Risk

Many investors in shares are wondering how they should respond to the current volatility in most Stock Markets and the fear that 2008 will be as troublesome as last year, if not more so.  The answer to this really depends on why you are investing and for how long.  Many cash rich emerging nations, such as Kuwait, China and Singapore, and other wealthy investors are greedily gobbling up almost anything we are selling at a knockdown price.  They have very long time horizons and very deep pockets.  For them, the prospect of picking up stakes in some of the developed world’s finest financial institutions at five year lows is too good to miss.

I strongly suspect that many guardians of public wealth in the UK, for example, company pension funds, are eager sellers and may well have proved once again to have sold at exactly the wrong time whilst buying into, probably, bonds at the wrong time as well.  Like second rate defenders in football, they seem destined to rush time after time towards the player with the ball only to see it deftly passed to another who has space and time.  Oh, the humiliation of it all.  Meanwhile, much as the England Football team are often found to wanting custodians of the hopes of a nation, the trustees responsible for around £1 Trillion of the public’s money are wrong footed by foreign operators to whom they gave the game in the first place.

Where does this leave the rest of us?  Well, if you are investing in shares you really ought to know that they will not deliver stellar returns year after year and sometimes suffer losses from which they can take quite a while to recover.  It makes sense to diversify your investments away from shares alone, this is generally held to be a sensible strategy but you should ask yourself about how long you intend to be invested.  If, like Kuwait, you expect to be an investor indefinitely, then, perhaps, you should not worry about how poorly things are going now but wonder whether you are in a position to buy something on the cheap.  It is odd how discounts in shops turn us into buyers and discounts in stock markets turns us into sellers.

Now may be a good time to reflect on whether you have the stomach for stocks at all, there is no shame in admitting that they hold too much fear.  Fear and greed need to be kept in balance and shares can be more scary than, for example, fixed interest investments.  What is wrong with holding index linked bonds?  They may not offer the prospect of much real growth but you may be able to sleep at night.

It looks as if future pensioners will find it harder than ever to buy an annuity which provides sensible value for money.  As with many things in life, there are a number of forces pulling in opposite directions with unforeseeable consequences.

For those with investment based pension schemes, whether company sponsored or not, the choice on retirement is to buy an annuity or draw an income directly from the investments in the pension scheme.  Buying an annuity provides certainty of income whilst drawing on the investments allows greater flexibility with the possibility of a higher level of income but with the continued investment risk.  There are many reasons why one or other route may be the most appropriate decision for an individual but the government seems resolutely wedded to the idea that annuities are better.  Current rules seem to favour those buying an annuity as the government seems reluctant to let go of the control it exercises.

Not for the first time, however, it seems that the market could scupper government plans.  The great thing about an annuity (supposedly) is that mortality is pooled, i.e., no one is exposed to their own life span.  If you happen to live for longer than average, you will not have had to have a lower income or have run the danger of running out of money because those who died early will have subsidised you.  Whether or not you are happy with this cross-subsidy is another matter.  If you only live for a few years in retirement, your family may not feel that they or you have received value for money.

The purchase of annuities, though, is becoming increasingly exposed to competitive forces and the regulator is encouraging this for obvious reasons.  This means that the insurance companies who sell annuities are having to create a competitive advantage and to do so they are slicing and dicing the pooled mortality to give some a much better deal.  At the moment, they mainly do this by allowing some with a health problem or dangerous lifestyle to opt out and get a better rate, i.e., receive more money quicker because they will not be around for long.  Insurers are now starting to assess people on the basis of where they live; we all know that those in Surrey outlive those in Glasgow.

the next step is to take into account former occupation to a greater degree and, perhaps, genetic testing.  Great if you are not going to be around for long but bad news for the wealthier, healthier retiree.

Buying an annuity is already a fraught and risky business; what is your view of future inflation for the rest of your life, are you likely to have a dependent when you die in thirty years, etc?  It is set to be a good deal more fraught in the future.  How then will tomorrow's retirees view the seemingly arbitrary restrictions on how they draw pension income?  My guess is, not very positively.  The government has proved fairly unsuccessful at modelling people's behaviour, partly because it is not very good at determining the best type of behaviour and partly because people are a good deal less persuaded by the merits of it than the government assumes.  It could be that we will see the reworking of pension rules over the coming years and tomorrow's pensioners will have to get used to the idea of drawing an income form an investment portfolio with all of the attendant risk and effort required to do it successfully.

In these uncertain times, it is hardly surprising that some investors are turning their attention to Gold, the traditional refuge.  Gold has outperformed most major stock markets this year (up about 20%) as well as many other indices, although Sterling returns are hampered by the fact the Gold, like most commodities, is quoted in US Dollars.

For most investors, though, Gold presents a few practical problems.  Firstly, it is expensive and I doubt many bullion merchants would be happy to sell a small piece of an ingot.  Secondly, it is costly to store and insure; it is hardly much of a refuge for your money if it lying about the house.  Also, most investors would not know where to go to buy it.  On the plus side, allocated bullion represents no credit risk and it does represent a traditional preserver of real value, even if its track record in this is patchy.

Access to gold has recently become easier; a number of ETFs (Exchange Traded Funds) now exist, some of which give access to allocated gold bullion.  This means that investors can include Gold in their portfolios, whether it is a good idea or not is another matter.  

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?