Jim Parker

History On The Run

When news breaks and markets move, content-starved media often invite talking heads to muse on the repercussions. Knowing the difference between this speculative opinion and actual facts can help investors stay disciplined during purported “crises.”

At the end of June this year, UK citizens voted in a referendum for the nation to withdraw from the European Union. The result, which defied the expectations of many, led to market volatility as participants weighed possible consequences.

Journalists responded by using the results to craft dramatic headlines and stories. The Washington Post said the vote had “escalated the risk of global recession, plunged financial markets into free fall, and tested the strength of safeguards since the last downturn seven years ago.”1

The Financial Times said “Brexit” had the makings of a global crisis. “[This] represents a wider threat to the global economy and the broader international political system,” the paper said. “The consequences will be felt across the world.”2

It is true there have been political repercussions from the Brexit vote. Theresa May replaced David Cameron as Britain’s prime minister and overhauled the cabinet. There are debates in Europe about how the withdrawal will be managed and the possible consequences for other EU members.

But within a few weeks of the UK vote, Britain’s top share index, the FTSE 100, hit 11-month highs. By mid-July, the US S&P 500 and Dow Jones Industrial Average had risen to record highs. Shares in Europe and Asia also strengthened after dipping initially following the vote.

Yes, the Brexit vote did lead to initial volatility in markets, but this has not been exceptional or out of the ordinary. One widely viewed barometer is the Chicago Board Options Exchange Volatility Index (VIX). Using S&P 500 stock index options, this index measures market expectations of near-term volatility.

You can see by the chart above that while there was a slight rise in volatility around the Brexit result, it was insignificant relative to other major events of recent years, including the collapse of Lehman Brothers, the eurozone crisis of 2011, and the severe volatility in the Chinese domestic equity market in 2015.

None of this is intended to downplay the political and economic difficulties of Britain leaving the European Union, but it does illustrate the dangers of trying to second-guess markets and base an investment strategy on speculation.

Now the focus of speculation has turned to how markets might respond to the US presidential election. CNBC recently reported that surveys from Wall Street investment firms showed “growing concern” over how the race might play out.3

Given the examples above, would you be willing to make investment decisions based on this sort of speculation, particularly when it comes from the same people who pronounced on Brexit? And remember, not only must you correctly forecast the outcome of the vote, you have to correctly guess how the market will react.

What we do know is that markets incorporate news instantaneously and that your best protection against volatility is to diversify both across and within asset classes, while remaining focused on your long-term investment goals.

The danger of investing based on recent events is that the situation can change by the time you act. A “crisis” can morph into something far less dramatic, and you end up responding to news that is already in the price.

Journalism is often described as writing history on the run. Don’t get caught investing the same way.

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The Wine Lovers Guide to Investing

Savoring a vintage wine is one of life’s great pleasures. But often overlooked in the joy of consumption is the carefully calibrated journey from grape to glass. Similar levels of care are critical to good investment outcomes.

A host of variables can determine whether a wine is great, good, mediocre, or undrinkable. These include the quality of the grapes, soil, position of the vineyard, weather, irrigation, and timing of the harvest.

And picking the grapes isn’t the end of it. The harvest must be sorted, the grapes crushed and pressed, then fermented, clarified, aged, and bottled. At any stage of the process, a lack of attention to detail can spoil the final outcome.

As in winemaking, investment management requires attention to detail—researching and identifying the dimensions of expected returns, designing strategies to capture the desired premiums, building diversified portfolios, and implementing efficiently.

Just as winemakers don’t have any say over the weather, investment managers can’t control the markets. Not every harvest will produce an excellent vintage, but expert professionals can still maximize their chances of success by putting their greatest efforts into things they can influence.

For winemakers, that may be taking extreme care in picking the grapes at a time that delivers the desired balance of acidity and sweetness. For investment managers, it can mean precisely targeting the desired premiums while ensuring sufficient diversification to lessen idiosyncratic risk in the portfolio.

