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Pocket World in Figures

Guide to investment strateGyHow to understand markets, risk, rewards

and behaviour

Peter stanyer

the economist in AssociAtion With ProFiLe books LtD

Published by Profile books Ltd 3a exmouth house, Pine street, London ec1r 0jh

www.profilebooks.com

copyright © the economist newspaper Ltd, 2006, 2010text copyright © Peter stanyer, 2006, 2010

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the greatest care has been taken in compiling this book. however, no responsibility can be accepted by the publishers or compilers

for the accuracy of the information presented.

this publication contains the author’s opinions and is designed to provide accurate and authoritative information. it is sold with the understanding that the author, the publisher and The Economist are not engaged in rendering legal, accounting, investment-planning, or

other professional advice. the reader should seek the services of a qualified professional for such advice; the author, the publisher and The Economist cannot be held responsible for any

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Where opinion is expressed it is that of the author and does not necessarily coincide with the editorial views of the economist newspaper.

While every effort has been made to contact copyright-holders of material produced or cited in this book, in the case of those it has not been possible to contact successfully, the

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to Alex

Contents

Part 1 The big picture

1 Setting the scene Financial fraud: “a hardy perennial” 3other catastrophic risk-taking 4think about risk before it hits you 7how much risk can you tolerate? 8know your niche 10 War chests and umbrellas 12 Box base currency 12

2 Understand your behaviourinsights from behavioural finance 14investor biases 16investor preferences 19 Loss aversion 19 mental accounting and behavioural portfolio theory 20investment strategy and behavioural finance 22Parameter uncertainty and behavioural finance 23traditional finance, behavioural finance and evolution 24

3 Market investment returns: will the markets make me rich?sources of investment performance 26safe havens that provide different kinds of shelter 28Which government bonds will perform best? 29Box is the break-even inflation rate the market’s forecast? 30What premium return should bond investors expect? 33the equity risk premium 35equity risk: don’t bank on time diversifying risk 40

4 Which should we do: buy-and-hold or time markets?model investment strategies 45strongly held market views and the safe haven 48Box stockmarket bubbles 49An appropriate role for strategy models 52

5 The time horizon and the shape of strategy: keep it simpleshort-term investment strategies 54 how safe is cash? 54 no all-seasons short-term strategy 55

Box Do bonds provide insurance for short-term investors? 56Are you in it for the long term? 58 time horizon for private and institutional wealth 58Long-term investors 60 Financial planning and the time horizon 61

“safe havens”, benchmarking, risk-taking and long-term strategies 62

the danger of keeping things too simple 64 Good and bad volatility 64 Box Unexpected inflation: yet again the party pooper 66 “keep-it-simple” long-term asset allocation models 67 should long-term investors hold more equities? 69 inflation, again 70 Laddered government bonds: a useful safety-first portfolio 70

bond ladders, tax and creditworthiness: the case of Us municipal bonds 72

Box the orange county saga: what is a good-quality municipal bond? 76

What’s the catch in following a long-term strategy? 77Long-term pension savings and risk tolerance 78Long-term strategy: “imperfect information changes everything” 79market timing: an unavoidable risk 80some “keep-it-simple” concluding messages 82Box the chance of a bad outcome may be higher than you think 83

Part 2 Implementing more complicated strategies

6 Setting the sceneA health warning: liquidity risk 91behavioural finance, market efficiency and arbitrage opportunities 93barriers to arbitrage 94 Fundamental risk and arbitrage 95 herd behaviour and arbitrage 96 implementation costs, market evolution and arbitrage 98 institutional wealth and private wealth: taxation 99

7 Equitiesconcentrated stock positions in private portfolios 104 corporate executive remuneration programmes 105the restless shape of the equity market 106stockmarket anomalies and the fundamental insight of the

capital asset pricing model 106

“small cap” and “large cap” 109Don’t get carried away by your “style” 112Box Value and growth managers 114should cautious investors overweight value stocks? 115equity dividends and cautious investors 117home bias: how much international? 118to hedge or not to hedge international equities 123international equities and liquidity risk 127

8 Creditcredit quality and the role of credit-rating agencies 129Portfolio diversification and credit risk 134Box Local currency emerging-market debt 136securitisation, modern ways to invest in bond markets and thecredit crunch 137 mortgage-backed securities 138

Box the role of mortgage-backed securities in meeting investment objectives 139

Asset-backed securities and collateralised debt obligations 142international bonds and currency hedging 145 What does it achieve? 145 What does it cost? 147 how easy is foreign exchange forecasting? 149

