Friday, December 12, 2003
HERESY AGAINST DOCTRINE
This week, I am going to commit heresy against doctrine, by overturning an investment myth that financial planners currently hold --- a myth that is widely believed to be true and whose application in financial planning could lead to widespread abuse, confusion, and possibly legal action.
The myth I want to attack is the notion that high risk equates to high returns, and low risk equates to low returns. I have NEVER in my entire life seen a myth as untrue, as destructive, and as foolish as this. This belief in this myth is a display of such sorry ignorance that I really should not even be discussing this to a learned audience like yourselves. But I must defeat this myth once and for all and set the record straight. I ask my readers to keep an open mind.
First and foremost, let us clarify what risk means in the investment context. Risk refers to volatility. A financial asset that is volatile is one which experiences greater price movements (in percentage terms) compared to a less volatile asset, and one in which the period-to-period returns change significantly. In other words, a more risky asset is one that experiences greater standard deviation in period-to-period returns comapred to a less risky asset. It is true that stocks are one of the most risky assets, in the sense of this definition. The next are bonds, which can be pretty risky too especially in an environment that anticipates near-term changes in interest rates (such as the present environment). Longer term bonds are more interest rate sensitive, and also more risky, than shorter term bonds. In bonds, price changes are not the only aspect of risk. There is also the risk of default, or credit risk, so to speak.
We frequently hear of financial planners touting the myth that high risk equates to high returns. They cite numerous studies of the US stock market indices, and assert that US stocks have generally returned between 8 to 12 percent over the past two or three decades, depending on the starting point and the index under consideration. Similar numbers are true for Asian and European stock indices. It is also true that US stocks in general have returned an inflation-adjusted average of 7 percent over the past century or so, outperforming real estate, bonds and art collectibles. These financial planners then extrapolate into the future, claiming that similar future returns can be expected, and then proceed to advise clients who have a larger appetite for risk to allocate more of their portfolio to equities.
The first thing to fault with this line of reasoning is that while the past two decades (at least from 1982 to 2002) have seen significant appreciation in stock prices to the tune of 9 to 12 percent compounded annually, this is not true of other similar periods. In the stagflationary '70s, US stocks as measured by the Dow Jones Industrial Average returned practially nothing, and in inflation-adjusted terms, actually experienced a substantial net loss over the 10-year period. The same is true for the period 1965-1982. An investor who invested in US stocks in 1965 at the behest of his financial adviser would have a good reason to drag the sad fool to court two decades later when the 1980's came around, especially if the investment was single-premium and if the adviser had told him statements like "every plan you implement is tied to a goal in the future".
Similarly, if an investor had invested in US stocks at the height of the 1929 stock market bubble, he would not have gotten his money back until a full 30 years later, and in inflation-adjusted terms, he would have actually lost more than half of his money. When the Japanese Nikkei peaked in January 1990, many thought that Japan was a booming superpower that could not be defeated. A mere 13 years later, the Nikkei had lost 80% of its value, and the Japanese economy was mired in a deflationary recession. If an equities investor had diversified from US stocks to Japanese stocks in a valiant but misguided attempt to add stability to his portfolio, he would have greatly compromised his investment returns.
Diversification across various equity markets may hold to key to stability (that much I admit and accept), and one must be cautious. The LTCM debacle has shown us that in a crisis situation, all market may move in the same direction regardless of national, political, or economic boundary. And that crisis situation surrounding LTCM was only confined to bond spreads and interest rate swaps (swaps are bets on relative interest rates). What if the crisis had involved equities as well? A clue might be seen when Japan expericed an earthquake in Kobe in 1995. The Japanese Nikkei was whacked 3% in a single trading day, and a few days later, equities all over the world followed suit. Nowhere to run, and nowhere to hide.
