Everyone loves market premiums. But not everyone can withstand the risks. There are two possible responses – try to time the premiums or ride out the risk for the return on the other side. Which works better? Let’s look at history.

When markets are stormy, it’s natural to want to pull your portfolio into a safe harbour and wait for the weather to clear. Tactical asset allocation, as it is known, involves short-term adjustments to take advantage of market pricing.

The temptation to tinker is particularly strong for some people now given the poor recent performance of value stocks in Australia. A Dimensional Value index shows these low relative priced stocks have underperformed the broad market since 2010. That’s the longest stretch of value lagging since at least the early 1980s.

It’s natural, then, that some investors (and their advisors) might ask ‘where is the advantage in targeting value stocks?’

The first response to that question is that periods when value has underperformed the market are not unprecedented.

Yes, there has been a positive value premium in Australia over the long term, as there has been in other markets around the world (see chart over the page). But from year to year, realised premiums can be positive or negative. And there is no statistically reliable and proven way of timing this.

In the early 1990s, for instance, two years of poor relative returns were followed by sizeable gains. More recently, the global financial crisis encouraged a lot of second guessing. By March 2009, the market had fallen nearly 40% in a year, with value stocks falling by nearly as much. But in the subsequent year, the market came back with a vengeance, jumping nearly 38%. Value rose by almost 50% in Australia.

Getting the timing right to this extent is fiendishly difficult. The expected value premium is never negative, but we have seen that realised premiums can be both positive and negative from year to year. When it kicks in, it can do so suddenly and dramatically. And research has found no reliable way of timing it.

Imagine you’ve spent a fortune on tickets to the soccer world cup final. You take your seat and decide to go back to the bar to buy beers. But the queue is long and you end up missing the only goal. Can you afford to be out of your seat?

Nothing that has happened in the Australian market changes that view. And keep in mind that while value has underperformed domestically, there has been a positive realised value premium in other developed markets in the past year. So the notion that there is no expected reward for targeting value any more really is just a rationalisation of how people are feeling the risk.

The great value an advisor brings to a client is not in picking the turn of the market or cycle or knowing when to get out and back in again. As we have seen, these are very hard decisions to finesse. Instead, the great value an advisor brings is keeping clients in their seats so they don’t miss the goals when they are scored.

It’s an old story, but a true story. And like most old and true stories, it’s one that needs retelling every few years, because people have a tendency to forget.

The Chinese philosopher Confucius once said that life is very simple, but we insist on making it complicated. You could say the same thing about investment.

Complexity in investment often goes with a lack of transparency. The highly engineered and multi-layered financial derivatives that contributed to the global financial crisis five years ago are a case in point.

For many investors, these products were problematic because their complexity was such that it was very difficult to understand how they were designed, how they were priced and whether the proposed payoffs were right for their own needs.

Of course, there is an incentive for many players in the financial services industry and media to make investing seem complicated. For some investment banks, for instance, complexity provided a cover for over-pricing.

In contrast, there are far fewer mysteries about the underlying stocks and bonds traded each day on public capital markets, where prices are constantly in flux due to news and the ebb and flow of supply and demand.

The virtue of these highly competitive markets for most investors is that prices quickly incorporate new information and provide rich information on risk and return. From these millions of securities, diverse portfolios can be built around known dimensions of return according to the appetites and needs of each individual.

The competitive nature of public capital markets, the efficiency of pricing and the difficulty of getting an edge are what underpin the ‘efficient markets hypothesis’ of Professor Eugene Fama, who recently was awarded the Nobel Prize in economics.

Essentially, the practical takeaway from Fama’s work is that you are better off letting the market work for you rather than beating yourself up adopting complex, expensive and ultimately futile strategies to “beat” the market.

Writing in The Financial Times on the Nobel, economist and columnist Tim Harford said Fama had helped millions of people by showing them the futility of picking stocks, finding value-adding managers or timing the market to their advantage.