9 Hedge fundsWhat are hedge funds? 151Alternative sources of systematic return and risk 152“Do hedge funds hedge?” 152the quality of hedge fund performance data 154What motivates hedge fund managers? 156Are hedge fund fees too high? 156the importance of skill in hedge fund returns 157types of hedge fund strategy 160 the size of the hedge fund market 161 Directional strategies 162

Global/macroequity hedge, equity long/short and equity market neutral 163short-selling or short-biased managers 164Long-only equity hedge funds 164emerging-market hedge funds 166Fixed-income hedge funds: distressed debt 166

Arbitrage strategies 167

Fixed-income arbitrage 168merger arbitrage 168convertible arbitrage 167statistical arbitrage 167

multi-strategy funds 170 commodity trading advisers (or managed futures funds) 170hedge fund risk 172 madoff, hedge fund due diligence and regulation 172 operational risks 173 illiquid hedge fund investments and long notice periods 173 Lies, damn lies, and some hedge fund risk statistics 174 “Perfect storms” and hedge fund risk 176 managing investor risk: the role of hedge funds of funds 177how much should you allocate to hedge funds? 178Questions to ask 180 Your hedge fund manager 180 Your hedge fund adviser 183 Your hedge fund of funds manager 184

10 Private equity: information-based investment returnsWhat is private equity? 185Private equity market risk 187Listed private equity 190Private equity portfolios 193Private equity returns 193

Box Private investments, successful transactions and biases in appraisal valuations 195

11 Real estateWhat is real estate investing? 198Box Using derivatives to gain real estate market exposure 199What are the attractions of investing in real estate? 201 Diversification 201

Box modern real estate indices and assessing the diversifying role of real estate 201

income yield 206 inflation hedge 207styles of real estate investing and opportunities for active

management 207What is a property worth and how much return should you

expect? 208 rental income 208

Government bond yields as the benchmark for real estate investing 210

tenant credit risk 211 Property obsolescence 211Private and public markets for real estate 212international diversification of real estate investment 213 currency risk and international real estate investing 213

12 Art and collectiblesDrivers of art market prices 216Box Art market indices 218investing in art 220other investments of passion 223

xii

List of figures

3.1 income yield from ten-year Us treasury bonds and three-month treasury bills 28

3.2 Us treasury 20-year yields 313.3 Us 20-year “break-even inflation”, difference between 20-year

treasury and tiPs yields 313.4 Us treasury conventional and real yield curves 333.5 Uk treasury conventional and real yield curves 343.6 French treasury conventional and real yield curves 353.7 cumulative performance of equities relative to long-dated

government bonds 363.8 20-year equity risk premium over treasury bills 383.9 20-year equity risk premium over government bonds 383.10 Frequency of equity underperformance of bonds 433.11 Frequency of equity underperformance of bonds 434.1 ViX indicator of Us stockmarket volatility 464.2 tobin’s Q, ratio of market value of Us corporate equity to

replacement cost 474.3 Us long-dated corporate bond spreads 484.4 Dow Jones industrial Average 514.5 cumulative Us market performance since Greenspan

“irrational exuberance” speech 525.1 surplus risk and opportunity for long-term investors: stylised

approach 685.2 comparison of municipal and Us treasury long-dated

bond yields 745.3 Long-dated municipal bond yields as a percentage of Us

treasury yields 745.4 Us stocks, bonds and cash: “efficient frontier” and model

allocations for “short-term” investors 866.1 implied Uk future inflation and interest rates 947.1 cumulative total return, before expenses, taxes and inflation,

of Us small cap and large cap stocks 1107.2 ten-year rolling average returns, before fees, taxes and inflation,

for Us small cap and large cap stocks 111

List of figures

xiii

7.3 cumulative total return performance of Us growth and value equity indices 116

7.4 Volatility of Us growth and value equity indices 1167.5 Us value and growth equity indices, rolling five-year

performance 1177.6 Us and eAFe five-year rolling equity performance 1197.7 Volatility of domestic and global equities from alternative

national perspectives 1217.8 Who needs international equity diversification? 1227.9 correlations between Us equity market, international equities

and emerging-market equities 1237.10 Global equity volatility from the perspective of different

countries 1257.11 Us perspective on impact of hedging international equities 1257.12 Uk perspective on impact of hedging international equities 1267.13 Performance of emerging-market equities in worst Us equity

market down months 1278.1 Us corporate bond spreads 1328.2 cumulative performance of Us under-ten-year treasury and

corporate bonds 1338.3 Yields on Us mortgage securities 1348.4 Us government bond monthly returns compared with

mortgage- backed securities 1418.5 euro monthly government bond performance in euros 1468.6 euro monthly government bond performance in Us dollars,

unhedged 1468.7 euro monthly government bond performance hedged to

Us dollars 1479.1 hedge fund industry assets under management 1519.2 cumulative performance hedge fund index and equities 1539.3 marketing illustration of the risk return trade-off being transported