Winemaking is as much an art as a science. While fermentation comes naturally, the winemaker must still guide the process, using a variety of techniques to ensure the wine is as close as possible in style and flavor to what he is seeking to achieve.

Similarly in investment, real world frictions mean that basing one’s approach purely on a theoretical model is unlikely to be successful. For instance, tradeoffs must continually be made between the expected benefits of buying particular securities and the expected costs of the transactions. Managing the effects of momentum and being mindful of tax considerations are among the other issues to be balanced.

Just as in viticulture, investment outcomes can also be affected by any number of external events—such as the imposition of capital controls in an emerging market, or changes in regulation, a severe financial crisis, or a major geopolitical event.

Dealing with uncertainty and navigating the “unknown unknowns” are part of the job. So investment managers must build into their processes a level of resilience—through diversification for instance—so they have sufficient flexibility to work around unforeseen events.

Ultimately, the benefits of discipline and attention to detail are easy to overlook. Great ideas count for a lot, of course. But great ideas without efficient implementation can mean even the best grapes in the world go to waste.

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10 Reasons to be Cheerful

Do you ever listen to the news and find yourself thinking that the world has gone to the dogs? The roll call of depressing headlines seems endless. But look beyond what the media calls news, and there also are a lot of things going right.

It’s true the world faces challenges in many areas, and the headlines reflect that. Europe has been grappling with a flood of refugees; as of May, the Chinese local A-share market declined by almost 20 percent1; and the US is in the middle of a sometimes rancorous election campaign.

More recently, citizens of the United Kingdom voted to leave the European Union, creating significant uncertainty in markets over the long-term implications.

But it’s also easy to overlook the significant advances made in raising the living standards of millions, increasing global cooperation on various issues, and improving access to healthcare and other services across the world.

Many of the 10 developments cited below don’t tend to make the front pages of daily newspapers or the lead items in the TV news, but they’re worth keeping in mind on those occasions when you feel overwhelmed by all the grim headlines.

So here’s an alternative news bulletin:

  1. Over the last 25 years ending May 2016, one dollar invested in a global portfolio of stocks would have grown to more than five and a half dollars.2

  2. Over the last 25 years, 2 billion people globally have moved out of extreme poverty, according to the latest United Nations Human Development Report.3

  3. Over the same period, mortality rates among children under the age of 5 have fallen by 53%, from 91 deaths per 1000 to 43 deaths per 1000.

  4. Globally, life expectancy has been improving. From 2000 to 2015, according to the World Health Organization, the global increase was 5.0 years, with an even larger increase of 9.4 years in parts of Africa.4

  5. Global trade has expanded as a proportion of GDP from 20% in 1995 to 30% by 2014, signalling greater global integration.5

  6. Access to financial services has greatly expanded in developing countries. According to the World Bank, among adults in the poorest 40% of households within developing economies, the share without a bank account fell by 17 percentage points on average between 2011 and 2014.6

  7. The world’s biggest economy, the US, has been recovering. Unemployment has halved in six years from nearly 10% to 5%.7

  8. The world is exploring new sources of renewable energy. According to the International Energy Agency, in 2014, renewable energy such as wind and solar expanded at its fastest rate to date and accounted for more than 45% of net additions to world capacity in the power sector.8

  9. We live in an era of innovation. One report estimates the digital economy now accounts for 22.5% of global economic output.9

  10. The growing speed and scale of data is increasing global connectedness. According to a report by McKinsey & Company, cross-border bandwidth has grown by a factor of 45 in the past decade, boosting productivity and GDP.10

No doubt many of these advances will lead to new business and investment opportunities. Of course, not all will succeed. But the important point is that science and innovation are evolving in ways that may help mankind.

The world is far from perfect. The human race faces challenges. But just as it is important to be realistic and aware of the downside of our condition, we must also recognize the major advances that we are making.

Just as there is reason for caution, there is always room for hope. And keeping those good things in mind can help when you feel overwhelmed by all the bad news.