“If more investors had taken efficient market theory seriously, they would have been highly suspicious of subprime assets that were somehow rated as very safe yet yielded high returns,” Harford wrote.¹

In The Sydney Morning Herald, journalist and economist Peter Martin said the world owes a great debt to Fama, who “demonstrated rigorously that if the supermarket crowd is big enough or if there are enough cars on the highway, you will get no advantage from changing lanes. Anyone who could have been helped will have already helped themselves.”²

This might be a counter-intuitive idea to many people. After all, in other areas of our lives, like business, the secret to success is to study hard, compete aggressively and constantly look for an edge over our competitors.

One of the other two academics that Fama shared the Nobel with this year – Robert Shiller – takes the view that markets can be irrational and subject to human error. In this, he is frequently cited as a philosophical opponent of Fama.

In practical terms, though, both men agree that it is very, very difficult for the average investor to get rich in the markets by trading on publicly available information. Most people trade too much or underestimate the unpredictability of prices.³

For example, many investors bought into supposedly sophisticated trading strategies during the financial crisis which left them on the sidelines in the subsequent rebound that has driven prices in many markets to multi-year or record highs.

The “simpler” approach is to adhere to three core principles – that markets reflect the aggregate expectations of investors about risk and return, that diversification reduces uncertainty and that you can add value by structuring a portfolio focused on known market premiums. For the individual investor, the essential add-ons to this are staying disciplined and keeping a lid on fees and costs.

Yes, these are simple ideas, but to quote another philosopher (Leonardo da Vinci), simplicity is the ultimate sophistication.

1. Tim Harford, ‘Why the Efficient Markets Hypothesis Merited a Nobel’, Financial Times, Oct 14, 2013

2. Peter Martin, ‘Pitfalls of Looking for Life in the Fast Lane’, Sydney Morning Herald, Oct 16, 2013

3. Robert Shiller, ‘Sharing Nobel Honours and Agreeing to Disagree’, New York Times, Oct 26, 2013

Interest rates around the world are at historic lows. They can only go in one direction from here, right? And aren’t rising interest rates bad for bond investors? The truth might surprise you.

Central banks in developed economies have injected extraordinary stimulus into the system since the recession arising from the global financial crisis five years ago.

The stimulus has come from reductions in official interest rates to historic lows and from more unconventional measures aimed at holding down long-term interest rates.

In 2013, markets became unsettled when the US Federal Reserve signaled it was contemplating a timetable for reducing its stimulus – the so-called “taper”. The central bank later changed its mind and markets cheered the news.

In the meantime, many investors are asking what will happen to their portfolios when central banks do decide to start restoring rates to more normal levels.

The market values of bonds rise or fall depending on investors’ views about the outlook for inflation and interest rates, their perceptions about the creditworthiness of individual issuers and their general appetite for risk.

The yield on a bond is the inverse of its price. So if the price falls, it means investors are demanding an additional return, or yield, on that bond to compensate for the risk of holding it to maturity. This sensitivity to interest rate change is called term risk. So if interest rates can only go up from current levels, why hold bonds? There are a few points to make in response.

First, it is very hard to forecast interest rates with any consistency. Standard & Poor’s regular scorecard shows most traditional forecast-based managers fail to outpace bond benchmarks over periods of 5 years or more.1

Second, there is nothing to say that rates will return to normal very quickly. In the case of Japan, benchmark lending rates have been at or close to zero for the best part of 15 years. We have already seen many large bond fund managers make badly timed calls on when the cycle will turn.

Third, bonds perform differently to shares. So regardless of what is happening with the rate cycle, there is a diversification benefit in holding bonds in your portfolio. Diversification is a way of controlling risk and making for a smoother ride.

Fourth, if you look at history, there is no guarantee in any case that longer-term bonds will underperform shorter-term bonds when interest rates are rising.

We carried out a case study of four periods of rising rates from the last 30 years. To meet the test, the rate increases had to be spread out over 12 months or more and the cumulative increase had to be at least 1.5 percentage points.

The four periods were December 1976 to March 1980 (when rates skyrocketed by 15.25 percentage points), September 1992 to June 1995 (3 ppts), November 1998 to December 2000 (1.75 ppts) and June 2003 to August 2007 (4.25 ppts).

The chart below looks at the performance of US government bonds during those four periods. We use standard indices – the Barclays Intermediate (1-10-year maturity, in blue) and the Barclays Long (10-30-year maturity, in green).