by adding hedge funds to traditional investments 1589.4 optimistic stylised effect on “efficient frontier” of adding hedge

funds 1599.5 short-selling equity strategy and msci Us monthly performance 1659.6 Pattern of arbitrage and multi-strategy hedge fund monthly

performance results 17710.1 Volatility of public and private equity, proxied by 3i share price

and Ftse 100 index 18810.2 60-day volatility of 3i relative to Uk stockmarket 188


xiv

10.3 Volatility of total equity as private equity increases 19010.4 cumulative performance of global listed private equity

companies and global equities 19211.1 the four quadrants of real estate investing 19811.2 Us institutional real estate investment cumulative return indices 20211.3 Us institutional property performance: 12-month rolling returns 20311.4 reit and s&P 500 12-month rolling performance 20511.5 is it cheaper to buy real estate on Wall street or main street?

Us reits’ share price compared with Green street estimates of property net asset value 212

12.1 Global art market price trends 22012.2 british rail Pension Fund realised rates of return for 2,505

individual works of art acquired between 1974 and 1980 222

xv

List of tables

3.1 Long-run market performance and risk, 1900–2008 373.2 Does time diversify away the risk of disappointing equity

market performance? 415.1 Unaggressive strategy: negative return risk varies as interest

rates move 555.2 bond diversification in months of equity market crisis 575.3 bond diversification in years of extreme equity market

performance 575.4 stylised model long-term strategies, with only stocks, bonds

and cash 685.5 model short-term investment strategies, with only stocks,

bonds and cash: historical perspective, 1900–2008 845.6 model short-term investment strategies, with only stocks,

bonds and cash: forward-looking perspective 856.1 the impact of taxation on taxable investment returns and

wealth accumulation 1017.1 Volatility of euro stocks and bonds, unhedged,

January 1999–march 2009 1247.2 Volatility of euro stocks and bonds, hedged,

January 1999–march 2009 1248.1 Long-term rating bands of leading credit-rating agencies 1308.2 corporate bond average cumulative default rates, 1990–2008 1318.3 Us corporate bond yields and spreads,

February 1987–April 2009 1328.4 total return to Us government and corporate bonds,

January 1987–January 2009 1338.5 Performance of selected debt markets in months of extreme Us

equity performance, January 1994–April 2009 1358.6 Us corporate high-yield and emerging-market debt markets

summary statistics, January 1994–April 2009 1358.7 Performance and volatility of principal components of the

barcap Aggregate bond index, January 1990–April 2009 1418.8 illustration of a cDo structure 1439.1 hedge fund and fixed-income performance during months of

equity market crisis since 1994 154


xvi

9.2 hedge fund industry: assets under management 1619.3 hedge fund performance during months of equity market crisis

since 1994 1639.4 selected hedge fund strategies: correlations with Us and

emerging equity market indices, January 1994–April 2009 1639.5 equity hedge fund performance during months of equity

market crisis since 1994 1659.6 emerging-market hedge fund performance during months of

equity market crisis since 1994 1669.7 Fixed-income hedge fund performance during months of equity

market crisis since 1994 1679.8 Arbitrage hedge fund performance during months of equity

market crisis since 1994 1689.9 multi-strategy hedge fund performance during months of

equity market crisis since 1994 1709.10 managed futures fund (ctA) and commodity index performance

during months of equity market crisis since 1994 17210.1 Geographical spread of standard & Poor’s Listed Private equity

index, December 2008 19111.1 Direct real estate investment by type of property 19911.2 Us real estate market indices: average performance, volatility,

and correlations with stocks and bonds, march 1984–December 2008 205

11.3 Us real estate indices drawdown experience 20611.4 income return from reits, quoted equities and bonds,

January 1990–December 2008 20611.5 Direct real estate investment by type of property 209

xvii

Acknowledgements

i owe a debt of gratitude to many individuals who helped me with this book. First and foremost to my wife, Alex, for her continued support

and encouragement. elroy Dimson and steve satchell provided invalu-able nuggets of advice and moral support along the way for both the first and second editions. Paul barrett, nick bucknell and stephen collins provided important advice and suggestions on the drafts. colleagues and former colleagues have been particularly generous with their suggestions. i also owe a substantial debt to the investors and trustees of the funds that i have been privileged to work with over the years. Generous and insightful contributions on particular issues or chapters were provided by susan Adeane, chris bartram, Jeff bryan, ewen cameron-Watt, Jon chesshire, ruth corb, Jeremy eckstein, hugh Ferry, charlie Goldring, howard Goldring, masood Javaid, tim Lund, Yoram Lustig, nick miller smith, David morris, cesar murillo, tanya Pein, steve Piercy, John Pullar-strecker, Fabio savoldelli and clifford smout. i am most grateful to each of them, but they are not responsible for the ways in which arguments are presented in their own areas of expertise.

