Could low interest rates in the long term be encouraging potential investor calamity?

"Mary Mary quite contrary,  How does your garden grow?

 With silver bells and cockle shells, And pretty maids all in a row"

          The ability for growth in the world's economy following the Great Recession can't quite be explained as easily as a classic nursery rhyme. 6 years on from the global financial collapse and we're still looking for many developed nations to prove that not only is the worst behind them, but that they're going to be on a strong forward trajectory for many years. Interest rates across the board are still at all time lows as the need for stimulus remains. Meanwhile volatility across many asset classes remain at levels below the average. With all these factors playing a part there exists a strong possibility that investors will seek to take even greater risks in the search for return.

           Whilst there is talk is of a growing confidence in the economy across the US, UK and Europe, with this being reflected in many economic indicators, from a central bank perspective this is not yet the time to hint at any imminent rise in interest rates. The Federal Reserve is reducing the amount of stimulus it is pumping in by $10bn a meeting, but the fact remains it is still pumping QE into the economy with no talk of interest rate rises until at least 2015. The Bank of England, which many are anticipating will raise rates first, is also not predicted to do so until early 2015. Meanwhile the ECB has just opted to put the rate at which it charges banks to hold deposits into negative territory. Even when rate rises do occur over the coming years, economic forecasters are not anticipating base interest rates getting beyond 2% in the US (PIMCO speaks about this level even being the new 'neutral/normal'). The UK is unlikely to reach 3% before 2018 if even much more than that further then, and the ECB looks set to stick with extremely low rates for the visible future due to its low inflation, high unemployment and still struggling economies.  All this assumes during this coming period that the economy doesn't suffer further economic turmoil forcing central banks to halt rate rises or reduce already increased rates at the time.

          With rates remaining so low, those with savings and looking to invest are seeing ever diminishing rates of return. Savings accounts, even those with boosted 1 year rates, are only getting 1.5% if you're lucky. Meanwhile the alternative for investors wishing to keep their money in a safer investment but with some security such as core government bonds are seeing continuously reducing yields with the US 10 year at 2.56%, UK Gilts at 2.66% and Germany's at 1.38%. As investors try desperately to earn the kind of returns they require in order to meet both their short and medium term goals they have turned to ever more risky investments. The peripheral European countries' bonds which just 2 years ago were reporting yields in high single or low double figures are being pushed to prices which don't adequately reflect their extra risk. Portugal's 10 year is currently yielding only 3.6%, just over 2% above Germany's, whilst Greece's yield is down to only 6.12%, a quite expensive figure considering the country is still in the depths of a continued depression and further debt restructuring is likely. Even outside the government sphere into riskier corporate and high yield bonds has seen prices pushed up (and yields fall as a result) as investors go in search of investments to give them the kind of returns they are used to, without potentially adequate assessment of the quality and risk of the paper they are buying. In the meantime, while some stock markets continue to tick up (such as the S&P 500 in the US), the rate of increase appears to be on the wane, with other equity markets, such as the FTSE 100, remaining in and around highs but not breaching those levels any further, reducing returns investors can seek on these assets. 

                       If the 'new normal' for the next 5-10 years is to see interest rates across the developed world remaining under 2.5-3% then it seems likely that more and more individual investors will seek to take more risks and effectively attempt to 'gamble' their way to retirement. The examples above show an already falling spread between more risky and safer assets but investors could be tempted to venture further into asset types which are beyond their true understanding. In the UK, especially in London, some investors who may have built up a sizeable but currently inadequate savings base, may be tempted to take advantage of the spiraling property market again. Whilst more safeguards are in place to ensure banks are only lending to those customers they deem "safer", the continuous rise in property prices, fueled in some way by the relatively affordable borrowing may convince banks and some of their customers looking for short term gains that no crash is imminent in the coming years whilst London still suffers from a housing deficit. 

             Retail investors may also seek to take advantage of leverage in other ways to multiply the small returns they can get on existing assets. There are many reports that margin loans (loans collateralised by borrowers investments) now exceed the levels pre-2008, whilst people may also seek to further benefit by releasing equity in their houses for use in investment, exposing themselves even further should house prices show a correction. There is also an ever increasing range of leveraged securities available for purchase by the retail investor. Why only get 1 times the return on the market when you can buy a leveraged ETF offering 2 or 3 times the return on an index? Whilst with the ETF purchase the investor will only lose the money they themselves invest, the ability to lose that money is enhanced because if the returns are leveraged on the way up, they're also leveraged on the way down, multiplying any negative returns. 

