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Risk management in times of crisis
by Gavin Lumsden on Feb 26, 2009 at 09:35
Investors could be forgiven for wanting to ditch all talk of asset allocation after the dreadful performance of their portfolios in 2008.
With all major asset classes crashing last year even well balanced and diversified portfolios suffered. Prudential's with profits fund, for example, which has kept ahead of rivals in recent years through skilful asset allocation, lost nearly 20% in 2008.
Of course individuals who throw up their hands in horror and vow never again to use asset allocation / listen to their adviser / invest in the stock market etc, are displaying the characteristic over reaction of investors over time.
I was reminded of this by reading an article on 'risk management in times of crisis' by behavioural finance expert Thorsten Hens, professor of financial economics at the University of Zurich's Swiss Banking Institute.
Hens has an hilarious chart showing the mood swings of the typical emotional investor (ie, most of us).
You've probably seen similar charts illustrating the buy-at-the-top and sell-at the-bottom behaviour of investors. Many people watch a stock rise too long before buying and then hang on too long when it starts falling. By the time the share price has waved up and down over the course of a few years they are thoroughly disenchanted.
And if they have gone through an exceptionally bad year like 2008 they are, as you know all too well, absolutely desperate.
Hens' point is that investors have to accept that market crashes are an occasional fact of life. Before last year's 41% loss, the S@P 500's other bad years were 1974 (-29%), 1937 (-32%), 1931 (-37%) and 1917 (-31%).
And he says an asset allocation strategy is the necessary discipline we all need to avoid the pitfalls of momentum investing.
He admits that a 100% equity investment strategy provides the best returns over the long term - a portfolio split 50-50 between 10-year US treasury bonds and the S&P 500 since 1871 would have produced only 58% of the value of the pure equity strategy.
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- behavioural expert Thorsten Hens
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3 comments so far. Why not have your say?
Philip Wise
Feb 26, 2009 at 21:00
His research sounds nice but I dont have that many clients with a 152 year time horizon who dont care about what they lose or gain on currencies. None of my clients think there are only two asset classes (so US shares outperformed US bonds, but how did they do agains property, cash, corporate bonds or commodities).
When I started 20 years ago, people used to show me five year performance figures to demonstrate equity outperformance. They started showing me ten year figures in 2003, and now 20 year figures are needed to prove this point.
I think 152 years is a record, but I wonder how long it will be before someone will feel the need to show me that "equities are obviously best for the client, as proven by this chart of 200 year performance (with dividends reinvested of course)."
Still, we are all living longer...
Perhaps for his next bit of research he should start by reading "The Emperor's New Clothes".
report thisMary Dunn APFS
Feb 27, 2009 at 08:59
Asset allocation can only be a dangerous practice when the model does not take into account - HOW MUCH IS ENOUGH !.
I believe that advisers and clients need to take on board the need to carefully plan for, and monitor, the very long term objectives, i.e. level of income required at various stages of life (with and without catastrophe) and what assets (if any) are to be left behind after death - only then, does the requirement for money, suitable asset allocation, investment risk and financial planning start to make real sense.
If you can quantify the individual's need and timescale; - investment risk and asset allocation will become a tangible factor which the client can take hold of and understand. Better still, the financial planning adviser becomes an absoluite necessity rather than a scapegoat when markets are against us or worse still, a pain in the rear end, who is perceived as just trying to pitch another sale.
I'd rather explain to a client, the overall effects of a stockmarket crash on their lifetime financial lifestyle and take measures to address the shortfalls than spout off a load of financial jargon which although important to the adviser is rarely of interest to the client.
report thisJohn Whipple
Mar 02, 2009 at 20:01
...as rare as hens teeth?
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