i am also indebted to those firms whose data i have used in the numerous tables and charts in the book. Without their support the book could not be published in this form. i would also like to thank stephen brough at Profile books and John crutcher and the team at bloomberg Press for their support and encouragement. i am particularly indebted to stephen for his suggestion that i revisit the case for investing in art and collectibles. my thanks are also due to Penny Williams, who skilfully edited the book.

this book aims to help inform the process of seeking and giving profes-sional advice, but it cannot be a substitute for that advice. it draws on and summarises research and investor perspectives on a wide range of issues, but it is not punctuated with footnotes citing sources for facts or opinions. Although important areas of debate are flagged with references to leading researchers, in other areas ideas which are more commonly expressed are presented but not attributed. sources which were particularly important for each chapter are listed in Appendix 4.

Please note that the views expressed in this book are my own and may not coincide with the views of the investment funds on whose boards or committees i am honoured to serve.


xviii

in conclusion, let me say how privileged i am that elroy Dimson, Professor of investment management at London business school, has agreed to write a foreword for this second edition of the book. Although my appreciation of markets owes a great deal to the economics that i learnt at cambridge University, particularly from the late michael Posner and from michael kuczynski at Pembroke college, the London business school’s investment management Programme gave me an invaluable bridge from economics to modern finance.

xix

Foreword

Few people realise that state pensions are a giant Ponzi scheme on which millions rely. to be secure in the future everybody needs to

save; and if their savings are to be meaningful, each saver needs a cogent investment strategy.

the subtitle of Peter stanyer’s book reveals his views on invest-ment strategy. strategy must be supported by an understanding of how markets move, how risk should be judged and how investors behave. in this extensively revised second edition, Peter elegantly surveys the entire field of investment, with valuable advice for individuals and investment professionals.

Global markets recently experienced one of the worst downturns ever. to better understand markets, long-term financial history has become a hot topic among investors and their advisers. it was therefore with great pleasure, and some pride, that i read through this volume. Peter interro-gates the long-term, international dataset that my colleagues and i have compiled, and allows the past record of financial markets to enlighten us about recent events and to underpin informed judgments about the future.

investors walk a tricky tightrope of risk and performance. if investors choose too little risk, they may fail to reach their goal. if they take too much risk, they may lose their balance, with potentially disastrous results. how should an investor decide how much risk exposure is appropriate? For many advisers, the solution is to ask clients to indicate how much risk they can tolerate, and then to design a portfolio that meets their risk pref-erences. but it is extremely hard to elicit a person’s appetite for risk: what investors say they want is not necessarily what they really want. investors may be ill-informed and their behaviour may be less than rational.

individuals face an even tougher challenge than pension funds and insurance companies. if a pension fund is in difficulty it can be closed and the plan sponsor asked to make additional contributions; an insurance company can reduce its payouts and dig into reserves. For many institu-tions there are opportunities to mitigate poor investment performance. in contrast, individual investors face fewer remedies for poor returns. they might wish to live as comfortably as possible, but it is not clear how to accomplish this objective. if the appropriate strategy for individuals is


xx

even more problematic than for financial institutions, how can one best help them?

Peter stanyer’s solution is to extend the investor’s knowledge about relevant theory and evidence, and to accomplish this without resorting to complicated mathematics. the result is a clear exposition of the arguments for and against different investment approaches. the author is not afraid to express a firm opinion based on his interpretation of current thinking. he presents valuable advice on how to construct a fixed income portfolio, how to think about liquidity, what quantum of risk is acceptable for different investors and how to think about investment risk.

Whether the reader is interested in the big picture in Part 1, or wants to learn about individual asset categories in Part 2, there is something for everyone in this book. it is comprehensive and moves at a cracking pace, but it is never forbidding or opaque. the surveys of each of the main asset classes provide a highly informative overview of all the key topics. Peter discusses equities and risky debt, alternative assets like hedge funds and private equity, and tangible assets like property and artworks. Personally, i particularly enjoyed chapter 12, on investing in emotional assets such as art and other collectibles.

in this concise book, Peter stanyer guides us through the complexities of modern investing in a clearly written, easily understood style. this volume will help you meet the challenge of investing for your future.