               The longer a period of low rates and returns exist there is also the risk that more and more less "sophisticated" investors will look to derivatives to boost their returns. This is already a factor in Japan where savers have seen the interest rates at levels close to zero for over a decade. Here it is most normal for individuals to go into their local bank and buy options on individual stocks or indices or ever more increasing complex structured retail investments. The government may seek to loosen the legislation on allowing regular retail investors (whether through pensions or individually) to purchase such products as it seeks to allow investors in such a low return environment to try better to meet their financial goals. Whilst I'm a firm believer that the use of derivatives by the individual retail investor is not specifically a bad thing in part of their portfolio, as I've mentioned previously, it's the lack of understanding that is the issue. This could cause many investors who are seeking to boost their returns to actually end up in a more perilous financial situation, negating the potential benefits and actually leaving further people dependent on the state at the time of retirement.  

              This isn't to say that any of this is inevitable. But as rates stay low and, as a result, the rate of return available to investors on regular products reduces, and remains low for a substantial amount of time, more and more investors will search for ever more risky and less understandable products to reach the financial aims they've set themselves. As a result the risk of loss and the consequences for a wider portion of the population increases. The truth is, if the existing low rate environment is likely to remain for the foreseeable future, we may also have to seek to reign in the financial goals we would normally look to achieve when the regular ability for higher returns were available to us. For those of us in the earlier years of our working lives it also emphasises the need to start saving (and investing) early enough for the future and not wait until we're in our late 30's or 40's to start a regular and sufficient pension pot. Our gardens may not grow as high Mary's, but we also need to make sure we act in the most sensible way to avoid the potential need to gamble it all away through ever increasing risk taking.

 

Getting by on being average - the benefits of following an index

                                  In most walks of life, people try very hard to make sure they're not just average. The competitive nature of sport makes even Sunday league footballers up and down the country try and be the best in their league. You certainly don't want to be the worst (and face relegation), but there's something wholly unsatisfying about finishing mid-table on a regular basis. In schools, kids want to do well in class and be above average, and in many work environments performing average could ultimately lead to you losing your job as younger employees continuously outperform you and push you down the pecking order due to the need for a normal distribution of staff performance measures.

                  That same feeling of wanting to do better than everyone else often pushes people to try and achieve the same with their investment returns as they look to outperform the market on a regular basis. We're not content with being average, we're obsessed with outperforming. At the end of the day, why would you want to just follow an index when that is just a benchmark, surely just the minimal amount, that you would want to obtain? After all, equity indices go down whereas the possibility exists of choosing a fund or individual shares which will hold their own in a downturn and excel in an upturn.

                      The reality however is that the ability to achieve "superior" returns over a period of time is remarkably difficult, especially for the individual investor, and the potential cost or loss involved in trying to do it could erode away at the necessary capital required in the long term. Many of you who read this will probably tell me that you don't invest in the market, so what difference does this make to you? But this is ignoring the fact that your pension assets will contain mainly equity funds, and it is this long term performance you should be concerned about. As I mentioned in my previous article, understanding finance and how it affects you is now increasingly important.

               When planning for the longer term, 15 and 20 years or beyond, investors are going to want to find equity assets to put in their portfolio which are going to grow at a rate which will deliver a comfortable income upon retirement (otherwise known as enabling them to live in the manner to which they've become accustomed). This will lead to the majority of people searching out the equity funds which will perform best and seeking to readjust on a regular basis.

              So how do we find these magical funds? Do we look at the funds that seemed to have performed well on a consistent basis for the last 5 years? What about finding funds that have consistently given positive returns for 10 years? Funds focusing on commodity stocks when they're in boom and looking to switch to funds in more "defensive" stocks when required? What about more dynamic funds which will reallocate between different strategies at the fund managers 'insightful' guidance? Picking a winning fund, fund manager or fund strategy in many ways is a lot harder than picking a handful of individual stocks which will grow in the long term. A quick look over many funds performance in searching for funds that will 'outperform' the market or benchmark index consistently over the longer term will turn up very few who have done this for greater than a couple of years. For every example like Neil Woodford's Income Fund at Invesco or Anthony Bolton's UK Special Situation Funds at Fidelity there are hundreds of equity funds who can't consistently beat an index benchmark.

