Adding together all the column inches written surrounding the ‘credit crunch’ and the collapse of the global economy would probably produce a paper trail that would stretch to the moon and back - and it is unlikely to be over yet!
Between March and November 2009 investment markets experienced a sharp reversal in trends and sentiment across all asset classes, and those assets that suffered most in 2008 have been the best performers during this period. Policies enacted by central banks and governments have all but avoided financial meltdown. The ‘crisis’ part of this credit crisis has probably passed, but many of the issues have not been fixed and could continue to be with us for many years. Sentiment has improved and, for the moment at least, it appears that we are no longer staring into the abyss.
Once economies and markets start to normalise, it is certain that there will be a lot of debate surrounding ‘lessons to be learned.’ But are there any lessons that we have learned already?
Riskier assets, such as global equities, have staged a spectacular rally since their March 2009 lows but it should be noted that despite the strong rally, most major equity market index levels are still in negative territory when measured over two years to November 2009 (date of writing) and are barely changed from their levels three years ago. It is clear that trustees and investors have been shocked by the degree of losses that they are currently facing. It is apparent that, in some instances, trustees and investors did not expect the valuation of their investments to be so volatile and behave in the way they have, i.e. they did not fully appreciate the degree of risk. So, how can we better protect ourselves from the occurrence of these kinds of events in the future and where do we start?
If your objective is not being achieved, it makes sense to go back to the blueprint of your plan. Setting the plan, or investment strategy, is one of the most important investment decisions that trustees and investors will make. Whilst setting a robust and appropriate investment strategy is not a panacea, this approach should significantly increase the probability of the investment objective being achieved.
Setting the appropriate investment strategy
In order to set an appropriate investment strategy we must first identify the investment objective, i.e. what do you want your assets to achieve either as an individual or as a trustee? This calls into question why we invest at all. The simple answer is, we accumulate and invest our assets so that we can pay for a stream of known and unknown costs or liabilities that we expect to arise sometime in the future, such as provision for the beneficiaries of a trust and financing school fees.
Investment objective
Effectively, the investment objective is determined by the size and incidence of this future stream of expected and unexpected liabilities. It follows that, the better our understanding of this future stream of liabilities is, the easier it should be to set an appropriate and robust investment strategy. For example, if we had one single liability of GBP10,000 maturing in one year’s time, we would simply put GBP9,615 in a bank account that is expected to accrue interest at 4 per cent. In one year’s time the amount of cash in the bank account should be GBP10,000, which covers our maturing liability in full. If only it were so simple…!
Future liabilities may be known and unknown and comprehensive analysis may prove difficult. The analysis may be further complicated by unforeseen changes in circumstances, which may lead to your liabilities maturing earlier than previously expected. Monitoring your liabilities and revising your investment strategy accordingly should ensure that your strategy remains robust.
Understanding risk
Now that we understand the liabilities, we need to consider what further information we require to be able to determine a robust investment strategy. Firstly, we need to understand the extent of any return or growth that can be achieved from various asset classes. More importantly, it is imperative that we have a clear understanding of what the potential risks of investing in these assets are expected to be.
Forecasts of future anticipated levels of risk and return from investment assets come from various sources, such as global economists and investment strategy teams from fund management companies. The process for forecasting starts with a study of how the assets have behaved historically during the various economic environments we have experienced. It then moves on to consider the expected economic environment in the future and, once this has been determined, anticipated levels of risk and return are calculated on the assumption that the assets are likely to behave similarly during the anticipated economic environment to the way they behaved in the past.
The limitations of forecasting are evident, in effect, forecasts will almost certainly be wrong but unfortunately we do not have a crystal ball! However, it is also evident that forecasts from recognised bodies should be the next best thing.
How is risk within investments measured?
Risk in investment assets is measured by the degree of volatility in the change of the price or value of the asset. Standard deviation is an industry recognised measure of the volatility of an investment and is the most common measure of statistical dispersion. Analysing a set of data for a given period of time, the calculation measures how spread out the values in the data set are from the mean or average. The further the spread or dispersion from the average, the higher the measure of standard deviation will be.
Using the example of a cash investment, the data points over the period analysed are all likely to be closer to the average, so the standard deviation is low. If we consider equity type investments, many of the data points over the period may be very different and further dispersed from the average. This results in a higher standard deviation or higher volatility/risk. In a nutshell, a higher standard deviation equates to a higher degree of volatility, which means higher risk.
Forecasts of risk and return
To achieve a market consensus view of the long-term (10 years) outlook for various assets classes it is important to consider the views of a number of forecasters. In our experience, long-term forecasts from a number of providers tend to be reasonably similar. We have detailed below the forecasts that have been very kindly provided by the Cazenove Capital Strategy Team as at December 2008 on a risk/reward chart. Expected volatility, or level of risk, is plotted on the horizontal axis and expected return is plotted on the vertical axis. It should be noted that the forecasts are provided as a long-term, 10 year view and will change over time.
What do these forecasts tell us?
The forecasts tell us that if we want very low levels of risk we must accept low anticipated levels of return (cash) and, vice versa, if we want higher levels of return, we must take on much higher levels of risk (International Equities or Commodities). The eagle-eyed amongst you will notice the forecast level of return from cash over the long term is significantly higher than the current achievable interest rates, which indicates the expectation of a return to a normal interest rate environment in the future.
We have already determined that forecasts of expected return may not be borne out, so how do we manage this eventuality? If we consider our simple example, given earlier when we considered the issue of ‘investment objective’, and assume that a fall in interest rates has led to a fall in the rate that we can achieve from our bank account to 2 per cent, the value of our investment after one year will be GBP9,808 and will not fully cover our maturing liability of GBP10,000. In this instance, we would need to find the extra funds from elsewhere.
Regular monitoring of returns from your investments and revising your investment strategy will help ensure that it remains robust and outcomes, such as the one described in the example above, can be identified early on.
Next steps
Doing nothing should not be an option. You should ensure that the investment strategy you set is the result of a positive decision. This means taking control of the asset allocation, i.e. the mix of bonds, equities, property and other growth assets, and putting in place a strategy that is a reflection of your anticipated liabilities. This mix must balance the conflicting objectives of risk reduction and higher return.
For example, if you have a liability that is going to mature in the short-term (less than three years) you should probably consider backing this with investments that are expected to exhibit low levels of volatility, such as cash. In contrast, if your liabilities are not expected to mature for a long time, let’s say 10 years or more, you can afford to consider investing in more risky assets to back these liabilities. The increased time period to maturity means that your assets should have a longer time period to recover from any market falls and you will not be a forced seller of these assets to cover liabilities at inopportune times.
Conclusion
We live in very interesting times and trustees and investors are faced with very difficult decisions. It is unlikely that the current difficulties within the global economic environment will go away any time soon and there has never been a more appropriate time to consider the risk inherent in your investment portfolio.
Setting the appropriate investment strategy is very important and the strategy you adopt is probably the single largest determinant of whether your investments will succeed in meeting their objective, i.e. to meet the liabilities as they fall due.
Setting the appropriate strategy appears common sense, but the workings behind the scenes, such as understanding anticipated risk, is complicated. It is therefore critical that you receive investment advice from an appropriately qualified investment professional and that your investment strategy is given sufficient attention and is set in accordance with your investment objective. Finally, it is almost certain that circumstances will change and investment markets will not behave as anticipated, so it is critical that you keep your investment strategy under regular review so that any changes in circumstances can be dealt with accordingly.