elroy DimsonProfessor of investment management

London business schoolJuly 2009

xxi

Introduction: taking stock

the credit crunch of 2007–09 precipitated a dismal performance by many investment strategies. numerous investors had earlier identi-

fied that the reward for taking credit risk had become much too small and many also wondered how an unwinding of leverage might affect markets. but almost no one anticipated the freezing of liquidity that accompanied the credit crisis. it soon became evident that the bundling and selling of bank loans in the preceding years had encouraged a widespread deteri-oration in banking disciplines. As this emerged, no one knew which banks and which credits were badly affected. As a result there followed a breakdown of trust, which has always been the cornerstone of banking. the drying up of lending between banks, and the withdrawal of credit facilities to investors, such as hedge funds, forced deleveraging and sales of investments. these drove the decline in equity prices even ahead of appreciation of the impact of credit rationing on the rest of the economy.

the crisis has left some modern ideas of investment diversification using combinations of “alternative” investments looking woefully inad-equate, as the shortcomings of commonly used measures of risk for many of these investments, with smoothed monthly valuations, took investors by surprise. but plenty of other long-term investors had never departed from the “keep-it-simple” combinations of government bonds and equities for their financial investments. For these investors, 2008 should have delivered the income that they were expecting from govern-ment bonds, but their equity investments, which they always knew to be volatile, will have been disappointing. this was the defining difference in 2008 between a keep-it-simple old-fashioned investment strategy and a sophisticated modern “multi-asset” strategy, which may have left its investors feeling confused and let down.

As with the first edition of this book, Part 1 describes the design of “keep-it-simple” strategies such as stocks, bonds and cash. chapter 1’s discussion of risk starts with a new section on financial fraud and how investors can help to protect themselves against this “hardy perennial”. it also includes a new section on risk profiling and discusses the role of risk tolerance questionnaires. in chapter 3 data are provided pointing to underperformance of equities in the United states between 1978 and 2008 and for 16 countries (taken together) in the rest of the world since


xxii

1966. these seem to be extraordinarily long periods over which risk-taking would appear not to have been rewarded. Against this background, there is a new chapter 4 – Which should we do: buy-and-hold or time markets? – which addresses the question posed by the late Peter bernstein in 2003 of whether strategy benchmarks, with more or less fixed allocations to different markets, are obsolete. this issue is more relevant than ever in the aftermath of the prolonged periods (to 2008) of underperformance by global and national equity markets in comparison with government bonds. chapter 5, which discusses the design of short-term and long-term strategies, includes a new section – how safe is cash? – and the discussion of bond ladders is extended to reflect issues of bond selection in the light of corporate credit risk and the financial difficulties of some Us municipal authorities.

Part 2 has been updated extensively to reflect developments in the past four years. As well as the impact of the crisis on credit instruments, hedge funds and private equity, there is a new section in chapter 10 on the listed private equity sector, which is a newcomer to a number of stock-markets. in chapter 11 there is an expanded section on the use of deriva-tives to gain exposure to the real estate market and a new section on the transaction-based indices for measuring institutional and residential real estate performance. these indices represent a qualitative improvement on old-style indices based on expert appraisals, and they help to shed light on the significant diversification advantages of investing in real estate. the book concludes with a new chapter on investing in art and collectibles. it explores the argument that art prices “float aimlessly”, discusses briefly experience with financial investment in art, and provides some reasons for expecting that a portfolio of art might perform well in the future.

i would welcome any feedback and can be contacted on the following email address: [email protected]

Peter stanyerAugust 2009

Part 1The big picTure

3

1 Settingthescene

Financial fraud: “a hardy perennial”

“in a boom fortunes are made, individuals wax greedy, and swindlers come forth to exploit that greed.” the experience of thousands of victims of fraud in 2008 and 2009 demonstrates that charles kindleberger’s analysis of the close relationship between boom, bust and swindles remains as relevant today as when he first published Manias, Panics and Crashes in 1978. it also suggests that modern regulatory frameworks have done less than might be hoped to reduce the risk for investors of falling victim to a financial scam.

Part of the problem is that many investors can be seduced by the belief that they have found a low-risk way of performing surprisingly well. they will be more easily convinced of this during good times, and yet, surpris-ingly good investment performance invariably involves risk. the unrav-elling of the multibillion-dollar fraud at bernard L. madoff investment securities in December 2008 and the shutting of the multibillion-dollar stanford international bank in February 2009, following allegations of a further substantial fraud, remind us of this and provide important lessons for investors and for their advisers. the old and seemingly trivial saying that “if it looks too good to be true, it probably is” remains among the most valuable pieces of investment advice anyone can give.

in the aftermath of the losses suffered by victims of the madoff scandal it is worth asking: how should those investors have avoided it? the scandal may have been the largest securities fraud in history, with perhaps $50 billion having evaporated in this Ponzi scheme (see Appendix 1), as departing investors were apparently paid off with money received from the most recent investors. it was soon evident that the victims, who lost all the money they had placed with madoff, included many wealthy individuals and charities, a number of wealth management professionals but relatively few institutional investors.