               There are many reasons for this failure of more active funds to do their stated aim. But no matter how much information, talent or experience a fund manager may have, consistent outperformance is more difficult. The pressure for fund managers to ensure they at least don't underperform has led to many actually managing their funds as phantom index funds. The need to report constant positive performance on a monthly or quarterly basis to ensure investors don't withdraw their money (and the fund manager doesn't lose his job) lead many to be too afraid to stick with the "long term" strategies they claim to be pursuing. These phantom index funds come at the price to the investor however of paying the cost of investing in an active fund, anything from 1.5% of NAV and upwards annually, a significant cost for a fund which isn't giving you any real outperformance for the additional potential risk involved. There is a genuine lack of visibility over the real strategy followed by many fund managers. Their stated aim may be 'growth', 'value' or 'income' but which stocks or how they're achieving this you are trusting in their ability to constantly pick the right winners with not much visibility over how they are attempting this. You then need to decide, if you've made the wrong choice initially, as to when to pull out of the fund and allocate your resources elsewhere. Is it after your fund choice has "underperformed" for 1,2,3 or even 5 years? Do you chase performance by looking at the top fund performers over the previous couple years potentially engaging in the sell low, buy high strategy that you always told yourself you'd never do? By constantly trying to outperform you may actually find yourself more concerned over your investments and ultimately falling short of your intended targets by trying to reallocate constantly.

               As any good investment advisor will inform you, and research has proven, one of the most important things to do in saving or investing for the long term is to ensure you're are putting away enough of your income on a regular basis from an early enough starting point. Increasing the amount of your salary constantly saved much earlier on from a 12% rate to 20% ultimately could lead to an extra 2% a year in market returns over a 20 year period. Concentrating on putting away a sufficient amount consistently earlier on is more important than trying to find those winning funds or stocks which are going to make you rich quickly or help you retire early. Let's be honest with ourselves, getting rich quick isn't how it happens for most people, and attempting to think we're able to pick the funds continuously which will perform the best to get us there quickly is a risky strategy.

               To mitigate the added risk that we will consistently underperform the market whilst trying to outperform the market, especially once we take fees into account, it begins to make sense to aim to be the market. Instead of risking constant underperformance, investing in index tracker funds is a safer way over the longer term to attempt to get the long term returns required. Whilst this form of investing may not have the exciting aspect of constantly trying to pick potential winners, it is this precise passiveness around the strategy which should bring more comfort in your investment decision. Of course we should never make an investment decision because it is easy to follow, but if the time, knowledge and, let's be honest, lack of foresight is missing then this becomes a perfect strategy for those looking only to the long term. Others around you might be seeing higher returns in both the short and long term, but an equal number around you will also be financially worse off through constantly reshuffling. It's the advantage of getting the average return that is the market. Meanwhile the relatively smaller fees in comparison associated with these funds is also a big bonus. Rather than the 1.5% and above of active funds, these index trackers will have a fee charged of between 0.3% and 1%, depending on the fund and index. That's potentially at least 1.2% extra returns per year for you as an investor compared to active funds. To think about that in context, if the underlying level of your fund remained constant for both the active and index funds, the value of your investment would drop 11.37% more over 10 years, and 21.45% more over 20 years, by investing in an active fund. So even if you have chosen active funds who are outperforming the market, they would need to do so by over 21.45% over a 20 year period before fees to make it worth your while.

            Over the last 20 years the FTSE 100 has returned 118.96% and the S&P 500 314.38% before taking dividends into account, or 4% and 7.4% annually before dividends respectively. This would show historically you would need an annual return every year on your active UK equity fund of 5.2% and active US fund of 8.6% just to match the price return on indices. This is before taking dividends into account. The approximate average annual dividend yield on the FTSE 100 was 2.92% over this same period pushing up the required rate of return on your active UK equity fund to 8.12% (assuming the lower level 1.5% annual fee) and this is just to keep pace with the "average" market performance. Looking at these figures it does suddenly begin to raise questions as to whether the majority of active funds can justify the fees charged over the long term.

             None of these statistics are of course to say that pure equity index investing is a risk free strategy. As with all investments, there is no such thing as a free lunch (in some cases there is, but generally not for the regular retail investor and I've not got the time to go into that here). A quick look over the last 15 years will see at least 2 occasions where equity market indices have plummeted, losing over 40% of value post 1999 only to rebound back to similar levels followed by a crash of equal proportions and further recovery in more recent times. Looking at the FTSE 100 over this period specifically will show that it is still yet to reach the same high level reached in 1999, whilst the S&P 500 has shown only a price return of 51% in that time. The broader FTSE All-Share index has returned just 24%. This though fails to include dividends and the impact of reinvesting them, whilst it also looks at a simplified approach of investing an amount solely at the start of the period. It also highlights the difference to your returns depending on which index to track and poses the question about how best to allocate your investment between indices. Meanwhile by investing with someone who actively manages the fund, they in theory should be trying to insulate themselves against the large market falls which just putting your money in index funds will expose you to.