Government Bonds – Annualised Total Returns Government Bonds – Annualised Total Returns What’s notable in the chart is that in two of these four periods of rising interest rates long-term bonds did better than shorter-to-intermediate-term bonds. In the other two periods (1998-2000 and 1976-1980) longer-term bonds underperformed.

This may seem counter-intuitive but can be explained by the fact that long-term bond holders, whose biggest concern is inflation, can be comforted by a central bank moving aggressively and pre-emptively against this threat by raising official rates.

Also note that seven of these eight bars show positive returns, which contradicts the view that bonds always deliver negative returns in periods of rising interest rates. The exception in this study is the late 70s when the longest-term bonds (10-30 years) suffered during a period of very sharp increases in rates.

So the first lesson is that an increase in official lending rates set by central banks is not always replicated across bonds of all maturities. Indeed, in some cases, as we have seen, longer-term bonds have outperformed in rising rate environments.

The second lesson is that bonds can play an important role in your portfolio whatever the stage of the interest rate cycle. How much term (or credit risk) you take with bonds will depend on your own risk appetite and investment goals.

Trying to forecast interest rates is not a sustainable way of investing in bonds. But there is plenty of information in today’s prices to base a strategy on. In the meantime, you can temper risk by diversifying across different types of bonds, different maturities and different countries.

Ultimately, the reasons for investing in bonds should be driven by your own needs, not by everybody else’s expectations.

(The author would like to thank senior portfolio manager Dave Plecha for his help with this article).

1. Source: Standard & Poor’s Indices Versus Active Funds Scorecard, year-end 2012

One of the great challenges of investing is being able to lean against the prevailing winds of the day. Sailors will tell you that it takes effort, discipline and patience when battling into strong headwinds.

Five years on from the global financial crisis share investors probably feel like they are entitled to enjoy having the wind at their back with the Australian sharemarket delivering 24 per cent growth so far this year as at the end of October.

That is good news for super fund portfolios as well with the average growth super portfolio delivering 15.6 per cent for the last financial year. – See Chant West returns.

But if there is one thing we can all learn from – and try not to forget – is how past performance influences our levels of confidence with investing.

This week in the Wall Street Journal was an illuminating article that highlighted how US investors are diving back into the sharemarket as market indexes set new highs.

According to fund research tracking group Lipper US investors have placed $US76 billion into share funds this year – the strongest year since 2004.

Between 2007 through 2012 investors withdrew $US451 billion from share funds.

There is no doubt that a more positive outlook for the US economy is fueling the rise in optimism among US investors.

However, it is perhaps time to sound a note of caution. If you look at fund flow data into US global share funds between 1993 and 2008 one strong message emerges – people invest more money into the sharemarket when it is high and sell out when it falls into negative territory.

The data may be for US investors but there is no reason to believe similar behaviour is not happening in other parts of the world.

Buying anything when prices are high and selling when they are low is never going to be a wealth creation strategy but what the fund cashflow data points to is how hard it is to time markets successfully and how much past performance influences our confidence levels.

Rising markets raises confidence levels which raises our propensity to take more risk.

But clearly the memory – and some of the lessons – of the global financial crisis seem to be fading. Investment markets – be it shares, property, fixed income – all move in cycles.

For investors the most important decision is to get their asset allocation mix attuned to their age and risk tolerance.

In that way you will hopefully be able to profit from the times when market winds are favourable and be able to weather the storms which will inevitably appear from time to time.

Importantly with a diversified portfolio you should never have the worry that drove one investor quoted in the WSJ article who is investing now because “I don’t want to miss out”.

Whenever investment markets are sharply rising or falling, do you feel a powerful urge to do something?

If your answer is “yes”, you are acting in a manner that is widely recognised by behavioural economists. And chances are that such an emotive response to market movements will be detrimental to your financial wellbeing.

When markets are moving rapidly, many investors become either frightened that they will lose money if asset prices are falling or afraid they will fail to make money when prices are rising.

Jeff Molitor, chief investment officer for Vanguard in Europe, recently wrote an investment commentary describing knee-jerk reactions to market movements as “reactionary investing”. It is an extremely apt description.

