Nothing “out there” can do as much damage to your clients’ investments as what is “in here”. The mindset and assumptions that underly your investment solutions are where risk lives.
Most people will not accept that. Let me remind you about all those hundreds of thousands of people who believed in 2007 that UK house prices could only go up and were happy to borrow six times their income to join a one-way get-rich party. Not to mention those who bought new flats off-plan because they were sure they could sell them at a profit when they were built. And the millions of people who believed in 2000 that you could make a fortune buying tech stocks on completely irrational valuations. I could go on, all the way back to the South Sea and tulip bubbles.
It seems a sensible response to this to say extreme valuations should have flashed big red lights in all these situations, and that if you weren’t asleep you should have dodged out of the way of the oncoming train.
The trouble is it is in the nature of a bubble that very sophisticated rationalisations are found to justify absurd valuations. Those clever arguments lull the suspicious brain back into a peaceful doze so it can graze comfortably with the other sheep.
Sometimes these elaborate justifications become ridiculous. The economists and analysts are all assuming everything is on the way “back to normal”, but hang on a minute. We are in the midst of the largest monetary experiment that humanity has ever undertaken. There are no road maps. If you believe the calm assurances of central bankers, you have swallowed too much of Alice’s medicine: they are not a hundred feet tall, they are guys hiding behind curtains pretending to be wizards.
I might be wrong about that. So I will not bet the ranch on it. But I certainly will not buy the “back to normal” story, especially when old models of cause and correlation just are not working in delivering accurate predictions of what happens next.
The most pernicious type of bubble thinking is to substitute data for history. The real issue with stochastic investment engines is that their data tanks contain a 30-year bond bull market. There is no bond crash in that data. And the dirty secret of these engines is there simply is not the data further back than that for series they pretend to be using – try finding a good corporate bond index for the 1970s, for example. If you build a bubble into your model, what kind of outcomes should you expect? “Safe” portfolios containing high allocations to bonds.
If you lived through the 1970s, you know that it is possible for five years of inflation to wipe out two-thirds of an investor’s real capital. You will find plenty of countries where that has happened – this was not a “five sigma event”.
An evidence-based model of the real world will tell you that there are different types of risk involved in different asset classes. Why would you choose to override that with a data engine that instead assumes that correlations and volatility accurately represent those risks?
I am not predicting Bond Doomsday. But I do want to protect our clients from it if it happens. I do not want to sleepwalk to the wild side.
Chris Gilchrist is director of Fiveways Financial Planning, a contributing author to Taxbriefs Advantage and edits The IRS Report