             While all of these are valid reasons as to the potential "perils" of index investing, I believe the benefits are still better than trying to use active funds for superior return. Selecting the correct active funds, for example, which might insulate you in times of a falling market, may come at the cost of substantial fees and also at failing to give you the full benefits of a rising market.  You might argue that you could only use these, or switch to cash, in a falling market, but then you are exposing yourself to trying to guess as and when to time the market peaks and troughs which research has shown investors tend to get hideously wrong. The better approach is, as mentioned earlier, making regular contributions (monthly if possible) to your investments from the start. This can make a massive difference in boosting your returns ensuring that you are still buying into the market when it is at the bottom and rising again getting more benefit immediately from a rising market.

                It is also important to remember that while the equity index number we all focus on is what's quoted on the media, both now and historically, those numbers only represent the price return and so don't account for the impact of dividends on return. Investing in index funds who reinvest the dividends received results in exposure to the total return of the index. When you take this into account, the fact that the concern that the headline index level hasn't risen much from it's peak becomes less of an issue. The FTSE 100 Total Return Index (includes dividends) has more than doubled since January 2002, versus only a 30.7% increase in the quoted FTSE 100, while the FTSE All-Share Total Return Index shows a 121% return over the period (6.8% annually) versus 44.3% for the headline rate. (Unfortunately data for Total Return Indices is a lot more scarce and only available from 2002).

             Of course, as with any investment product, the caveat emptor principle always exists. Some indices never recover, even with dividends, back to their peaks for decades, or potentially ever. The Nasdaq, from a price perspective, still sits 23.5% below it's March 2000 peak, but this is more as a result of it being a tech heavy index still shrugging off the dotcom exuberance and collapse. Meanwhile Japan's Nikkei 225 peaked at 38,957 back in December 1989. It's level at the close this morning was 14,042, down 64% nearly 25 years later. Japan too though must be taken into context, with the Nikkei 225 rising uncontrollably by 224% in just under 5 years to 1989 in response to a similar appreciation in Tokyo property prices. This unsustainable property bubble and subsequent severe collapse, following large interest rate hikes by the Bank of Japan, led to an equity market crash in 1990-91 from which Japan is yet to recover. Whilst we may be seeing a spiraling London property bubble at the moment, it is by no means comparable to that seen by Tokyo in the 1980's. In addition, the existing Bank of England governer Mark Carney seems reluctant to use interest rates as the tool to calm it down, preferring other less severe measures, seemingly learning from the BoJs mistakes. Meanwhile the effect of house price rises on UK equity markets is much less pronounced. Both the FTSE 100 and FTSE All-Share are much more affected by more global conditions given the international nature of many of the firms which make them up.

               All of this leads me to believe that, for most investors looking to grow their savings and pension pots for the longer term, index investing is the best step forward. From the substantially lower fees and growth benefits once dividend reinvestment is considered, to the reduction in the risk of constantly trying to chase the winners, the pros for me far outweigh the arguments against. There is still the difficult choice to be made of what percentage to allocate to which domestic and foreign indices, which could still impact your returns substantially, but on this the individual needs to decide. Of most importance is the need for the investor to constantly be investing, whether in a pension, ISA or both, from as early an opportunity as possible and as regularly as possible. This is what will both boost long term returns and ensure money is invested at the bottom as well as the top. It may not be as exciting as constantly seeking the best fund managers or stock market stars, but this is one of the times in life where getting by on being average will work just fine. 

         

         

       

     

The Complexities of Finance

             There's many aspects of our daily lives which rely on the help of others to ensure things go as they should. When we are ill, we seek the advice or go to a doctor to find a solution to our illness, especially when it is something of concern. When we are looking to buy a car or a new appliance the majority of people will trawl magazines or the internet seeking the best deal, reading up on the technical specifications to ensure we are getting what we need and that it works accordingly. Looking at things from that angle, it seems exceptionally strange that the vast majority of people fail to understand, or want to try to understand, one of the other fundamental aspects of their lives - finance and it's various impacts on them.