these investors included those who were following the recommen-dations of investment advisers, who appeared to take pride in their professional diligence and skill in identifying good managers. they also included others who relied on personal contacts who could attest to the respectable community and business pedigree of the manager, bernard


4

madoff, a former chairman of the nasdaq stock exchange. the advisers could often point to the name of one of the leading accountancy firms as the auditor of the third-party fund which was the conduit to madoff investment securities, but this provided no protection for investors. how was someone who had followed the recommendation of a friend or an adviser supposed to identify the risks?

several old lessons re-emerge:

? A reliable rule is that returns in excess of the return offered by the government can only be achieved by taking risk.

? risk is most obvious when an investment is volatile and least obvious when a risky investment has not yet shown any volatility. be particularly questioning when an adviser recommends a low-volatility investment that offers superior returns. but in the madoff fraud, the returns offered to investors did not seem, at first glance, implausibly generous.

? Do not invest in something you do not understand simply because a group of your peers is doing so. A desire to conform can explain many decisions that we would otherwise not take.

? Whatever your adviser says, make sure that your investments are either in treasury bonds or else are well diversified. but again diversification is most difficult to assess when risky investments are not obviously volatile.

? Pay particular attention if an adviser gives you inconvenient cautious advice (such as a recommendation to avoid something that you would like to invest in, alongside your friends).

? status may not be a good indicator of honesty.? Just because an investment firm is regulated by the authorities,

do not assume that the regulators have been able to check that everything is all right.

? the ability to rely on good due diligence on investment managers is the key to minimising exposure to risk of fraud. An authoritative post-mortem report on the madoff affair is called “madoff: a riot of red flags” (see chapter 9). it was not by chance that few institutional investors lost money with madoff, and a challenge for private investors is to ensure that they also have access to good-quality manager due diligence.

Other catastrophic risk-taking

Leaving fraud to one side, other people’s dreadful investment experiences

setting the scene

5

can provide useful cautionary tales. so it is instructive to start a discussion of managing wealth with some historic examples of institutions, advisers or individuals who got things badly wrong.

spectacular losses of financial wealth can be put into three categories. the first is where investors fully understand the risks they are taking, and against their better judgment, they deliberately gamble and the gamble fails. they regret what they did, they know it was ill-considered and they can blame only themselves for their misfortune. A good example of this behaviour is the often-told story of sir isaac newton’s financial ruin.

in the spring of 1720, sir isaac newton, “a scientist and presumably rational”, sold his investment in the south sea company, collecting £7,000, a 100% profit on his investment and a substantial sum of money, equivalent to as much as £7m today. he wrote that the stock price had by then become irrationally inflated by “the madness of people”. the south sea company itself contained a toxic mix of government sponsor-ship, endorsement by the great and the good of the day, and management by energetic fraudsters. in the subsequent months its price climbed yet further. newton could have profited more during that summer of 1720. then, perhaps overcome by regret at missing these additional profits, he invested heavily – £20,000 – at the top of the market. however, as the speculation unravelled, he lost it all. “Although the most imperturbable of men, [he] could never bear to hear the south sea referred to for the rest of his life. intelligence was no protection.”

the second category of spectacular losses is where a concentrated position is established because of faith in a particular investment story, while the benefits of diversification are dismissed as holding back the prospects for rapid wealth accumulation – but then the concentrated position turns sour. A celebrated episode that conforms to this pattern is the attempt by bunker hunt, his brother, herbert, and a few other investors to establish and maintain enormous positions in the 1970s silver market. one irony is that the hunt brothers shared with Paul Volcker, the newly appointed chairman of the Federal reserve, the view that inflation was getting dangerously out of control and embedded as a malaise in the Us economy (and elsewhere). “A billion dollars ain’t what it used to be,” bunker hunt complained, and he was right, as in the 1970s Us consumer prices more than doubled. hunt’s reaction was to put his faith in long-term holdings of a real asset, silver, for which demand was outstripping new production and supply was consequently squeezed. Volcker’s reaction to entrenched inflation was to squeeze the money supply, with a dramatic effect on short-term interest rates. this was to be a once-in-a-generation


6

shift in policy that ushered in a period of sustained disinflation. bunker hunt, through concern about the same macroeconomic trends as Volcker, ended up losing enormous sums of money as he found himself on the wrong side of those momentous events. he was also a victim of a change in commodity exchange rules, which were deliberately adjusted to relieve supply shortages.