Following the bursting of the US stock market bubble in March-June 2000, equities all over the world trended downwards, not only US equities. The Japanese Nikkei was cut in half in a matter of 18 months, just like the S&P_500 index. Asian equities were also walloped. The Singapore STI index bottomed out a week after the Sept 11 terrorist attacks at a price level that was a full 55% lower than its all-time high achieved in 2000. Unfortunately, Sept 11 was not the bottom for world equities. After a bear market rally that lasted until March 2002, global equities resumed their downward trend until another intermediate bottom in October 2002. Japanese equities in fact continued to decline even further, with the Nikkei bottoming out at the 7862 level only in March 2003, at a time when US and other global equity market were also at a low point. So throughout these three years lasting from March 2000 to March 2003, diversification across equity markets did not hold the key to stability. All equity markets moved in the same direction at the same time. When the downtrend was in force, there was no major equity market, US or Asian, that was spared the devastation.
The truth is that high risk does not equate to high returns AT ALL. Look at one of our local stocks, Chartered Semiconductor Manufacturing. At at all time high of S$19.20 per share in the year 2000, there was no doubt in many people's minds that it was a "high risk, high return" stock. Barely three years later it had plunged to S$0.60 per share --- a staggering loss of 96.9%. Even compared to its IPO debut price of S$3.20, Chartered is still dealing investors with substantial negative returns at its current price of S$1.50 plus per share. Tell those aunties and uncles who bought Chartered Semicon that "high risk equals high returns", and you'd be thrown out of the interview room faster than you can string the words "plan", "goal" and "future" in a single sentence.
"But wait a minute, E-Jay", you might say, "what if an investor had simply bought the entire STI index and held it over time, rather than just speculating on a few selected technology stocks?" Well, the fact remains that the STI has provided investors with a NEGATIVE 4% return compounded per annum over the past 8 years when measured from its peak in late 1995. If you don't believe me you can check Dollardex. I am not kidding you, and I am not kidding anyone when I say diversification DOES NOT NECESSARILY hold the key to stability.
The truth is that high risk implies the possibilitity of high returns, as well as the possibility of high losses, as my numerous examples amply demonstrate. Let us now return to the fact that US equities have returned roughly 7% per annum (inflation-adjusted) over the past century. Does this exonerate the many so-called investment consultants and financial planners that say that stocks provide the best returns over the long term? I do not think so. Firstly, if you analyse that 7% return that US stocks supposedly provided over the past century, you would find that all full 5% of the 7% was attributable to dividend income re-invested, and only the remaining 2% was attributable to capital gains. If an investor was forced to neglect his dividend income or could not re-invest his dividend income at an attractive rate of return, his total return from US stocks over the past century would have been very mediocre, underperforming even bonds which are supposed to have less volaility. Why do I make special mention of dividend income? It is because dividends provide a crucial, if not the ultimate barometer of corporate earnings (at least on a sector or national level), and because at present price levels, stocks are yielding an average 1% to 1.5% in dividends, far below the historical average of 3% to 4%, and very far below the average of 5% to 7% frequently seen in true bear market bottoms. At present dividend yield and price/earnings levels, the valuation of stocks resembles previous major MULTI-DECADE bull maket tops, not bottoms. If an investor assumes from past historical data that he can expect 7% to 10% returns from US stocks over the next 10 years or so, he might be in for a very big disappointment.
An equally important fact to remember is that investors frequently have limited investment horizons. No investor can wait one full century to obtain his so-called inflation-adjusted 7% return on stocks. Most people start to accumulate wealth in the ages of 20-30 (some even later), and can afford to invest surplus income in the capital markets for a period of at most 25-30 years before retirement. Is this sufficient time for an investor to obtain significant market returns? Major bear markets in the past have lasted anywhere from 15 to 20 years, starting from valuations even lower than what we are currently measuring today. What if a US investor had planned his investment starting from 1965? Or from 1929? Or what if a Japan investor had begun investing in 1990? Or a Singapore investor had begun in 1994? Will we hand back their multi-year, even multi-decade losses to them on a silver platter and say that high risk equals high returns over the long run? How long a run do we need? Is our poor investor going to retire at age 80, 90 or 100 just so that he can get high returns from his high risk investment? Forgive me if I sound harsh. If it is people's retirement we are dealing with, we cannot afford to let slack thinking or poor judgement get in the way of proper and prudent action.
