty of positive returns only arrives over a period longer than most of us could tolerate – 20 years or more. This also takes no account of those of the world’s stockmarkets that closed and never reopened.

This is not to say that there isn’t room for equity investing in a balanced portfolio – of course there is. In The Bear Book: Survive and Profit in Ferocious Markets (1998, John Wiley), John Rothchild highlights a few key defensive sectors: soft drinks firms, pharmaceuticals, food suppliers, major oils, household products, telephones, tobacco, utilities and gold. Markets are dynamic, so some of these defensive sectors have already lost some of their lustre since Rothchild’s book was first published. Pharmaceuticals, for example, have had to cope with a slowing pipeline of blockbuster discoveries and the simultaneous rise of generic competitors; telecommunications firms have lost their monopoly status and are faced with the rise of mobile and internet competition. Nevertheless, as a starting point for a stock portfolio, Rothchild’s selection has merit. Even better news is that with the growth of exchange traded funds especially sector funds, investors can now get the merits of diversification with a single asset.

Investment risk: what to include in a balanced portfolio

Still, equities alone can’t make up a solid defensive portfolio. What else should be included? No investment is entirely without risk – even money in the bank carries the risk that the bank becomes insolvent, or that its purchasing power will be destroyed by inflation. But in terms of simple volatility or risk of loss, ‘low-risk’ investments start with cash, investment-grade government bonds, and then corporate bonds. As one’s risk appetite grows, large capitalisation stocks enter the picture, along with high-yield bonds.

But it’s worth questioning how much value bonds will likely generate within a private portfolio with a limited requirement for the generation of income. It’s in the interests of the issuers of bonds – be they governments or corporations – to destroy their value. One should also question the unthinking stampede of long-term institutional capital into the Government bond market and into assets that have no possibility of generating decent real returns over the long run because they will only ever offer a sequence of fixed, nominal returns at the mercy of future inflation – or default.

Rising further up the risk ladder, we get to small capitalisation stocks, convertible bonds and then to more complex financial instruments. In each case, we are moving further away from ‘efficient’ markets (or ‘traditional’ asset management) and towards areas where there’s greater scope to add value from market inefficiency (or ‘alternative’ asset management) – towards hedge funds, private equity, commodities and property. There is no easy answer to optimal allocation between asset classes. But a general principle must surely be that diversification is in the best interests of the investor, not least because at times of acute market stress, genuine asset-class diversification offers a realistic chance of capital preservation.

For proof, consider the Yale Endowment as managed by David Swensen. As at June 2006, this portfolio was invested across hedge funds (23.3%), US equities (11.6%), bonds (3.8%), international equities (14.6%), private equity (16.4%), “real assets” (timber, energy and natural resources, at 27.8%) and cash (2.5%). Note the significant allocations to so-called ‘alternative’ investments (hedge funds, private equity and natural resources) at the expense of more traditional asset classes. But note too the success of this strategy: Yale Endowment has a 20-year track record of returning annual average returns of 15.4%.

Why it's now easier for ordinary investors to diversify

This is where the good news comes in: 20 years ago, the average investor wouldn’t have had a chance of replicating either Yale’s strategy or success. Today, he has. The last decade has seen extraordinary innovation – we now have access to instruments that the previous generation could barely have dreamed of: exchange-traded funds, inflation-protected bonds, capital-guaranteed structured notes, closed-end funds of hedge funds and private-equity funds. The fully stocked financial supermarket is open for business and that means we all can, and should, aim to make regular absolute returns on our money.

Why, for example, would one give ones money to so-called active managers who practised little more than index tracking and so lost fortunes during the bear market, rather than to one of the hedge funds that did not? Any hedge fund worthy of the name should be viewed as a “stay rich”, and not necessarily as a “get rich”, investment. The point is to generate solid positive returns irrespective of market direction – the primary focus is on capital preservation, and absolutely not on “growth at any price”. Hedge funds are widely misunderstood and the range of styles is too broad for hedge funds to qualify as a distinct asset class, but one thing we can say is that, on average, they have hugely outperformed equity indices since 2000 – primarily because they never, as a whole, incurred significant losses. Between December 1999 and January 2007, the CSFB/Tremont index of hedge funds returned 77%. Comparable returns from the FTSE 100 and the S&P 500 index were 13% and 10% respectively. 

The private investor’s universe – once made up of stocks, bonds and cash and nothing else – has evolved into a cornucopia of choice. How best to use it? By taking advantage of the way it allows us to diversify. One benefit of multi-asset class investing, however, is that a diversified portfolio across equities, bonds, cash and ‘non-traditional’ investments reduces the need to have precise (subjective) opinions about market direction. Instead, the diversified investor can spend more time assessing the merits of individual securities, or of selected fund managers, and how that portfolio should fit together, and less time trying to predict the direction of markets.

In conclusion, complete safety is illusory. But we can take calculated risks, and we can diversify. And when volatility is extreme, we can always shift into cash – an asset often excoriated by fund managers who have no potential to earn fees from its use. What ultimately matters is not return on capital, but return of capital.

Tim Price is CIO: Global Strategies at Union Bancaire Privée, London.