in this second category are included the concentrations of pension savings of employees in the stock of a number of failed Us corporations and some well-publicised, ill-fated concentrations of institutional invest-ment which have caused acute embarrassment to particular funds. in the 1980s and 1990s, boston University suffered an enormous financial setback through having invested nearly 20% of its investment portfolio in one biotech company, seragen; and in the early 19th century, Yale Univer-sity lost more than 90% of its endowment when its efforts to sponsor banking competition by founding a local bank failed. When such misfor-tune affects an institution, the consequences are public, because the fiduciary structure carries with it exposure to public scrutiny. this account-ability helps to enforce diversification (see chapter 6 for a discussion of the role of the “prudent person” obligations on fiduciaries). however, instances of unnecessary concentrated risk-taking are probably a more common threat to financial well-being in the confidential world of private wealth than in institutional investment.

the third category of spectacular losses is where investors did not know the risks that they were taking, and would probably have altered their risk exposure if only they had had adequate information. instead, they were taken by surprise and suffered the consequences. investors should not take risks that are not expected to be rewarded, and uncer-tainty caused by poor information is never likely to be rewarded. the credit crunch of 2007–09 provided numerous examples of banks which were carrying risk exposures, particularly to securitised subprime housing debt, that investors (and the banks themselves) had little awareness of. there may be little that investors can do about such hidden risks other than the defence of having a properly diversified portfolio.

but investors can often put themselves in a position where they inad-vertently take risks that they could have seen. no investor needs to take this risk. All investors should worry about the information that they need before worrying about issues of investment strategy. this is an unavoid-able first step for any investor who wishes to sleep easy at night. (see Appendix 2 for an illustration of the sort of information that investors should review.)

setting the scene

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Think about risk before it hits you

risk attracts much discussion. risk is about bad outcomes. What consti-tutes a bad outcome is far from simple. it is determined by each investor (and not by the textbooks). it varies from one investor to another and from investment to investment. if an investor is saving for a pension, or to pay off a mortgage, or to fund a child’s education, the bad outcome that matters is the risk of a shortfall from the investment objective. this is different from the risk of a negative return. in chapter 5, the distinc-tion is drawn between threats to future income (which is of concern to a pensioner) and threats to the value of investments (which may be critical to a cautious short-term investor). this shows that the risk of losing money cannot be a general measure of risk. this means we need to be cautious in the use we make of common metrics such as the standard deviation or volatility of investment returns.

risk relates to the danger of failing to meet particular objectives. but risk is also the chance of anything happening at intermediate dates which undermines an investor’s confidence in that future objective being met. since those working in the investment business are uncertain about market relationships, it is reasonable for investors to be at least as uncertain. it is also reasonable for their confidence to be shaken by disappointing devel-opments along the way, even if those developments are not surprising to a quantitative analyst. investors’ expectations are naturally updated as time evolves and as their own experience (and everyone else’s) grows. so far as the investor is concerned, the perceived risk of a bad outcome will be increased by disappointments before the target date is reached, undermining confidence in the investment strategy.

research by mark kritzman and Don rich on risk measurement has explored this theme – the pattern of investment returns along the way matters to investors, not just the final return at some target date in the future. this focus on the risk of suffering unacceptable losses at any stage before an investor’s target date has highlighted the dangers of mismeas-uring risk. An investor might accept some low probability of a particular bad outcome occurring after, say, three years. however, the likelihood of that poor threshold being breached at some stage before the end of the three years will be much higher than the investor might expect. the danger is that the investor’s attention and judgment are initially drawn only to the complete three-year period. As the time period is extended, the risk of experiencing particularly poor interim results, at some time, can increase dramatically.

the insights from behavioural finance (see chapter 2) on investor


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loss aversion are particularly important here. Disappointing perform-ance disproportionately undermines investor confidence. the risk of this, and its repercussions for the likelihood of achieving longer-term object-ives, represents issues that investors need to discuss regularly with their advisers, especially when they are considering moving to a higher-risk strategy.

research findings on behavioural finance emphasise that investors often attach different importance to achieving different goals. the risk of bad outcomes should be removed, as far as possible, from objectives which the investor regards as most critical to achieve, and, ideally, any high risk of missing objectives should be focused on the nice-to-have but dispensable targets. investors may then be less likely to react adversely to the disappointments that inevitably accompany risk-based strategies. they will know that such targets are less critical objectives.

