Business | Investment
Diversification: What to do in a crisis?
This article is a direct attack on financial advice seen in local newspapers that seem to be telling the layman when to buy, when to sell, and even what to swap into; buy gold and precious metals when stocks crash.
- By Sean Kelleher, Special to Gulf News
- Published: 00:02 October 13, 2008
This article is a direct attack on financial advice seen in local newspapers that seem to be telling the layman when to buy, when to sell, and even what to swap into; buy gold and precious metals when stocks crash.
Useful information? Dangerous is more like it. I have two significant allies on my side should the local media defend their "freedom of speech" right.
So to my allies: Messrs Buffett and Prof Brinson. Admittedly, some repetition on previous weeks - but CRITICAL repetition. Buffett has frequently referred to his metaphorical characters Mr Market and Mr Media. The characters stem from Buffett's mentor Benjamin Graham's description of Mr Market as a normally sane personality prone to wild swings in temperament both positive and negative.
If Graham were around today he would see Mr Market in an exceptionally negative disposition, one based on feeling and confidence, and not based on fundamentals. The result is that Buffett, despite taking the view that the US economy is "on its back", is nevertheless buying stock because Mr Market is providing medium-term pricing opportunity. The point is: Mr Market is best used as a servant, not a guide.
Another part of the "Mr Equation" is Mr Media - a personality prone to exaggerate the extremes of Mr Market. This week's journalistic advice gets close to the worst traits of Mr Media. Here is why: Two points - firstly, if the layman were to rely on newspaper advice on when to buy and what to buy, chances are that prices will have changed significantly. By the time a reporter understands it's a good idea to buy X and sell Y, the layman will be significantly disadvantaged.
Further, history will support the statement that re-bounds on equities, and the best bull years can be captured in about 10 trading days of each year. This means that advice to sell any asset when the market is down will consolidate loss. You only lose by selling. The chances of getting back in at the right time is remote. "Only baboons pick bottoms." The advice to sell stock and buy gold is encased in complexity.
Point two relates to my Magnum Ice Cream and the way markets work. The Magnum, a critical component of my UAE diet, has a wrapper on it. The full product is the wrapper and the ice cream. Take off the wrapper I still have the chocolate-wrapped ice cream. Most of what happens to the edible part of the product, "the substance", will happen with or without the wrapper, i.e. whether it melts and disappears or whether it gets eaten or goes up in value. The wrapper is a health issue. The connection with markets? Hang on a second. Most Western markets have a lot of funds and pension fund monies that are constrained by mandates that do not allow them to sell. The price of an asset goes up or down depending on whether there are more buyers than sellers.
The Magnum? If the current market were a metaphorical Magnum, the selling parties would represent the wrapper. The chocolate-wrapped ice cream is still there. Concern should occur when the chocolate starts to melt. The message then: just because Mr Market, supported by Mr Media, recognises that the wrapper has been ripped off it doesn't mean that the product has been harmed. That might happen later. We must sympathise with Mr Market's positioning that the substance might decay, but the skill is in recognising the signs of that decay. Not selling because the wrapper has been stripped.
This leads to my other ally: Prof Brinson. His quote should be typed into the header of every balance sheet: "Asset Allocation constitutes the most important step in portfolio construction, accounting for more than 90 per cent of the variability in portfolio performance over time."
Brinson was supported by a team of people to come up with this conclusion. Given that my overall point on "journalistic advice" is in respect of delivering advice to layman, than we are generally talking about the issue of building and protecting wealth, long-term retirement monies. This too is what Brinson and his mates are talking about.
To make my connection I will dumb-down Brinson into two points. Point one: Performance is about diversification. Not just spreading risk but how you spread the risk. How many different types of assets should you have and what should the weighting be? If Brinson had been employed by local media he may be guided towards advice that says "sell some equities and buy more gold", but no way would he mean sell all your equities and swap all of it into gold. The difference is colossal in respect of the medium-term overall result.
Efficient frontier
Point two: individual sell and buy decisions should not impact on an overall portfolio. As Markowitz pointed out the most efficient performance result will come from buying the asset that goes up the most. Currently that looks like a Van Gough! Yet his Nobel Prize was based on accepting that he would never know the answer to that so his alternative was to invest in as many different assets as possible where the key difference was their uncorrelated nature and their different volatilities. His "efficient frontier" thinking was about reducing risk and is not a million miles away from Brinson's point on overall asset allocation.
Concluding: If you need support don't expect Mr Media to be of any use. Mr Media unchecked is dangerous. We may be in a crisis, but it isn't actually the first. Therefore, good advice should be centred on planning your money around crisis. This one will be followed by Mr Market's next wobbly. Diversification allows for planning. Evidence of the success of planned actions is seen within RMBI's Multi-Manager portfolios. Portfolios that mix both assets and management styles. The result is negatives for year-on-year of around minus three per cent (conservative portfolios) to minus 10 per cent (aggressive portfolios) - against equity markets in free-fall. While this represents poor absolute returns they also represent some positioning into equities for an eventual rebound. Not even they pretend to know when that rebound will occur. The negative component therefore embeds a positive story.
My grand-dad's economic theories were frequently wrapped with an "I lived through the Great Depression", meaning that he had insights that less-depressed experiences would not feel. We are living through a Great Something. Currently a "Great Credit Crunch", maybe the "Great Recession", hopefully not An Even Greater Depression than the previous one. One thing is for sure - asset prices are in free-fall, but the Magnum-substance hasn't disappeared [yet]. What we live through will be remembered by what we come out of it with. Gamble on Gold or diversify through proper planning and expert advice - your choice.
- The writer is chairman of Mondial Financial Partners.
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