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INVESTMENT INSIGHTS ARCHIVE
Originally posted in December 2015
An Investor Insights written seven years ago that stands the test of time.
The daily work of a trader or an investment manager revolves around monitoring the economic and global information, devouring research and world headlines, and looking for themes that will affect asset classes in the future. It is as wise to read a wide choice of research with differing views, rather like reading both ‘The Guardian’ and ‘The Daily Mail’ and hoping to find a balance, as well as your own original thoughts.
Writing research often swings between writing new stuff – hard when there is not much to say – or repetition of the important stuff, potentially too polarised between optimism and pessimism.
In that vein, I will be drawing on some material from the October (2015) letter that is increasingly important, as well as the concept of diversification in a standard portfolio.
My main theme in 2015 was that equity markets would have regular 5-10% declines, followed by grinding recoveries “going nowhere”, which was the blog written in December 2014. For the index trackers, with the UK FTSE suffering a 5% decline, the US and Europe markets (slightly down year on year) showed that often only an active trading strategy or excellent stock selection sees real returns.
Unfortunately, my theme for 2016 – as you may have guessed from the introduction to this month (Dec 2015) – is the belief that we are at risk of severe asset price declines in most high weighting portfolio components, namely equities, bonds and property. It is only my theme and a view that is shared by some, but not by others; however, once you have developed a theme, you have to set your stall by it and continue to allocate your portfolios accordingly, until your theme ideas change.
Most people expect or would like their savings and investments to have characteristics such as:
• Strong and credible returns of 10-12% a year
• The ability to compound that return intra-year and yearly
• Very low volatility with limited risk of huge capital loss
• Very low cyclicality, where an investment is not reliant on market and interest rate cycles
• Complete transparency in pricing on recognised exchanges. Too many investments have opaque or zero price visibility and don’t necessarily compensate with high returns
• Immediate liquidity on request, no questions asked. This is only truly possible when the underlying assets are truly liquid themselves, such as large cap equities. Seasoned investors may have learnt the hard way that student accommodation, private equity, mini-bonds et al, fall way outside this liquidity rule despite advertised claims
• An intuitive methodology that investors can follow and feel comfortable with in all market conditions
Many people tend to leave the investment decisions to their wealth or pension managers, who often try to diversify for the sake of diversification, often not paying enough attention to the above points of the correlation. We have discussed one of the most straightforward portfolios over time, often known as “The permanent portfolio”, which splits 100% across:
Gold portfolio management - https://www.hindesightletters.com/wp-content/uploads/2022/12/01_02_11_Gold_Portfolio_Management.pdf
This permanent portfolio, as you can read via the link, has stood many of the tests of different times, producing solid returns, as the name suggests. The reason was that the relationships (the correlations) between the asset classes had different cycles – when one went up, some of the others tended to go down, and so on. Another clear indicator that all is not well is that this portfolio looks every bit at risk as any other in these times. Equities, Bonds and Cash are at very high valuations, providing only return free risk it would appear. Only gold looks comparatively cheap.
As I touched on in the introduction, since 1987, wealth managers have been able to start any portfolio with high weightings of equities and bonds, confident that they have inverse correlation (stocks down, bonds up), especially in times of stock market crises, as well as gaining good coupon income from the bonds. While weightings may vary, these two asset classes make up a very high portion of wealth in any fund or pension plan. Property, of which the UK investors typically have far, far too much exposure, often feels like a mixture of both.
The issue that is obvious to many is that easy money policies have driven these over valuations in these asset classes and as such, they are all at risk. As a pension manager, you are often bound by certain rules and wealth managers by benchmarks to own this mix, but as an investor you are not.
Developing your own investment plan is key, including what you can live with, what you afford to lose and what you are trying to achieve. Age can be very relevant to investing and, of course, there are two sides to every coin. I believe that asset classes are at risk of catastrophe, others may not. We met many people in 2008 where the wealth manager was trying to justify that, although they had only lost 30% of their clients’ wealth, it was better than the benchmark!! One thing I feel strongly about is that, if there is another crisis and wide spread asset price declines, the central bankers’ inability to cut interest rates by 5% this time will make that wealth loss much more permanent. That is not an outcome I would like.
