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Chris Gilchrist: The 3 investor responses to the last crash

Chris Gilchrist MM blog

The crash of 2008 was far worse than that of 2001 in that almost all assets apart from gilts fell together. The result was that even cautious portfolios saw unacceptably large falls in value.

Over the past few years the different responses to this disaster have clustered around three propositions:

This time isn’t different. The 2008 crash was just somewhat more extreme but the usual rules apply. Long-term investors who ignore the noise will continue to earn equity risk premiums higher than those suggested by the academics. Diversification among other asset classes will provide as much protection against volatility as is feasible.

Returns are tactical. In markets that could be trendless for years, active tactical asset allocation and switching between asset classes is the only way to deliver positive returns.

The world is hedge shaped. Unprecedented monetary easing with unforeseeable consequences, a broken financial system and contradictory fiscal policies mean we are in a different world in which volatility is certain to be much higher. No asset class is safe. The only answer is absolute return hedge-style mandates and funds.

The no-difference guys include almost all talented long-only stockpicking managers. Using the Warren Buffett perspective they conclude that if capitalism survives, good companies will deliver enormous returns over the long term. They happily accept the inevitable volatility – the more of it there is, the fewer players have the stomach for the game and the larger the returns will be.

The tactical guys start from the academic proposition that asset allocation is what delivers returns but then contradict modern portfolio theory by saying they are clever enough to time the markets with their active trading in ETFs. The more active the approach, the greater the risks, so some will probably blow up spectacularly. The range of outcomes is likely to be at least as wide as between good and not so good stock-pickers.

The hedgies have come onshore with their Ucits III funds, though thankfully leaving the 2 plus 20 fees and the gearing offshore. Absolute return is where hedge funds started from and is certainly capable of producing low steady returns. But they will probably be lower than cash plus 5 per cent unless investors accept downside risk of as much as 15 per cent.

The first proposition requires advisers to choose talented stockpickers or to know a man who does. I don’t think this is hard because there aren’t that many of them. Simplistically, acknowledge higher volatility by holding more in cash and wait for the fund managers to bring home the bacon. The only question is how long you might need to be patient for.

The second proposition requires you to pick a good trader. Jessie Livermore’s autobiography is the best guide to the difference between a trader and investor. The best traders operate not on brain but on instinct. The more mathematical their methods, the more dangerous (take trader Victor Niederhoffer’s advice: ‘A good bet is that all systems will stop working when you use them’, a truth computing power hasn’t changed).

The last proposition requires you to find people who really do control risk. Absolute Return mandates aren’t about making money, they’re about not losing money. Most such funds don’t have the people, the understanding or the systems to do this. This is a game for armies, not for guerrillas – expect a lot more fund closures or ‘re-positionings’.

Chris Gilchrist is director of FiveWays Financial Planning, edits the IRS Report newsletter and is the author of the Taxbriefs Guide, The Process of Financial Planning


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