Diversification

The explosion in the number of Hedge Funds over the last decade is indicative of the desire by many, often very rich, investors to beat what might be called normal market returns.

Prior to the late Nineteen Fifties, in particular, before Harry Markowitz’ seminal work on Portfolio Selection, investing in shares was considered to be a risky and unquantifiable business, one of the main reasons why dividends then were usually higher than the return on Government Bonds.

Once it became possible to apply a bit of ‘science’ to risk and return and, in particular, the benefits of diversification became better understood, the stock markets became a more comfortable place for more investors.  Unfortunately, with the banning of insider dealing, improvements in corporate governance and the wider availability of high quality information, much of the mystique disappeared taking with it the prospect of excess returns.

This leant a huge helping hand to Hedge Funds who were able to market themselves on the basis of excess returns created by clever (at least in theory) financial models and leveraging.  The great advantage of leveraging is that if you expect a return of 10% and borrow ten times your original capital, that turns into a 100% return, very nice.  However, if you lose money with borrowings, you may find out that all of your capital is lost and you owe the bank money, not so nice.

Also, those running hedge funds were, in many cases, the cream of the financial world, particularly on the academic side.  Hedge funds gave plenty of scope to the highly intelligent to make money on the back of academic work.  In some cases, this level of applied IQ has been their downfall.  In physics, classical mechanics works very well in many practical applications and was good enough to land a rocket on the moon safely.  It breaks down completely at the margins, however.  In much the same way, many seemingly low risk ways of making a ton of money which were created by these boffins seem to break down spectacularly when faced with real world problems, particularly lack of liquidity.

So it is that Peleton, until last week a highly regarded British hedge fund, has found its strategies wanting.  In the process, it may be that investors will lose much if not all of their money in at least one of its funds.

You have to hand it to the old fashioned technique of buying a range of investments and sticking with it.  They may have dropped in value periodically but there was always the hope (born out in fact) that prices would recover with patience.

It may be that, for many, hedge funds will permanently have lost their lustre, as will any strategy promising to deliver excess returns for lower risk.  That is until the lessons of today have been forgotten, as they almost always are.

Driving to Perth Zoo this morning, we were listening to MIX 94.5 FM Radio Station, which is pretty much as you would expect and much the same as many pop stations in the UK.  Whilst the music is patchy, the station clearly expects its listeners to take an interest in matters financial.  At the end of a news bulletin came a piece of the current state of the Australian stock market and the benefits of overseas diversification.  It is hard to imagine a similar station doing the same in the UK, I would expect the audience to be almost universally uninterested.

Now, this hardly constitutes exhaustive research allowing us to conclude that Australians are more sophisticated than their British counterparts when it comes to investing but it does form part of a consistent picture, as I have commentated before.  Australia is very different to the UK in many ways, not all of which are better, but they run a budget surplus and seem to take pension funding very seriously as a nation.

 Of course, it helps to be sitting on top of a disproportionately high amount of the world’s natural resources but they do seem determined to make the most of their good fortune.

For those holding cash, now could be a fantastic time to pick up some stock market investments at a knock down price, while some commodities (previously, the darling of investors)look overpriced.  Of course, it is perfectly possible that markets could drop further, after all, even if markets are efficient, they are not always rational.  At the moment, however, the stock markets, in particular, are volatile because investors are finding it hard to gauge the full extent of the sub-prime problem and its longer term impact on corporate profitability.

For those looking to hold investments for the long term, the FTSE100 looks a bit of a bargain at around 6300 when it has traded above 6700 only a matter of months ago.  The cautious, though, will be mindful of the fact that the index has yet to regain the heights of 1999 when it exceeded 6900.  It is always possible that we are in the early stages of a protracted bear market but many will find it hard to believe that the banks, even with all their problems, are as bad a profit prospect as their price would suggest.  Now, more than usual, we are seeing the benefits of diversifying.

For some investors, the January Sales have come early in the Stock Markets.

It is all getting a little hairy in the markets at the moment; all major markets posted significant falls yesterday and the news may not be much better today.  Are we witnessing (or, for those of us with investments, experiencing) the final act in the credit crunch tragedy or merely another scene?  Also, what course of action should a rational investor take?

No one can be sure where this crisis is heading; quite a few problems have been brought to the fore but there may be more to come.  It is almost laughable now that, only a matter of weeks ago, our august politicians were focused on the rate of tax paid by Private Equity to the extent that they restructured our entire tax system in an attempt to penalise them.  Meanwhile, in the real world, things were going pear shaped.

Poorly diversified investors may have the least comfortable experience, particularly those poor private investors who held significant chunks of Northern Rock stock for no real reason.  Also, those with too large a proportion of equities may find themselves ruing their lack of investment spread and property looks set for a difficult period.

What is holding up?  Well, the bond markets, unloved of late, may find themselves viewed more favourably (especially government and high quality) and commodities may continue their climb.  But it seems, oddly enough, that emerging markets may emerge (pardon the pun) the real winners from this period of instability.  A year or so from now, they may look quite grown up, while some of the racier classes of investment, such as private equity, may look a little discredited (another pun?).

As ever, the advice to any investor is to ensure that you are properly diversified.  Do not get drawn into this year's must have (or have not) sector and only invest if you have a long term outlook.

Is the stock market, as a whole, an inherently riskier place to invest money than the residential property market?  Now, I am not for one second suggesting that either is an appropriate place to put your money, although one or both may be, I am just opening up the discussion.  I am also considering the property market in investment terms rather than housing terms, no share portfolio will keep you dry through the winter or give you somewhere to show off your latest plasma TV.  These thoughts are probably, therefore most applicable to excess property investment, by which I mean a second property, a buy-to-let property or a house larger than your requirements, which you hope to sell to fund your retirement.

Firstly, what do we mean by risk?  It is, I suggest, unlikely that the stock market or the property market will drop in value to zero.  It is, of course, possible to make a bad choice of investment.  Some companies will go bust and some properties may become worthless, perhaps because of flooding or encroachment by the sea.  Now, you would be daft to buy a property without insuring it against these risks but most people will buy a share in a company without any corresponding insurance against loss (i may cover how another time).  This, then, starts to colour our view of the relative merits of the investments; we take more risk with our stocks, for some reason, than we do with our real estate.

The world of professional investors usually expresses risk in terms of the volatility of returns.  An investment which can deliver high returns with periodic big drops in values is considered to be riskier than an investment which is more steady in its delivery, even if they end up at the same spot.

So, how does volatility compare?  My main concern here is one of information delivery.  If you valued your share portfolio every year, it may not look particularly volatile and, indeed, in most years it would have gone up in value, probably even in 1987.  This is where the stock portfolio is at something of a disadvantage when compared against property.  You see, property is not valued by anyone, let alone the market (as distinctly opposed to an estate agent or even a surveyor) in anything like real time.  Depending on how often we move, a property may only be market valued, i.e. bought, once every seven years.  We may read in the press about the general sentiment but no one is able to rub our noses in its value in real time, minute by minute.  If you own a stock portfolio, you can watch it go up and down every minute of the working day, responding instantaneously to investor sentiment, and it can be frightening for some.

Also, I have referred to a stock portfolio as opposed to one stock, mostly, as it would not be rational to hold only a couple of different shares.  Diversification is easy with shares, not so with property as it is expensive and slow to sell, amongst other things.  

What of the returns?  Well, ignoring income form dividends or rent, which I gauge to be similar after costs, I think property and equities have probably delivered similar capital growth.  If you take into account transaction costs and the difficulties of diversifying across a number of properties, it may well be that a property portfolio has lost ground to a share portfolio.  What, though, will the next twenty bring?