               Over the last couple of weeks I've found myself in discussions with 3 different people about different parts of the financial world. None of these people were involved in finance but I would class them all as being smart people. There was a severe lack of knowledge or in some cases a misinterpretation in their knowledge about the workings of different aspects. To me this seems to represent the population as a whole when it comes to managing their finances. Finance forms such an important part of all our daily lives that one would imagine we would all take it upon ourselves to gain an understanding, or look to someone else to give us an understanding, about either planning for the future or the impacts of financial events. As per one of the previous examples, we wouldn't look to self-diagnose ourselves as to what symptoms of all but the basic illnesses we had represented and we certainly wouldn't be able to go to the pharmacy to buy all but basic over the counter drugs to self cure. Yet often when it comes to financial matters we look to seek the solutions ourselves without first seeking the methods to fully understand both how what we are looking at works and whether it is indeed the best cure for our issues.

The situation is rather neatly summed up by Morgan Housel of The Motley Fool in his article '77 Reasons You're Awful at Managing Money':

"People usually get better at things over time. We're better farmers, faster runners, safer pilots, and more accurate weather forecasters than we were 50 years ago. But there's something about money that gets the better of us. If you look at the rate of personal bankruptcies, financial crises, bubbles, student loans, debt defaults, and savings rates, I wonder whether people are just as bad at managing money today as they were in previous generations, maybe even worse. It's one of the only areas in life we seem to get progressively dumber at."

The issue is not solely one of a lack of want for people to understand. True, there are many who consider finance, and it's relation - economics, to be tediously boring and would shirk away from reading any article, leaflet or book on the matter. But the majority of those, when the consequences involved are explained to them, find themselves thoroughly interested and wanting to learn more. But, as Housel talks about, even when we do find ourselves reading about it we still enable ourselves to make the same behavioural mistakes as others and ourselves have made in the past. To take just a few of the examples he states:

"32. You spend a month researching the best washing machine, then invest twice as much money in a penny stock based solely on a tip from a person you don't know and shouldn't trust.

55. You hate finance, think it's confusing, and don't want anything to do with it. You do, however, love money. You see no irony in this.

56. You think the stock market is too risky because it's volatile, without realizing that the biggest risk you face isn't volatility; It's not growing you assets by enough over the next several decades."

There's plenty of other snippets in there which are amusing but the core point is important.

            Forty, maybe even thirty years ago, the requirement for most people to have a broad understanding of finance was a lot lower. Investing in anything beyond savings accounts was often only the preserve of the wealthy and many pensions were still final salary based, so the need to understand much beyond the current interest rate and mortgages for the average person wasn't particularly necessary. 

            Nowadays this is no longer the case. Most people are now responsible for their own pension choices, having to decide how much and what to invest in. The creation of ISAs in the UK has encouraged more and more people to look to save their money and invest for the medium term of up to £11,500 a year (£11,880 from April). Mortgage choices are all the more complicated and even the provision of financing for cars and other personal items, which are popular to allow people to "afford" the things they don't have the up front cash for, should require better understanding. A much larger percentage of the population now has disposable income with which to use and is also more likely to be susceptible to being taken advantage of through their lack of knowledge, as the recent PPI and Interest Rate Swap scandals prove. There's only a certain amount further that proclamations of ignorance can go when trying and failing to manage our own finances.

        The obvious starting point for this education would be to include the basic concepts of finance, economics and money management as a compulsory element of the school curriculum. The complications of this are that within a society, especially in the UK, where there is already continuous debate over getting the most out of an existing curriculum, the proposal to add an additional compulsory subject on personal financial management is unlikely to get much traction for many years. This, coupled with the traditional laissez faire attitude of students to the subjects they deem as boring, would perhaps not add much more to the knowledge of the general populace. 

          Another point of education could be advice provided by employers through professional educators as part of an employees benefit package. Firms themselves are often affected by their employees inability to keep their personal finances in check and would benefit from their employees having a better grasp of their own finances and pension options. Certainly larger firms could provide ongoing advice or courses to employees helping to properly understand the various funds available under their pensions schemes and the amounts they should contribute to their pension to realistically have an opportunity of achieving their financial aims. This, as well as assisting employees in understanding other financial concepts affecting them and how to best assess the right options for them would at least give each employee equal opportunity in using their options. Everyone, of course, is different and their personal situation and risk profiles will vary wildly. But at least some level of formal education will ensure people have been given the opportunity to make better decisions.