What if a client comes to us and says that he has to prepare to support his parents' in 5 years time, to send his children to university in 10 years time, and retire in 15 years time? Are we going to say that equities return 8% over the long run, bonds 5%, money market funds 2.5%, and then proceed to give him a globally-diversified asset allocation based on this model? Most of us are going to practice this, I'm sure. Now let me ask each of you: what if our projections don't work out? What if global equities make a negative return over the next 5 years? How is our client going to support his parents? What if our client's portfolio gives mediocre returns over the next 10 years? Is he or she going to have to forsake sending his children to university? Are we prepared to stake our clients' future and that of his family on the returns of the capital markets? Are we prepared for the consequences should we fail in our projections? Do not think the capital markets are there "for you", to serve your needs like an ATM machine. Think instead of the capital markets, especially the stock market, as a lion that cannot wait to rip your lungs out.
How many of us are prepared to tell our clients that US equities are currently trading at astronomical valuations compared to their long term average over the past century? How many of us are prepared to face the possibility of a 15 to 20 year secular bear market in global equities (US, Asian, etc, etc)? Have we made provisions that our projections of market returns may not work out and tried to control our risk? Or do we merely concentrate on getting our commissions and annual trailer fees? Are we sure we are astute enough to help our clients balance their portfolios so that they can profit from both bull and bear markets? These are just some of the questions financial planners must ask themselves today. And the first step in the right direction is to ONCE AND FOR ALL eliminate the notion that high risk equates to high returns --- because that simply is not true in the extremely finite context of our clients' investment horizon no matter how you slice and dice it. Period.
Twenty years of fanatstic gains in stocks have led investors to assume without any deliberation that the market will always give them a good return provided they wait patiently enough. When the bear market resumes and bottoms out many years later, many people will once again be so afraid of stocks they will not even consider them an asset class. This was the case in 1722, 1842, 1865, 1932, 1942, 1982, and will be the case again someday .... but not today. If there are inevitabilities in this world, then the emotionally-oriented irrationality of human nature and the cycles of economies and financial markets must count amongst them. This is not some New Era where things are finally different. When one day mankind finally takes off to the stars and to distant worlds hundreds of light years away, maybe that will be a New Era. But for now, I invite all readers to plant their feets firmly on the ground and let the facts of nature speak for themselves.
This week, I am going to commit heresy against doctrine, by overturning an investment myth that financial planners currently hold --- a myth that is widely believed to be true and whose application in financial planning could lead to widespread abuse, confusion, and possibly legal action.
The myth I want to attack is the notion that high risk equates to high returns, and low risk equates to low returns. I have NEVER in my entire life seen a myth as untrue, as destructive, and as foolish as this. This belief in this myth is a display of such sorry ignorance that I really should not even be discussing this to a learned audience like yourselves. But I must defeat this myth once and for all and set the record straight. I ask my readers to keep an open mind.
First and foremost, let us clarify what risk means in the investment context. Risk refers to volatility. A financial asset that is volatile is one which experiences greater price movements (in percentage terms) compared to a less volatile asset, and one in which the period-to-period returns change significantly. In other words, a more risky asset is one that experiences greater standard deviation in period-to-period returns comapred to a less risky asset. It is true that stocks are one of the most risky assets, in the sense of this definition. The next are bonds, which can be pretty risky too especially in an environment that anticipates near-term changes in interest rates (such as the present environment). Longer term bonds are more interest rate sensitive, and also more risky, than shorter term bonds. In bonds, price changes are not the only aspect of risk. There is also the risk of default, or credit risk, so to speak.
We frequently hear of financial planners touting the myth that high risk equates to high returns. They cite numerous studies of the US stock market indices, and assert that US stocks have generally returned between 8 to 12 percent over the past two or three decades, depending on the starting point and the index under consideration. Similar numbers are true for Asian and European stock indices. It is also true that US stocks in general have returned an inflation-adjusted average of 7 percent over the past century or so, outperforming real estate, bonds and art collectibles. These financial planners then extrapolate into the future, claiming that similar future returns can be expected, and then proceed to advise clients who have a larger appetite for risk to allocate more of their portfolio to equities.