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2016: Ten Predictions to Count On

The New Year is a customary time to speculate. In a digital age, when past forecasts are available online, market and media professionals find it hard to hide their blushes when their financial projections go awry.  But there are ways around that.

The ignominy that goes with making bold forecasts was highlighted in a recent newspaper article, which listed many bad calls US economists had made about 2015. These included getting the timing of the Federal Reserve’s interest rate increase wrong, incorrectly calling for a rise in long-term bond yields, and assuming an end to the commodity rout.

For the broad US equity market, 22 strategists polled by the Wall Street Journal2 estimated an average increase for the S&P 500 of 8.2% for 2015. The most optimistic individual forecast was for a rise of 14%. The least optimistic was 2%. No one picked a fall. As it turned out, the benchmark ended marginally lower for the year.

In the UK, a poll of 49 fund managers, traders, and strategists published in early January 2015 forecast that the FTSE 100 index would be at 6,800 by midyear and 7,000 points by year-end. As it turned out, the FTSE surpassed that year-end target by late April to hit a record high of 7,103 before retracing to 6,242 by year-end.

Australian economists were little better. The consensus view, according to a January 2015 Fairfax Media poll, was that local official interest rates would stay on hold all year. The Reserve Bank of Australia proved that wrong a month later, before cutting rates again in May.

It shouldn’t be a surprise that if economists can’t get the broad variables right, it must be tough for stock analysts to pick winners. Even a stock like Apple, which for so many years surprised on the upside, disappointed some forecasters last year with a 4.6% decline.

In Australia, the “Top Picks for 2015” published by one media outlet a year ago included such names as Woodside Petroleum, BHP Billiton, Origin Energy, and Slater & Gordon, all of which suffered double-digit losses in the past year.

It should be evident by now that setting your investment course based on someone’s stock picks or expectations for interest rates, the economy, or currencies is not a viable way of building wealth in the long term. Markets have a way of confounding your expectations. So a better option is to stay broadly diversified and, with the help of an advisor, set an asset allocation that matches your own risk appetite, goals, and circumstances.

Of course, this approach doesn’t stop you or anyone else from having or expressing an opinion about the future. We are all free to speculate about what might happen in the economy and markets. The danger comes when you base your investment strategy on such opinions.

In the meantime, if you insist on following forecasts, here is a list of 10 predictions you can count on coming true in 2016:

  1. Markets will go up some of the time and down some of the time.

  2. There will be unexpected news. Some of this will move prices.

  3. Acres of newsprint will be devoted to the likely path of interest rates.

  4. Acres more will speculate on China’s growth outlook.

  5. TV pundits will frequently and loudly debate short-term market direction.

  6. Some economies will strengthen. Others will weaken. These change year to year.

  7. Some companies will prosper. Others will falter. These change year to year.

  8. Parts of your portfolio will do better than other parts. We don’t know which.

  9. A new book will say the rules no longer work and everything has changed.

  10. Another new book will say nothing has really changed and the old rules still apply.

You can see from that list that if forecasts are so hard to get right, you are better off keeping them as generic as possible. Like a weather forecaster predicting wind, hail, heat, and cold over a single day, your audience should prepare themselves for all climates.

The future is always uncertain. There are always unexpected events. Some will turn out worse than you expect; others will turn out better. The only sustainable approach to that uncertainty is to focus on what you can control.

In the meantime, let me wish a happy new year to you all.

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Second-Hand News

Why doesn’t the media run more good news? One view is bad news sells. If people preferred good news, the media would supply it. But markets don’t see news as necessarily good or bad, rather in terms of what is already built into prices.

One academic study appears to confirm the view that the apparent preponderance of bad news is as much due to demand as to supply, with participants more likely to select negative content regardless of their stated preferences for upbeat news.

"This preference for negative and/or strategic information may be subconscious," the authors conclude. "That is, we may find ourselves selecting negative and/or strategic stories even as we state that we would like other types of information."