          There is also the opportunity for the individual to seek professional advice in the form of an Independent Financial Adviser (IFA) if they feel the capacity of understanding their options to be too overwhelming. I believe there is vast scepticism amongst the majority of the population in using an IFA, which given the scandals of the past is understandable. Regulation nowadays makes it harder for an IFA to sell only specific products which they would receive a kickback on, but the fear is still there. As with any adviser though, just because they have been in the industry for 10-20 years, doesn't mean what they recommend you invest in will necessarily see you outperforming on your investments. It would still be important for the individual to understand what it is they're using their money for and a good adviser should ensure that the client is aware of this. Unless fraud is involved though, people must accept that if investments didn't perform as hoped for, they are as much to blame as their adviser because the ultimate investment decision rests with them, emphasising further the need for understanding. 

                   The reality is, unless we are truly missold by being told certain investment risks didn't exist, or that a product would definitely perform a certain way which ultimately wasn't true, we cannot blame someone else for us making the wrong financial investments. For me it seems incomprehensible that Richard Desmond, for example, can successfully sue GLG for £20m for his misinvestment into a complex product known as a CPPI (Constant Proportion Portfolio Insurance) now that it's lost him money. If he truly didn't understand it to begin with, then he should never have gone through with it. We can't blame others when we lose money on our decisions which we'd wrongly assumed we were bound to win on. It doesn't mean that fraud doesn't happen. Of course it unfortunately still does. But we do need to understand the difference of when we have been missold something and when we have purely made an underperforming investment or taken out a disadvantageous loan through our own choice. Even with medicine it is sometimes not clear what the cure is, if there even is one, but we trust that the doctor will use the best of knowledge available to him/her to improve the situation. 

           The world has become an ever more complex place and, in terms of finance, it's impact on us and our need to understand these complexities only continues to increase. Pleas of ignorance, boredom and a lack of understanding will only help us so far in failing to grasp the personal implications of the management of money. To paraphrase Morgan Hounsel, you can hate finance, think it's confusing, and not want anything to do with it, but ultimately by loving money you should feel necessitated to try to understand how to make it work. There are no definitive answers in how best to manage your money and ensure you'll have what's required at the various stages of life. The unpredictability of markets, interest rates and global economic events mean that we can only try to strive to do what's best for us in various circumstances. But we owe it to ourselves to ensure we truly understand the financial decisions we are going to make and their implications, or get the advice to understand these decisions, before it's too late.   

Up all night to get lucky........or sleep soundly at night?

            The song of the year winner at the Grammy's last week was awarded to Daft Punk and Pharrell Williams rather catchy tune "Get Lucky". It's often quite hard in the modern world to find successful people who have the confidence to attribute a chunk of their success to luck. However in his recent letter to investors, Howard Marks, Chairman of hedge fund Oaktree Capital Management, speaks about how much of his career he must attribute to luck. Now it's quite clear that Pharrell and Marks are talking about getting lucky in rather different ways in life and, as much as I'd like to analyse the song, it's really Marks' insights which provide the more thought provoking ideas.

           Marks talks in depth about how luck and circumstance come into our lives in many shapes and form. He uses the example of the country we're born into, the income level of the family we're born into and the year we're born all as having a significant factor in our ability to achieve certain objectives. All of these are pieces of luck, or, if you prefer, divine providence, which straight from the off give a better or worse chance of 2 people, with the same intelligence and knowledge of a subject, achieving the same results. It is these such circumstances he points out that are often neglected to be mentioned when we believe we have achieved something entirely through skill alone, yet will often be brought up ad nauseum should "events" conspire against us. As he points out the Twitter CEO's tweet of "Success is never accidental" and the popularity of the phrase "you make you're own luck" present a skewed view to the world that when we achieve success, it is purely due to our own making.

                 The truth, as Marks points out, is much more different than that. Even the most determined, intelligent and hard working individual may not get the desired events necessary for their plans to succeed. None of us in the modern world truly hold the ability to prophesise. However, as Marks points out:

       "We arrange our lives – or, in investing, our portfolios – in expectation of what we think will happen in the future. In general, we get the desired results if future events conform to our hopes or expectations, and less-desired results if they don’t.........even the most rigorously derived view of the future is far from sure to be right. Many other things may happen instead."
  
          In a nutshell, man proposes and g-d disposes.