“Fear and greed are two powerful emotions that represent major obstacles to investment success,” Molitor writes. “Worried that they might be on the wrong side of a trend, some investors fall into the trap of ignoring their long-term plans and disciplines and instead react to the noise of the market.”

And he emphasises: “The reality is that successful investing requires discipline and a clear set of objectives.”

Rather than being swayed by the “noise” in the market into following the investment herd, investors should ideally focus on:

Setting clear investment goals. Investors can concentrate on achieving these goals, regardless of changing investment conditions. Developing an appropriate long-term asset allocation that is designed to meet your investment objectives. (A landmark research paper – Determinants of Portfolio Performance by Gary Brinson, Randolph Hood and Gilbert Beebower – confirmed in 1986 that asset allocation was responsible for the vast majority of a diversified portfolio’s return over time.) Keeping investment costs to a minimum. In short, high investment management costs really handicap a portfolio’s real returns. Maintaining a disciplined approach, focussing on long-term investment objectives. This should discourage investors from making emotionally-driven decisions, particularly in times of high volatility. Part of having a disciplined approach involves regularly rebalancing a portfolio to bring it back in line with its long-term target or strategic asset allocation.

The inevitable times of uncertainty and high volatility in the market can serve as a useful prompt to ensure that your investment basics – concerning long-term goals, asset allocation and low cost- are in the best possible shape. This is a much superior approach to “reactionary investing”.

APC was invited to enter the Professional Planner/Business Health 2013 Best Practice Awards.

Business Health owner Rod Bertino described it…

“as the “highest quality group of entrants he’s ever seen in such a competition. you should be extremely proud to be ranked in the top six practices in the country”.

“These practices as a group have a ruthless focus on efficiency. They are crystal clear on their value propositions and ideal clients. They market their services effectively, and harvest healthy referrals from a supremely loyal client base.”

“For them the future of financial Advice arrived long ago!”

From an initial 118 practices, 20 were considered “Super Fit” from a comprehensive online “HealthCheck” administered by Business Health.

20 “Super Fit” practices were then physically audited and reduced to a Finalist Group of 6 practices. APC has been ranked in this Finalist Group on each occasion we have entered the Industry Awards, (2005, 2006, 2008 and now 2013).

This result would not have been achieved by APC without our wonderful team who support our Clients every day.

We would also like to thank all of you who continue to support APC and refer your family and friends. We wouldn’t have arrived in this select Finalist Group without you!

We are very proud of this achievement and we will endeavour to continually improve the quality of our advice processes so that APC remains at ‘Best Practice’.

The recovery of the All Ordinaries Accumulation Index (share prices plus dividends) to exceed its pre-GFC high holds valuable lessons for investors.

These lessons reinforce some of the fundamentals of sound investment practice including the benefits of sticking to a carefully-constructed, long-term plan while ignoring any temptation to just follow the investment herd.

The All Ordinaries Accumulation Index reached 42,951 points this month, beating its previous high of 42,946 set on November 1, 2007. (The All Ordinaries Index and the S&P/ASX200 Index – which do not count dividends – climbed to five-year highs this month yet remain significantly below their pre-GFC highs.)

Investors who had followed the herd in the depths of the GFC by jumping out of shares into all-cash portfolios are likely to have paid a high price.

Such attempts at timing the market led to many investors selling at a loss when the market was at or near a GFC low only to buy back at high prices after the market had turned upwards.

The accumulation index shows the possible rewards for investors who reinvest their dividends. An investor who concentrates only on share price movements only sees part of the picture – particularly given the value of Australian franking credits.

A look at the long-term performance of superannuation funds with diversified portfolios also underlines the benefits of setting and keeping to a long-term target asset allocation for your portfolio.

The latest report by superannuation fund researcher SuperRatings tracks how $100,000 invested 10 years ago in a balanced super fund would have grown. (It is assumed that the fund produced average returns for a balanced fund. SuperRatings defines a balanced fund as one with 60-76 per cent of its portfolio in growth assets.)

The $100,000 would have reached a pre-GFC peak of $168,596 by October 2007 before falling to a GFC low of $126,401 in February 2009 and then more than recovered to $192,066 at the end of August this year – $65,665 above the GFC low.