Economic conditions have changed so drastically that what once was viewed as common sense now threatens your financial wellbeing. Patrick Commins examines strategies to thrive.
After a new mantra for your investing? Try this: "When the facts change, I change my mind."
That pithy line is attributed to economist John Maynard Keynes. And when it comes to investing, the facts have changed - or rather, what we thought were the facts no longer ring true. Here is a sample of former truisms: buy and hold is a safe way to invest sharemarkets outperform over the long term house prices only go one way - up.
After a long, sunny period, a splash of cold water - courtesy of the GFC - has left many investors bewildered and gasping. The first response was flee to safety. Deposit accounts around the country bulge.
But it's unlikely that bank deposits will provide you with the wealth creation you need to reach your financial goals, especially if inflation gets on the march.
And paralysis is not an investment strategy. If you are thinking about reinvesting some of those dollars, you need to understand the new rules of investing. What worked in the 1990s may not work now.
There are six commandments you need to learn to be successful in the brave new world of investing: lower your expectations seek absolute returns minimise volatility in your portfolio forget set-and-forget think global and get a grip on how your mind can play tricks on you.
1. Get real on returns, part I
The first thing you need to do is accept that the days of easy money and double-digit returns are over. For good. The period of the 1990s and early 2000s were known as the "great moderation", a period of stable prices and steady economic growth. Disinflation - low and falling inflation - was a wonderful base on which to make money. "It was like riding a bike downhill," Jonathan Ramsay, head of asset consulting at van Eyk, says. In retrospect, it's obvious that the normal ups and downs of economies and markets were still there, it's just they were being muffled by ever-increasing piles of debt.
Australian equities returned about 6.8 per cent a year on average during the past decade, according to Russell Investments - with volatility, as we know - and will probably generate a little over 8 per cent, including dividends and the effects of franking, in the coming five to seven years. (See the chart, above, for an idea of how asset classes will perform in this period.)
An even more sacred cow needs to be addressed: residential house prices do not always go up. They fell last year and don't look so hot this year, either. Residential property prices increased by more than 9 per cent during the past 10 years. We all know why: debt and the "greater fool" theory. Investors and home owners were happy to pay ever-higher sums with borrowed money on the basis that an even greater fool would buy it from them at an even higher price. No more.
Bottom line: you need to get real on how much you can expect to earn from your investments. You might also need to reassess and perhaps start saving more.
2. Get real on returns, part II
The second thing is, you need to be targeting absolute - rather than relative - returns. This idea is not new. "From the 1950s through the 1970s, investors were primarily concerned with securing a positive real return," the head of global investment solutions at UBS, Curt Custard, says. "They wanted to look at their end-of-year statement and see their account going up, and they hired active managers to achieve this goal."
The "cult of equities" that gripped investors from the 1980s came about as a result of the great moderation we talked about above. We all believed in the mythical 30-year time horizon where shares would always outperform. In this context, fund managers became more specialised by asset class and started being rated against benchmarks, rather than their ability to actually make money for their clients. After all, when the benchmark always went up, they always made you money.
No more. Now is the time to go for absolute returns, preferably targeted at a rate above inflation.
Steer away from "fully invested" equity funds. Fund managers need to be able to go to cash when things go pear-shaped. It's common sense. That does mean you need to keep better track of what your fund is invested in. You could find yourself more exposed to cash than you thought, for example.
Also, take a look at funds that invest in infrastructure assets such as airports and toll roads - real assets with reliable and often inflation-linked earnings.
3. Understand volatility
Volatility gets you in two ways. First, it unnerves investors and can lead them to bail out of assets at the wrong time. Second, a volatile asset compounds in value at a lower rate than another asset with similar returns but lower price variation.
Smoothing out volatility is therefore a key consideration for investors and one of the new rules of investing. For example, the headline return of 6.8 per cent a year for Aussie equities in the past decade looks OK but consider this: the annual volatility was a massive 13.7 per cent, on Russell Investments numbers. Bonds returned 6.3 per cent a year on average, with a volatility of 2.8 per cent. Which would you prefer?
A tried and true way to reduce the volatility in your portfolio is to invest in a diverse range of assets that are lowly correlated with each other (that is, their prices don't move in lock step).