              Harping briefly back to my last post with this in mind, it almost seems absurd when thinking about the analyst criticism heaped on the central banks for getting their projections of unemployment and economic improvement incorrect. If we accept that the future is an unknown, and that it can only be "modeled" and expectations "predicted" to a certain degree, we must also accept that future events sometimes don't always conform to what even those we consider expert to have predicted. Meanwhile we often heap continuous praise on those, as Marks puts it, "in the investment business who get famous for having been “right once in a row.”"

            As part of his realisation of the luck afforded him in his investment career, Marks talks of the opportunity landed to him to get involved in two inefficient markets early on, in both high yield bonds and distressed debt, before they became so well known as to remove the obvious inefficiencies which previously existed. Such opportunities in the information age, he points out, are now few and far between, with the ability of algorithms and widely availability of information on all topics making a true arbitrage opportunity hard to spot. It doesn't mean that there is a lack of undervalued investments in the market, after all he would have long retired if he believed that, it just means it is much harder to take advantage of them.

            The problem of course lies in the ability to truly pick those undervalued whilst they are still undervalued in the market. We might crunch all the right numbers and make all the right projections, but an unprecedented macro event could be the luck that causes our meticulous predictions to be undone turning a certain winner into a sure fire loser. The planning was all right, but the desired result unfortunately went against us.

                None of this means choosing the correct investments is entirely down to luck, but it serves as a warning for those of us who believe that they have superior skill to outperform the market on a constant basis. I can't help but agree with Howard Mark's final assertion that, "it makes sense to accept that most games are no longer as easy as they used to be, and that as a result free lunches are scarcer........it will be harder to earn superior risk-adjusted returns in the future, and the margin of superiority will be smaller."

If this is indeed the truth, then where does that leave those of us looking for a way to get a return on investment for our future?

If we are honest with ourselves, can we really believe that we have the ability to either pick the stocks or the fund managers that will outperform the market for our given time frame. As common sense will point out, the market return is simply the average return of all investors. Some will outperform the market and some will underperform the market. What is to say we will have the skill and luck required to be or to pick the ones with the ability to outperform the market. As John C. Bogle points out in a letter for the CFA institute:

"If “active” and “passive” management styles are defined in sensible ways, it must be the case that (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar."

Hence by investing in funds that we believe will outperform the market there is the potential we will only achieve the average market returns at best, but at a greater cost. That is, if our luck even holds that much. 

So why put ourselves through this? Back in my post on December 4th I warned people to invest their money in what they do understand. The solution I believe is to stop telling ourselves that we need to outperform the market and instead to follow the market. If you are taking the true long term view (especially from a pension perspective in your 20's, 30's or 40's) then there is no need to fear the dips and falls which occur on a cyclical basis. The likelihood is that, over the 40 year span you are investing, then you will see the required level of growth in your portfolio. The fear of those with this strategy is that when the market falls (like it is now and certainly like it did in 2000-03 and 2008-10) they have lost out. But the comfort should lie in the fact that when the market rises they too will rise with it - they have removed an element of luck attributable to the active manager or stocks they might otherwise have chosen. 

So long as you are looking to a long term horizon, the palpitations associated with extreme market moves should be less than those associated with trusting your judgement and luck in picking an active fund hoping for it to outperform. As Pharrell might have put it, it's a question of waiting up all night to get lucky with your investments or doing your best to sleep soundly at night. You just have to hope that luck let's you sleep through.

The code, it's more what you call guidelines, than actual rules

         Thursday's rate decisions by the Bank of England and ECB provided no new sparks or additional pieces of information around timing of either rate rises in the UK or further stimulus in the eurozone. It didn't however stop speculation being rife about whether Mark Carney had actually set his forward guidance levels too conservatively. Debate raged on CNBC, Bloomberg and between analysts over whether Mark Carney was either going to have to raise interest rates later this year, sooner than expected, or make, in their words, 'an embarrassing about turn', and drastically reduce the level of unemployment he has set as the barrier level.

         Any regular readers of my articles will be familiar with the fact that I have been a fan of forward guidance in both the US and UK so far. Unfortunately I think it is in the most basic concept that many of these analysts panicking over an earlier rate rise, either in the UK or the US, are missing. The hint for me is in the name - forward guidance. Guidance isn't hard fast rules which must be followed.  

