by Tim Farrelly | Monday, 28 April 2008
The past quarter’s wild markets have really reinforced the key messages that farrelly’s has been emphasising over the past few years. So what are the sensible courses of action for clients now?
What have we learned?
1. When assets are overpriced, just don’t buy
This should be rule number one for financial planners and their clients! In March 2007, farrelly’s published the results of a study on optimal strategies for buying into markets at different pricing levels. The clear recommendation that flowed from that study was that when an asset class is overpriced, just don’t buy it. Instead, sit on the sidelines and wait for better prices to emerge, either in that asset class or in another. On this basis, new investors would have stayed out of property, New Zealand equities and Australian equities for most of last year.
2. When everything is overpriced or very fully priced, scale down the overall risk level a notch or two
This was farrelly’s consistent refrain throughout the past year. Essentially, the logic is that if the expected return on a risky portfolio is close to that of a low risk portfolio, why bother with the riskier portfolio? If, instead of investing in a portfolio with 75% equities, a client invested in a 35% equity portfolio can get returns that are similar over the long term, why dial up the risk? If, in the short term, prices continue to run, the client will still get some upside which should help prevent the panic buying we often see at the top of the market when formerly patient investors surrender and buy regardless of value. However, more often than not, this strategy will be rewarded by an opportunity to buy at sharply lower prices somewhere down the track. The client is richer and happier. The adviser looks like a genius.
3. When switching assets, concentrate on big differences in expected returns
This again has been reinforced by recent events. If, for example, late last year you had switched out of New Zealand equities to international equities, you will have made some small gains so far, but nothing dramatic. That’s because the difference in expected returns from the two assets classes was only a few percent apart. It’s better to wait until the differences in expected returns are around 4% per annum at which point the likelihood of one sector outperforming the other is very strong.
4. Buying good assets at silly prices can still hurt – a lot
Most – but not all – of the LPT universe is made up of high quality assets, sensibly managed (with only the occasional bouts of stupidity.) And yet, the average LPT has fallen in price by over 37% over the past year. farrelly’s best guess is that it may take around ten years before the ASX LPT index again moves above the February 2007 peak of 2560. That’s a very long time to be under water. And, while returns to investors buying in today will be fine, those who invested near the peak will see very mediocre returns indeed.
What should we do now?
For clients who invested some time ago at reasonable prices, this will feel like a blip in a few years time, even if it gets worse in coming months. This financial crisis is unlikely to have any real impact on where prices finish up in ten years time, and so really is irrelevant to long-term investors. Unless, of course, they have some new money, in which case, the downturn is an absolute bonus.
For those who have held back waiting for better prices – buy, and do it now. This is not to say prices won’t go lower. They could easily fall another 20% from here. Equally, we may be very close to the bottom… we just don’t know the likely direction of prices in the short term. What we do know is that, at these levels, international equities and LPTs are all at, or close to, fair prices. So regardless of whether they go higher or lower in the short term, long-term results should be solid.
Don’t be overly cautious, or overly clever
I am talking with some advisers who were happy to be 100% in the market in October, but who are now holding back due to market uncertainty. This is absolutely the wrong attitude! If you were happy to buy in October you should be deliriously happy to buy today. Don’t hold back. Above all else, don’t fall for the trap of getting it half right. Let’s assume you got it right in the second half of last year and you held off investing, or maybe even took some profits to raise some cash. Try to be too clever about when to get back into the market and you may see markets 25% higher while you’re still sitting on a pile of cash, wondering how you could have got it so right and still not made any gains for your clients.
Lastly – don’t dollar cost average unless you have to
The farrelly’s March 2007 study on dollar cost averaging showed clearly that the strategy is at its most costly when markets were fairly priced, as they are now. Hence, unless a client is so nervous that they won’t invest any other way, avoid dollar cost averaging at the moment. And if you do use it, keep the program to as short a term as possible – three to six months at most.
Tim Farrelly is principal of farrelly’s, the first dedicated asset allocation research house in the Australian and New Zealand financial services industry. Established in 2004, it aims to help advisers make superior asset allocation decisions for investors. For more information, go to www.PortfolioConstruction.com.au/farrellys
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