A perspective on the current investment climate

In volatile markets, wealth transfers from weak hands to strong hands. Now is a time for strong hands.

Recent turmoil in financial markets has caused concern to many investors. Share markets worldwide have fallen heavily, significantly impacting portfolios and confidence in the US financial system is weak. It is not every day that major investment banks go broke.

Financial decisions in a downturn can impact our wellbeing for years to come. We can’t control markets but we can control how we respond. Here we try to make sense of the turmoil and how to get through to better times.

How did it come to this?

Share markets, jumpy for 12 months, recently fell further and some are now well off their highs. The issues are complex but the cycle is simple:

1. Low interest rates and slack lending policies make home loans freely available. This works fine while house prices rise. U.S. house prices have fallen, up to 15%-20% in some areas.

2. Many borrowers can’t repay loans

3. Portfolios of mortgages held by investment banks and other institutions plunge in value. Some firms that are over-exposed, and have too much debt, go under.

4. Confidence disappears – a classic “credit crunch” ensues.

Casualties have included Bear Stearns, Lehman Brothers, mortgage providers Fannie Mae and Freddie Mac, and American International Group (AIG). Merrill Lynch fast tracked its sale to Bank of America to avoid a similar fate. The US government has acted swiftly, bailing out some and proposing a $700 billion fund to help others. Their aim is to prevent a Wall Street event from causing a deep recession.

While this is a real possibility, there are also some pluses to note – lower oil prices, lower mortgage interest rates, and globally co-ordinated government action among them. The world economy has been resilient and remains so.

What to do?

In the past 25 years, we’ve guided investors through six downturns, each one different. The truth is we know only one sensible way to get through such a difficult period: stay well diversified, ignore “noise” as much as possible and get good advice. Here’s some of what we’re doing to manage investment portfolios:

Staying diversified: While diversified portfolios have lost ground, maintaining a wide range of investments mean disastrous results from one or a few have a small effect.

Managing to long-term asset allocations: The evidence of history is that knee-jerk reactions like major switches to cash when share markets fall heavily can be very costly. Moving to cash will mean losses are locked in.

Rebalancing: We continue to rebalance between different investment types so we routinely buy asset classes that have fallen in value, and sell those that have risen. This effectively means that over time we consistently buy cheaper assets and lock in the profit of more expensive ones.

Uncovering opportunities: Good investments usually emerge from periods like this. Banks that make it through will be better regulated and may end up with fewer competitors. One of the world’s best known “value” investors, Warren Buffett, recently pumped around $5 billion into US investment bank Goldman Sachs, suggesting he thinks it is undervalued. Compelling opportunities are likely to emerge but risks will also need to be closely managed.

Everyday companies haven’t stopped performing well just because markets are down. Fisher and Paykel Healthcare’s underlying growth remains reassuring. Mainfreight has been a solid performer this year and Michael Hill International is a quiet achiever.

There will be winners from the current turmoil in global financial markets. For example, Lloyds TSB is a large and stable UK bank with a diversified business model and broad retail base. They have purchased HBOS (Halifax Bank of Scotland) who was impacted by the current crisis. Lloyds were previously prevented from similar acquisitions. Lloyds will eventually profit from increased market share and improved efficiencies.

What does history tell us?

Most forecasts of market direction are worth less than the paper they’re written on. But there are typical market behaviours during and after most downturns:

It’s different (and the same): Every downturn is different but financial institutions have failed before. The system normally emerges stronger but never foolproof.

Markets typically do recover: When markets have fallen sharply – the 1987 crash, Dot Com Bubble, 1970s oil crisis and so on – they have typically recovered. Sometimes recovery is surprisingly quick, other times it takes years. Only those who are invested participate in the return.

Recovery may come without warning: No-one holds up a big sign saying “market recovery”, so parking too much in cash may mean missing a rebound. Markets often recover from a downturn six to nine months before the economy.

Markets are cheaper post-fall: At times like this, good stocks are thrown out with bad. Currently share prices in many markets are below long-term averages. A combination of fair economic conditions and lower prices sets up diversified portfolios to deliver reasonable returns in the coming years.

What can you do?

Keep perspective: While the last year has been tough, even including this poor recent performance, the past five years have still been good in many markets.

Try not to be affected by daily news: We don’t attempt to downplay the very real challenges facing markets in the period ahead, but reacting to daily news may be a bigger threat to long-term success than a fall in the market.

Remember why you did, what you did: At some point in the past with the help of a financial adviser you established a portfolio to assist in supporting the life you want to live. Unless you’ve changed your goals, think very carefully – and consult your adviser – before changing your portfolio.