So an innate and unrecognized demand among consumers for bad news tends to encourage attention-seeking commercial media to supply more of what the public appears to want, thus fueling a self-generating cycle.

Insofar as consumers of news are investors, though, the danger can come when the emotions generated by bad news prompt them to make changes to their portfolios, unaware that the news is likely already built into market prices.

This is especially the case when the notions of "good or bad" are turned upside down on financial markets. For example, stocks and Treasuries rallied and the US dollar weakened in early October after a weaker-than-expected US jobs report. Some observers said the "bad news" on jobs was "good news" for interest rates.

Conversely, a month later, stocks ended mixed, bonds weakened, and the US dollar rallied after a stronger-than-expected payrolls number. While an improving job market is good news, it was also seen by some as cementing the case for the Federal Reserve to begin raising interest rates. In both cases, the important thing for markets was not whether the report was good or bad but how it compared to the expectations already reflected in prices. As news is always breaking somewhere, expectations are always changing.

For the individual investor seeking to make portfolio decisions based on news, this presents a real challenge. First, to profit from news you need to be ahead of the market. Second, you have to anticipate how the market will react. This does not sound like a particularly reliable investment strategy.

Luckily, there is another less scatter-gun approach. It involves working with the market and accepting that news is quickly built into prices. Those prices, which are forever changing, reflect the collective views of all market participants and reveal information about expected returns. So instead of trying to second-guess the market by predicting news, investors can use the information already reflected in prices to build diverse portfolios based on the dimensions that drive higher expected returns.

As citizens and media consumers we are all entitled to our individual opinions on whether news is good or bad. As investors, though, we can trust market prices to assimilate news instantaneously and work from there.

In a sense, the work and the worrying are already done for us. This leaves us to work alongside an advisor to build diverse portfolios designed around our own circumstances, risk appetites, and long-term goals.

There’s no need to respond to second-hand news.

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Which Hat Are You Wearing?

Most of us have multiple roles—as business owners, professionals, workers, consumers, citizens, students, parents and investors. So our views of the world can differ according to whatever hat we’re wearing at any one time.

This complexity of people and their range of motivations, depending on their circumstances, highlight the inadequacy of cookie-cutter or automated investment solutions.

For instance, if you work for a taxi booking firm, you’re naturally going to take greater-than-usual interest in technology that allows consumers to book cabs directly. That’s because these new disintermediated services might affect how you make your living.

On the other hand, as a consumer you may welcome any initiative that increases competition, widens your choice and lowers prices.

As a taxpayer, you may look kindly on efforts to encourage user-pays systems in universities. But as a parent, you may be concerned about your teenage children taking on excessive debt to fund their education.

As citizens, we might champion a laissez faire approach to economic policy. But as investors, we may feel uncomfortable about certain policies and seek to express our values by placing limits on how our money is invested.

The point is everyone has the right to their own opinions and intelligent people can legitimately and respectfully disagree on many issues, including about what might happen in the world economy and about how policymakers should act.

The trick is in being clear with ourselves about which hat we are wearing when we make investment decisions and the trade-offs involved in reconciling our personal opinions with our desired investment outcomes.

For example, you may have an opinion on what central banks should do in normalizing interest rates. But do you really want to hang your decision about your portfolio allocation to longer-term bonds on your view of the interest rate outlook?

As a worker in an industry undergoing digital disruption, you may have an aversion to the technology putting you out of a job. But as an investor, do you want to forsake earning a share of the wealth from the new forces created by this disruption?

As a resident of a suburb near the airport, you may oppose on noise grounds a government decision to build a new runway, but as an investor and a worker you might benefit from the increased productivity generated by the investment.

The point is we have many roles in life and there often can be conflicts between our personal beliefs and opinions in one area with our desires in another.

Our strong view on the economic outlook may lead us to think the market will come around to pricing assets based on that opinion. But the power of markets is such that they reflect the views of millions of people, many of whom may hold contrary views.