Naturally, this is not a recommendation, but having written about the Wiley Coyote moment, this is how I have altered my wealth exposure over the recent year and my current position.
Although I sold my London home and moved to the coast to take advantage of the ability to downsize and gain in the price spread, my recent late charge into fatherhood also tipped the balance, but I no longer own any commercial property either. I have sold all the bonds in my portfolios or moved to very short durations, like Treasury Bills, which is the best way to hold cash balances as well. Remember Cyprus! For the equity component, I continue to look for selective stocks, such as the HindeSight Dividend portfolio, to invest for capital and income return, but I will run a short index position to hedge out the market exposure while my crash theme is in place. I hold a reasonable allocation of precious metals, which despite having fared poorly in recent years, are now at levels that make them one of the few cheap assets classes and history tells us that they are an excellent safe haven diversifier of risk.
Clearly that is a very defensive portfolio. I expect to make money on the long/short nature of the equity component and I believe the gold is cheap, but having a high cash balance held in zero yielding T-Bills is going to earn me nothing. Bearing in mind my views, avoiding a 30-40% catastrophic drawdown in wealth is my aim and holding cash has the opportunity cost of being able to buy cheap assets after the crash. If I am wrong, and hopefully I am, I don’t think we are going to be able to see a roaring bull market in those assets classes in the near future, rather a muddle through continuation of going nowhere. I am prepared to take that risk.
From the October 2014 Letter
Write down all of your investments, property, bonds, equities, schemes and pension plans. Then try to group them into market exposure by asset class as best you can. Start to record your NAV (net asset value) of your total portfolio, quarterly or even monthly.
The first and easiest example of risk for many is often stock market risk. Most people have exposure to this, either in their pension funds or equity schemes, like an ISA or single stocks in a broker portfolio. Let’s just assume you have worked out that you have a stock portfolio of £25,000 at your broker account, £25,000 in an equity scheme and £100,000 pension pot, which you understand is broadly 50/50 bonds/equity. You are roughly exposed to £100,000 in equity risk. The older you are, the more the pension pot seems to tend towards 100% and vice-versa. The young might often ignore this distant exposure.
While reports are only sent out quarterly at best in most cases, so actual visible valuations may not be possible on a live basis. Everyone should be aware that the FTSE 100 index dropped from 7000 on May 1st to 5800 on August 24th, roughly a 17% loss. On a £100,000 starting portfolio, this is a whopping £17,000 loss. Of course, you are in it for the long term and it always comes back, doesn’t it?? Understanding your exposure is very important to being able to accept or mitigate these risks.
I have been trading my own account for over 30 years and I can save you the trouble of looking around for the best spread betting firm. It is IG, the new brand name for IG Index, which has been around since 1974. They are head and shoulders above the competition in my opinion. Not only are they the best spread better, but you can in fact run your stock broking account at IG at the same time, if you wish, although this is not essential.
Of course, in order to trade, you will need to open up an account and fund that account with enough money to cover your margin. These will vary according to the market movements, which again at first sounds scary, but it is not. It can be risk reducing, not risk increasing.
So in the very basic terms, if on May 1st this year you believed you had exposure of roughly £100,000 in your equity basket primarily in UK stocks, you could have decided to hedge that for the summer by:
Selling £100,000/Index price of 6960 = £14.4/per point (units) of the FTSE 100 Dec future equivalent.
At the low point on August 24th, your £100,000 exposure would only be worth £83,000, as the worries about the collapsing Chinese economy sent shivers through the market. However, your hedge of short £14.4 a point would have been in profit by 6960-5800 (index low price) = 1160 points X £14.4 = £16,704. You would have completely protected your portfolio during those troubling times. You then can then buy back the hedge on St Leger day for example and benefit from some of the subsequent recovery. This is just one of the many ways that the average investor with more knowledge and more work can dramatically increase their odds at investment success over time.
Naturally, there are some hurdles to overcome in understanding the jargon and exact methodology, but IG provide training videos and their excellent brokers are at hand to help as well.
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