How to create the right portfolio

Creating a balanced portfolio is easier than it once was. How much of each you hold depends on your risk profile, but here are some things I’d put in a defensively orientated portfolio.

Individual equities

I’d go for insurers, notably Legal and General and Zurich Financial. I’d also buy telecoms (BT and Vodafone) – their utility style cash flows make them defensive. For steady yields I’d buy some straight utilities – United Utilities and Kelda. From the retailers, I’d take Tesco – whatever happens in the stockmarket people will still shop there. Then I’d buy packaging firm Rexam, which on a yield of 3.39% is a classic defensive and Lloyds TSB and HSBC for their yields of 6.12% and 6.79%. I’m a fan of British American Tobacco, Altria (tobacco is a defensive investment) and General Electric and for exposure to Asia’s emerging middle class, luxury goods firms LVMH and PPR.

Exchange traded funds

ETFs really are the investor’s best friend – they are the cheapest and easiest way to diversify a portfolio in a hurry. I’d buy the Central Fund of Canada (CEF), which tracks the price of gold and silver bullion, the US-listed streetTRACKS US large cap value fund (ELV), the Telecom HOLDRS (TTH), which tracks an index of telecom funds and the iShares GBP index-linked Gilts (INXG). Also of interest are three new ETFs recently created by iShares: the iShares S&P Global Water Fund, the iShares S&P Listed Private Equity Fund and the iShares FTSE EPRA/NAREIT. UK Property Fund offers exposure to leading property firms and real estate investment trusts domiciled in the UK.

Hedge funds

This is harder. You can’t get  sufficient diversification from one alone, but most funds of hedge funds don’t perform that well. The best of the listed ones are Dexion Absolute (DAB) and Thames River Hedge+ (TRMA), but you may be better off simply buying shares in some of the hedge-fund groups instead – RAB Capital (RAB) and Man Group (EMG) are the ones to go for.

How high is the current level of investment risk?

Is the global economy heading for disaster? Niall Ferguson, whose arguments we briefly covered in last week’s issue, thinks so. The world looks very much like it did in 1914, the “first great age of globalisation”,” he warns. Amid low inflation, interest rates and volatility, markets were wrong-footed by the outbreak of World War I, resulting in a sell-off that saw the London stock exchange shut until January 1915. Ferguson warns that today’s investors are similarly blasé about the prospect of a global conflagration in the Middle East, which could cause a massive liquidity crunch.

But the trigger for a credit crunch need not be so drastic. As recent market jitters show, investors are only too aware the good times can’t last. In fact, William Conway Jr, founder of private-equity giant the Carlyle Group, recently wrote: “Frankly, there is so much liquidity in the world financial system, that lenders are making very risky credit decisions.” He added, “This liquidity environment cannot go on forever…and the longer it lasts, the worse it will be when it ends.” As Anthony Hilton says in the Evening Standard, the current boom has gone on this long partly because derivatives have enabled lenders to sell their risk on to other people. “This means that the natural ceilings on lending – the point where the banks are so bloated with loans that they no longer have the appetite for more – have failed to kick in… the big question is, what happens now?” We could be facing the “first truly modern financial crisis”.

Others are more sanguine. The optimists’ view is best represented by Anatole Kaletsky of GaveKal.com – “The world has changed beyond recognition since the early 1990s,” says Kaletsky. Globalisation, outsourcing, the internet, and the wider availability of capital have made the world a less risky place, enabling interest rates to remain at lower levels without resulting in an inflationary bust.  

As regular readers will know, we tend to side with the more bearish commentators on this issue. Prices are high, fear of risk low; mean reversion dictates that at some point this situation will reverse. We can’t tell when – given the carnage in US subprime mortgages it may be soon, but arrive it will. As Steven Pearlstein puts it in the Washington Post, all credit bubbles are finally pushed too far and “the whole thing collapses.”

Why you needn’t watch the market

On the topic of human frailty, in Fooled by Randomness: the Hidden Role of Chance in Life and in the Markets, Nassim Nicholas Taleb uses the example of a retired dentist who now plays the markets and is guaranteed to earn a 15% annual return, but with volatility of 10%, to look at how emotion affects investing.

Given the inherent volatility of markets if our imaginary dentist monitors his portfolio closely online every second, there is only a 50.02% probability of him experiencing a positive outcome at each viewing. There is a 49.98% probability, in other words, of him encountering the sort of regret highlighted in studies conducted by Amos Tversky and Daniel Kahneman.
If our dentist rigorously watches his portfolio online, at the end of each day he is going to feel exhausted. If he merely restricts the frequency of his observation to once per day, that probability of experiencing a positive outcome (ie, a gain in value) rises to 54%. If he has the discipline (or otherworldly patience) to restrict his observations to just once per month, that probability of happiness shoots up to 67%. If just once per quarter, it shoots up again to 77%, and so on.

Note that nothing is changing about his portfolio, which is still destined to deliver 15% per year – only the frequency with which he monitors it. Over a short time period, the watchful dentist encounters not so much return as variability, but nonetheless, were he prone to reacting to emotion (“easily scared” would be another way of putting it), the more he checked his portfolio, the more he would find himself both overtrading and underperforming.

Published in How to invest | More articles by Tim Price

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