Keep in mind, also, that competitors in those markets include professional investors with multiple sources of information and state-of-the-art technology. And even they have trouble getting these forecasts right with any consistency.

This isn’t to say we can’t invest based on our personal principles. But we first have to start from the assumption that in liquid markets competition drives prices to fair value. Prices reveal information about expected returns. That leaves us to diversify around known risks according to our own preferences and goals.

In short, life is full of trade-offs. It is the same in investment. We may pursue higher expected returns, but we want to do so without sacrificing diversification or cost.

The over-riding principle is to understand what we can and can’t control. We can have an opinion on government policy and we can express it through our vote, but we can’t control the investment outcome. We can have an opinion on what should happen to interest rates, but we can’t control what happens. So we diversify.

The role of a financial advisor is to help you understand these trade-offs and to separate opinion from fact, to balance your risk preferences with your desired wealth outcomes, and to accommodate your personal values within a diversified portfolio.

People with many hats require many different investment solutions. And that’s a good thing.

 

Unhealthy Attachments

Have you ever made yourself suffer through a bad movie because, having paid for the ticket, you felt you had to get your money’s worth? Some people treat investment the same way.

Behavioral economists have a name for this tendency of people and organizations to stick with a losing strategy purely on the basis that they have put so much time and money into it already. It’s called the “sunk cost fallacy.”

Let’s say a couple buy a property next to a freeway, believing that planting trees and double-glazing will block out the noise. Thousands of dollars later the place is still unlivable, but they won’t sell because “that would be a waste of money”.

This is an example of a sunk cost. Despite the strong likelihood that you’ll never get your money back, regardless of outcomes, you are reluctant to cut your losses and sell because that would involve an admission of defeat.

It works like this in the equity market too. People will often speculate on a particular stock on the basis of newspaper articles about prospects for the company or industry. When those forecasts don’t come to pass, they hold on regardless.

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The Patience Principle

Global markets are providing investors a rough ride at the moment, as the focus turns to China’s economic outlook. But while falling markets can be worrisome, maintaining a longer term perspective makes the volatility easier to handle.

A typical response to unsettling markets is an emotional one. We quit risky assets when prices are down and wait for more “certainty.”

These timing strategies can take a few forms. One is to use forecasting to get out when the market is judged as “overbought” and then to buy back in when the signals tell you it is “oversold.”

A second strategy might be to undertake a comprehensive macro-economic analysis of the Chinese economy, its monetary policy, global trade and investment linkages, and how the various scenarios around these issues might play out in global markets.

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The China Syndrome

The recent severe volatility in China’s share markets has raised questions among many investors about the causes of the fall and the wider implications for the global economy and markets.

The Shanghai Composite Index—the mainland stock market barometer and one dominated overwhelmingly by retail investors—more than doubled during the year from mid-2014, only to lose more than 30% of its value between mid-June and mid-July this year.

The volatility was much less in Hong Kong, where foreign investors tend to get their exposure to China. The Hang Seng Index fell about 17% from April’s seven-year high, though it had a more modest run-up in the prior year of about 25%.

Nevertheless, the speed and scale of the fall on the Chinese mainland markets unsettled global markets, fueling selling in equities, industrial commodities, and allied currencies like the Australian dollar and buoying perceived safe havens such as US Treasuries and the Japanese yen.

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Greece is the Word

In recent weeks, the world’s markets and media financial pages have focused intensely on the standoff between debt-laden Greece and its international lenders over the conditions of any further bailout.

For investors everywhere, both of the large institutional kind and individual participants, the story has been fast-paced and difficult to keep up with. More importantly, the speculation about possible outcomes has been intense.

Of course, no one knows the eventual outcome or whether there will even be a definitive conclusion. After all, this is a story that has been percolating now for six years—since Greece’s credit rating was downgraded by three leading agencies amid fears the government would default on its debt.

Since then, the Greek situation has faded in and out of public attention as rescue packages came and went and as widespread social and political unrest gripped a nation known as the birthplace of democracy.

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