A separate issue is whether a bad outcome is itself a measure of risk. the simple answer is that performance itself is not a measure of risk. it is easy, but human, to extrapolate from the performance of an investment the risk of that outcome occurring.

the important message is that risk is about the chance of disappointing outcomes. risk can be managed but disappointing outcomes cannot, and surprising things sometimes happen. however, measuring the volatility of performance, as a check on what the statistical models say is likely, can be helpful in coming to an independent assessment of risk. but it will always be based on a small sample of data. thus we can attempt to measure only perceived risks. risks that exist but that we do not have the imagination to perceive will always escape our metrics. there is no solution to this problem of measuring risk, which led Glynn holton to write in Financial Analysts Journal in 2004, “it is meaningless to ask if a risk metric captures risk. instead, ask if it is useful.”

more often than not, the real problem is that unusual risk-taking is rewarded rather than penalised. We need to avoid drawing the wrong conclusions about the good times as well as the bad times. this theme is captured by a photograph at the front of Frank sortino’s and stephen satchell’s book Managing Downside Risk in Financial Markets. it shows karen sortino on safari in Africa, petting an intimidating rhino. the caption underneath reads: “Just because you got away with it, doesn’t mean you didn’t take any risk.”

How much risk can you tolerate?

the assessment of investor risk tolerance is a fundamental step in

setting the scene

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designing any investment strategy, but advisers and academics approach it in different ways. Academic economists use mathematical assumptions to model risk aversion. these assumptions are attractive to them in part because they can be used in models (and also because they can be tested empirically). meanwhile, behavioural finance stresses the importance of loss rather than risk aversion, and the asymmetry of response between gains and losses which is revealed in behaviourist studies (see chapter 2).

Wealth managers have for a long time used questionnaires to categorise their clients by their attitudes to risk-taking. these questionnaires typically cover investors’ circumstances (age, family, income, wealth, expenditure plans and so on) as well as their attitude to risk. one problem is that questions posed by wealth managers about risk may use language and concepts that are unfamiliar to non-experts. Anecdotal evidence suggests that people without a familiarity with investments often expect a risk questionnaire to be difficult to complete. they may therefore ask their advisers to help them answer the questions. this introduces errors and also seems to introduce systematic bias, as investment advisers appear to be more tolerant of risk than their clients. For these reasons, conven-tional risk questionnaires may fail standard criteria for assessing people’s attitudes.

in recent years psychometric profiling services have developed to address these concerns, making use of focus groups to ensure that their questions are easily understood. For example, Finametrica, an Australian consultancy, has built up a database of over 260,000 responses from around the world to its questionnaire, which itself grew out of research by psychology academics in the United states. these responses reveal some interesting patterns. For example, Finametrica reports that: the pattern of responses does not vary much by country; women tend to be more cautious than men (which is important for investing family wealth); and investment professionals tend to be more tolerant of risk than their clients (who in turn tend to be marginally more tolerant of risk than the popula-tion as a whole).

the finding that investment advisers were on average more tolerant of risk than their clients may help to explain instances of investors saying to their advisers: “i didn’t realise we were taking that much risk.” this greater tolerance of risk might be interpreted as reflecting advisers’ greater under-standing of investment risk than their clients’. separate survey findings (also from Australia) suggest that investor education (for example through attendance at seminars) has little impact on the risk tolerance of investors, even though it can be effective in persuading employees to save more for


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retirement. this suggests that investment advisers may think it reasonable to take more risk than most people would wish, not because they have a better understanding of investment risk, but because their nature is to enjoy the proximity to volatile markets. it seems that cautious people probably cannot be educated out of their disposition to be cautious, and it also seems likely that well-designed psychometric testing may help to categorise the risk appetite of investors better than ad hoc question-naires. neither, though, is a substitute for an adviser also finding out what the investor wishes to achieve and when, and whether those goals are realistic.

Know your niche

the style of involvement in decision-making is one of the most important issues that investors need to decide. how hands-on or hands-off do they wish to be, and what are their preferences and special areas of investment expertise? this is a natural starting point for discussions for any investor with a new investment adviser.

some investors like to devote much time and personal effort to their investments. others prefer to delegate as much as possible to someone they trust. neither policy is inherently superior, so long as keen investors have grounds for believing that their interventions are likely to add value (or to save value), and disinterested investors are sure that their advisers properly understand their investment objectives and that a reliable process of review has been established.

successful entrepreneurs often have specialist skills that put them in a privileged position in the assessment of new business opportunities in their specialist areas. this role as potential informed investors is likely to open doors to investment opportunities that are not available to other investors. but it will be unclear how these investments should fit into an overall investment strategy and how the entrepreneur should weigh the risks.

hindsight is a useful guide here. An entrepreneur with specialist knowledge in the technology sector is unlikely to have been able to protect investments in this sector during the bear market of 2000–02. neither the skills of the investor nor the quality of the venture capital investments would have protected them from that downturn, even if they subsequently recovered. each specialist investor will best be able to assess these risks individually.

such investors need to consider whether and how far to diversify away from their niche area to provide a downside layer of protection, or a safety

guide to investment...

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