Bonds typically provide a great counterpart for equities. They suffered along with equities at the height of the financial crisis but strongly outperformed local equities last year, for example. So, says the head of research at Macquarie Private Wealth, Riccardo Briganti, don't lose faith in bonds as a great way to offset the risk of the equity component of your portfolio.
When it comes to diversifying the growth portion of your portfolio, "alternative" investments are increasingly popular. Consider "market-neutral" hedge funds, or those which invest across a broad range of asset classes including commodities futures (such as the Winton Global Alpha Fund through the Macquarie Professional Series). You can also invest in oil, agricultural commodities, gold and other precious metals through exchange-traded funds. Remember that while commodity prices may move independently of sharemarkets, they are highly volatile in themselves, so you need to be careful.
4. Forget 'set and forget'
Some investors will tell you it was never alive but the idea that you could sock some money away into blue-chip company shares and pull them out 10 or 20 years down the track in time for a comfortable retirement is dead.
"Time in the market, rather than timing the market" was a sound premise that went too far. It became an excuse to tune out.
"The world is changing a lot more quickly now," Macquarie's Briganti says. You can't buy shares in a company, thinking its business model will be as sound in five or 10 years as it is now. Not when technology is moving so quickly and our - and the world's - economy is undergoing structural change.
Take banks, for example. After a decade of double-digit credit growth, they now have to get used to a slower consumer demand for loans.
That means you need to be more active in how you manage your money and alive to what's happening in markets.
Take the risk of inflation. We are at an inflection point - will Europe and the US take a turn for the worse and drag down the world economy with them? If so, we could be in for a period of deflation - falling prices. In that kind of environment, bonds typically do best. Or will all the freshly printed money in the system find its way into prices as banks regain the confidence to lend and businesses and consumers to spend? In that case, a spike in inflation is the risk. That would be bad for bonds, less so for equities, although both would suffer in the first stages.
5. Think global
In late 2007, something extraordinary happened: China overtook the US as the single biggest contributor to global growth, according to International Monetary Fund figures. Indeed, the emerging Asian economies had for some years already accounted for a greater share of global GDP growth than the US had.
This global growth leadership handball means, in effect, that world economic health no longer depends solely on the robustness of the US economy. That is especially true for Australia. Thanks to our abundance of mineral resources, Australia teeters between the global economy of the past and that of the future. Our sharemarket still follows New York but our economy depends on news out of Beijing.
Chinese authorities are now trying to author a slower, more sustainable development path, with the Chinese consumer at its core.
Chinese workers are demanding and winning wage increases. Millions enter into the middle class every year. That transformation will also affect the relationships between countries within the emerging Asia bloc, as other countries, such as Vietnam, begin to emerge as alternative sources of cheap labour.
The first rule of investing to be gleaned from the great global growth handball is that it's no longer enough to follow developments in Europe, Japan or the US. You need to turn your gaze to our Asian-region neighbours. Likewise, your portfolio needs to recognise that much of the growth will come from these emerging countries. That could mean giving your money to a professional fund manager who invests in emerging economies, or buying an exchange-traded fund that tracks one or more of those markets.
A related rule is to recognise the evolving role of the Chinese consumer. A popular way to play this of late has been to buy global brand names with a growing profile in Asia - LVMH, Yum! Brands or BMW, for example. But think: what do we have that emerging-market consumers will want? Education, tourism, healthcare and agricultural goods. Also, perhaps financial services or engineering consulting, particularly in the mining space. Be alive to opportunities.
6. Get in touch with your emotions
In the brave new world of investing, rationality doesn't always have the last word. An increasing number of professional and amateur investors are recognising that our minds tend to fall prey to a range of biases that can lead us to make subpar financial decisions. "Behavioural and neuroscience research suggests that fundamental changes in circumstances can accentuate these biases by confusing the 'analytical' part of the brain and allowing the 'emotional' part to take over," writes Mohamed El-Erian in his best-selling book, When Markets Collide.
Most of us accept that we need to match our assets with our financial goals and time horizon. Fewer of us take the time to understand our level of risk tolerance. But taking up an aggressive investment strategy when you are, in fact, uncomfortable with taking financial risks can lead to poor decisions in the heat of the moment.