The first thing to fault with this line of reasoning is that while the past two decades (at least from 1982 to 2002) have seen significant appreciation in stock prices to the tune of 9 to 12 percent compounded annually, this is not true of other similar periods. In the stagflationary '70s, US stocks as measured by the Dow Jones Industrial Average returned practially nothing, and in inflation-adjusted terms, actually experienced a substantial net loss over the 10-year period. The same is true for the period 1965-1982. An investor who invested in US stocks in 1965 at the behest of his financial adviser would have a good reason to drag the sad fool to court two decades later when the 1980's came around, especially if the investment was single-premium and if the adviser had told him statements like "every plan you implement is tied to a goal in the future".
Similarly, if an investor had invested in US stocks at the height of the 1929 stock market bubble, he would not have gotten his money back until a full 30 years later, and in inflation-adjusted terms, he would have actually lost more than half of his money. When the Japanese Nikkei peaked in January 1990, many thought that Japan was a booming superpower that could not be defeated. A mere 13 years later, the Nikkei had lost 80% of its value, and the Japanese economy was mired in a deflationary recession. If an equities investor had diversified from US stocks to Japanese stocks in a valiant but misguided attempt to add stability to his portfolio, he would have greatly compromised his investment returns.
Diversification across various equity markets may hold to key to stability (that much I admit and accept), and one must be cautious. The LTCM debacle has shown us that in a crisis situation, all market may move in the same direction regardless of national, political, or economic boundary. And that crisis situation surrounding LTCM was only confined to bond spreads and interest rate swaps (swaps are bets on relative interest rates). What if the crisis had involved equities as well? A clue might be seen when Japan expericed an earthquake in Kobe in 1995. The Japanese Nikkei was whacked 3% in a single trading day, and a few days later, equities all over the world followed suit. Nowhere to run, and nowhere to hide.
Following the bursting of the US stock market bubble in March-June 2000, equities all over the world trended downwards, not only US equities. The Japanese Nikkei was cut in half in a matter of 18 months, just like the S&P_500 index. Asian equities were also walloped. The Singapore STI index bottomed out a week after the Sept 11 terrorist attacks at a price level that was a full 55% lower than its all-time high achieved in 2000. Unfortunately, Sept 11 was not the bottom for world equities. After a bear market rally that lasted until March 2002, global equities resumed their downward trend until another intermediate bottom in October 2002. Japanese equities in fact continued to decline even further, with the Nikkei bottoming out at the 7862 level only in March 2003, at a time when US and other global equity market were also at a low point. So throughout these three years lasting from March 2000 to March 2003, diversification across equity markets did not hold the key to stability. All equity markets moved in the same direction at the same time. When the downtrend was in force, there was no major equity market, US or Asian, that was spared the devastation.
The truth is that high risk does not equate to high returns AT ALL. Look at one of our local stocks, Chartered Semiconductor Manufacturing. At at all time high of S$19.20 per share in the year 2000, there was no doubt in many people's minds that it was a "high risk, high return" stock. Barely three years later it had plunged to S$0.60 per share --- a staggering loss of 96.9%. Even compared to its IPO debut price of S$3.20, Chartered is still dealing investors with substantial negative returns at its current price of S$1.50 plus per share. Tell those aunties and uncles who bought Chartered Semicon that "high risk equals high returns", and you'd be thrown out of the interview room faster than you can string the words "plan", "goal" and "future" in a single sentence.
"But wait a minute, E-Jay", you might say, "what if an investor had simply bought the entire STI index and held it over time, rather than just speculating on a few selected technology stocks?" Well, the fact remains that the STI has provided investors with a NEGATIVE 4% return compounded per annum over the past 8 years when measured from its peak in late 1995. If you don't believe me you can check Dollardex. I am not kidding you, and I am not kidding anyone when I say diversification DOES NOT NECESSARILY hold the key to stability.