Be careful how you use cash: Cash is fine for the short-term. But as a long-term investment, it’s likely it will not support the lifestyle you’d otherwise enjoy. Switching to cash in a downturn may simply close the door to an eventual recovery.

Get good advice: If advice is important in good markets, in tough times it’s essential. Work with your adviser so you make the right choices.

Finally, the current turmoil will most likely pass. We don’t know when (no-one does for sure) but our research and experience suggests it will happen.

The bridge of wellbeing

Truly content people are in control of several key domains of their lives – work, health, recreation, social life, money and relationships – and they aim to balance their time and effort across them.

Lifestyle financial planning involves looking inward to uncover your values and goals, then making choices that are consistent with these, rather than treating money as a measure of success.

Sustained investment success requires a personal financial framework that enables you to understand the role of money in your life and the choices you make to support the life you desire.

This framework is known as the Bridge of Wellbeing and the three pillars that underpin it are:

1. Understanding and defining your values and goals

2. Deploying financial strategies that use your resources in a way that is consistent with your values and goals

3. Developing your financial and investment strategy

There is considerable empirical and anecdotal evidence showing that increasing the strength of each pillar will help you cross the bridge to wealth and wellbeing.

Understanding your values and goals

The reality is many of us spend too little time thinking about what would make us happy and disproportionate time and effort chasing goals that don’t bring the satisfaction we seek. When setting goals, it’s important to look forward, not back.

Too often, people look back at what they’ve learned, at what qualifications they’ve achieved, and at what loved ones have identified as their strengths and weaknesses. The problem with this approach is that your future is dictated by the limitations of your past. So suspend reality and the limitations of the past and think about the things to which you genuinely aspire.

One aspect of determining how much money is enough is planning for security in retirement. The general rule of thumb is that once work stops, the kids leave home and expenses fall, most people find that they need something like 75% of their final working income to sustain a good lifestyle in retirement.

Applying your resources to achieve your goals

Begin by mapping out your financial resources today and in the future. This is easier – and more fun – than it sounds. In fact, if you have spent time thinking about what you want to achieve at various stages of your life, it can be very enlightening.

The basic steps are:

1. Identify your current income and expenditure by doing a budget

Don’t be too precise, estimates will get you started. Also list your assets and liabilities to work out your net wealth.

2. Estimate your income and expenditure in the medium term (3 years) and longer term (5-10 years)

Taking into account your savings potential, estimate the growth of your assets, net of liabilities, in the medium term, at the point of retirement and a couple of years into retirement. A valuable exercise is to calculate how long your estimated retirement savings will last, given your desired lifestyle.

3. Balance your current and future needs and goals

As you go through this process, you will start to see how many of the goals that are important to you are affordable, given your current plans. One of the biggest challenges that we face is reconciling our strong desire for security and a good lifestyle in retirement with the many pressing day to day demands – particularly if we have teenagers or ageing parents.

4. Savings and investment are complementary.

Often too much emphasis is placed on investment returns and not enough on saving. Savings can be thought of as the cake. Investing them, to enhance their value over time, is the icing. If you save a dollar, it doesn’t make much difference to your wealth if the return after one year is 5% or negative 5%. But you have nothing if you don’t save the dollar in the first place. Over time, investment returns can compound massively. Combined with a regular savings plan, this means the cake will grow very large, and the icing very thick.

Developing your investment strategy

To develop a sensible investment strategy, all you need is to understand four key investment principles and get good advice. Having a simple strategy that you understand, plus a sensible investment portfolio, will hold you in good stead during periods when the markets are working against you.

Quality: the only way to identify quality companies and investments is through rigorous analysis. Look for attributes that include sound longer-term earnings; good return on equity; capable management with a solid track record; and a sound balance sheet.

Value: this means the quality and price. Some of the worst disasters have arisen from people paying too much for what are, essentially, quality assets. The key to assessing value and quality is to know whether an asset can produce an attractive return relative to its risk.

Diversification: is important because it provides access to a wide range of investment opportunities, rather than one or two. Diversity involves having investments across different asset classes, countries and funds.

But, the ultimate test of a successful portfolio comes with time.

Over long periods in the market, say 5-10 years or more, virtually all strategies based on the above four principles have greater upside potential, with less downside.

Your feedback is welcome

Financial Update is a regular publication published by Spicers Portfolio Management. It discusses topical investment and financial planning issues. A free copy of Spicers disclosure statement can be obtained by calling 0800 102 100 or visit www.spicers.co.nz.
Spicers is widely recognised as one of New Zealand's leading financial planning firms with a strong reputation for quality advice, integrity and delivering results. Established in 1987, the company has a network of 60 advisors throughout New Zealand and successfully manages more than NZ$1.5 billion on behalf of its clients.