The truth is that high risk implies the possibilitity of high returns, as well as the possibility of high losses, as my numerous examples amply demonstrate. Let us now return to the fact that US equities have returned roughly 7% per annum (inflation-adjusted) over the past century. Does this exonerate the many so-called investment consultants and financial planners that say that stocks provide the best returns over the long term? I do not think so. Firstly, if you analyse that 7% return that US stocks supposedly provided over the past century, you would find that all full 5% of the 7% was attributable to dividend income re-invested, and only the remaining 2% was attributable to capital gains. If an investor was forced to neglect his dividend income or could not re-invest his dividend income at an attractive rate of return, his total return from US stocks over the past century would have been very mediocre, underperforming even bonds which are supposed to have less volaility. Why do I make special mention of dividend income? It is because dividends provide a crucial, if not the ultimate barometer of corporate earnings (at least on a sector or national level), and because at present price levels, stocks are yielding an average 1% to 1.5% in dividends, far below the historical average of 3% to 4%, and very far below the average of 5% to 7% frequently seen in true bear market bottoms. At present dividend yield and price/earnings levels, the valuation of stocks resembles previous major MULTI-DECADE bull maket tops, not bottoms. If an investor assumes from past historical data that he can expect 7% to 10% returns from US stocks over the next 10 years or so, he might be in for a very big disappointment.
An equally important fact to remember is that investors frequently have limited investment horizons. No investor can wait one full century to obtain his so-called inflation-adjusted 7% return on stocks. Most people start to accumulate wealth in the ages of 20-30 (some even later), and can afford to invest surplus income in the capital markets for a period of at most 25-30 years before retirement. Is this sufficient time for an investor to obtain significant market returns? Major bear markets in the past have lasted anywhere from 15 to 20 years, starting from valuations even lower than what we are currently measuring today. What if a US investor had planned his investment starting from 1965? Or from 1929? Or what if a Japan investor had begun investing in 1990? Or a Singapore investor had begun in 1994? Will we hand back their multi-year, even multi-decade losses to them on a silver platter and say that high risk equals high returns over the long run? How long a run do we need? Is our poor investor going to retire at age 80, 90 or 100 just so that he can get high returns from his high risk investment? Forgive me if I sound harsh. If it is people's retirement we are dealing with, we cannot afford to let slack thinking or poor judgement get in the way of proper and prudent action.
What if a client comes to us and says that he has to prepare to support his parents' in 5 years time, to send his children to university in 10 years time, and retire in 15 years time? Are we going to say that equities return 8% over the long run, bonds 5%, money market funds 2.5%, and then proceed to give him a globally-diversified asset allocation based on this model? Most of us are going to practice this, I'm sure. Now let me ask each of you: what if our projections don't work out? What if global equities make a negative return over the next 5 years? How is our client going to support his parents? What if our client's portfolio gives mediocre returns over the next 10 years? Is he or she going to have to forsake sending his children to university? Are we prepared to stake our clients' future and that of his family on the returns of the capital markets? Are we prepared for the consequences should we fail in our projections? Do not think the capital markets are there "for you", to serve your needs like an ATM machine. Think instead of the capital markets, especially the stock market, as a lion that cannot wait to rip your lungs out.
How many of us are prepared to tell our clients that US equities are currently trading at astronomical valuations compared to their long term average over the past century? How many of us are prepared to face the possibility of a 15 to 20 year secular bear market in global equities (US, Asian, etc, etc)? Have we made provisions that our projections of market returns may not work out and tried to control our risk? Or do we merely concentrate on getting our commissions and annual trailer fees? Are we sure we are astute enough to help our clients balance their portfolios so that they can profit from both bull and bear markets? These are just some of the questions financial planners must ask themselves today. And the first step in the right direction is to ONCE AND FOR ALL eliminate the notion that high risk equates to high returns --- because that simply is not true in the extremely finite context of our clients' investment horizon no matter how you slice and dice it. Period.
Twenty years of fanatstic gains in stocks have led investors to assume without any deliberation that the market will always give them a good return provided they wait patiently enough. When the bear market resumes and bottoms out many years later, many people will once again be so afraid of stocks they will not even consider them an asset class. This was the case in 1722, 1842, 1865, 1932, 1942, 1982, and will be the case again someday .... but not today. If there are inevitabilities in this world, then the emotionally-oriented irrationality of human nature and the cycles of economies and financial markets must count amongst them. This is not some New Era where things are finally different. When one day mankind finally takes off to the stars and to distant worlds hundreds of light years away, maybe that will be a New Era. But for now, I invite all readers to plant their feets firmly on the ground and let the facts of nature speak for themselves.