          I find it amusing that often the best way to explain analysts' current reaction to serious issues, and how they should be dealing with it, is by referencing the relationship of the Fed/BoE to the market as being akin to a parent child relationship. There are many analysts out there who seemingly hear the projections and the levels mentioned by the central banks and take them as being hard code, as rules. Parenting, not that I have much experience in such I may add, often requires the parent to guide their child in the right direction. Providing guidance to someone is more about pointing them in the right direction to help them get to where they want to be (or in some cases where you want them to be).

The real purpose, in my opinion, of the projections and guidance is, whilst trying to give a best estimation of where and when the central bank sees the economy as being, it is merely an indication. Whilst giving these indications and informing the markets of the sort of levels they view as being important to their interest rate decisions, they are hoping to 'guide' the market to realise that they are considering raising rates in the future, but only when the economy is able to handle it. The guidelines which they have mentioned (7% unemployment and inflation around the 2-2.5% mark in the UK, 6.5% unemployment and 2% inflation rate in the US) are indicators. If unemployment performs better than expected, like it currently is doing, but all else appears to remain the same, it becomes acceptable for the central bank to adjust their guidance levels of unemployment to an even lower level as a target and trigger for a potential rate rise. The Fed even says as such on it's own website:

"Neither the unemployment rate threshold nor the inflation threshold should be viewed as triggers that would automatically lead to the immediate withdrawal of accommodative policy. Policymakers recognize that no single indicator provides a complete assessment of labor market conditions or the outlook for inflation. In addition, when the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent"

The Bank of England has given similar statements in relation to it's own forward guidance. 

It seems remarkable that the same analysts at various banks (or on TV), who are continually readjusting their own projections and predictions, feel the need to criticise the central banks for the possibility they may need to adjust their own projections or guidance. In last week's article I assessed how the vast majority of analysts were predicting equity markets to go up further this year. What is the likelihood that the Citibank analyst who predicted the FTSE 100 to hit 8,000 or the JP Morgan analyst who predicted the S&P 500 to hit 2,000 in 2014 will turn round and admit they were wrong if it doesn't? The chances are that they will brush it under the carpet and, if the information available starts to change, they will adjust their predictions throughout the year to reflect the new reality. When we look at the central banks we need to accept they too are making predictions about the future, which is their current best assessment of the situation, and this may be done in a way to guide market rates and assets to where they need them to be. 

          Anyone familiar with Pirates of the Caribbean will know about the Pirate code. As Captain Barbossa, explains to Keira Knightly, "the code, it's more what you call guidelines, than actual rules". This is the theme throughout the films. So too with forward guidance, It's more what you call guidelines, than actual rules. They've managed those guidelines well so far and from those guidelines it seems the base rate isn't going anywhere. Certainly not until enough parts of the economy are showing true recovery, not just unemployment. 

Ask the experts and the only way is up!

        2014 has arrived and, as is the tradition for the start of any year, predictions are rife for what is going to happen to the economy and markets in the year ahead.

              Last year saw equity markets continue to plough ahead, with stronger growth in both the UK and US economies. As predicted, despite the threat (and start) of the US Fed tapering and the introduction of forward guidance into the UK, US equity markets hit record highs and UK, European and Japanese markets all saw strong positive returns. Whilst yield curves began to steepen following the fear of interest rate rises in both the US and UK in the coming couple of years, it would appear that the management of forward guidance by the Bank of England and Federal Reserve in the US acted to ensure that, after the initial panic, there is an acceptance that base rates will only rise when the economy is ready. 

            So to 2014. After the strained optimism of last year, with the bears and bulls fighting it out in almost equal numbers, market analysts and "experts" almost to a man are making optimistic predictions for the markets and economy in both the US and UK. I mean why shouldn't they? The US and the UK are growing again and look like picking up speed, unemployment on both sides of the Atlantic is coming down, the US has finally managed to come to an agreement on its budget and some measures of business confidence in the UK are at a 20 year high. All this appears to have convinced even the most skeptical (aside from the permanently pessimistic and critical Robert Peston) that the only way for markets is up.

               Renowned economic journalist Anatole Kaletsky sees US economic growth hitting 4% this year (a level many see as the sort of figure for sustainable growth) whilst also seeing global stock markets still having "a long way to go". Even in a potentially rising interest rate environment he believes that this is no sure reason to suppress equity market advances claiming that in an growing economic climate equities rise alongside bond yields. He even believes that the Euro will eventually weaken later in the year leading to a recovery in the much battered economies of Southern Europe. But whilst he is perhaps overly optimistic about the year ahead he is not alone in his assertions for a bumper year. A recent Daily Telegraph article approaching several market participants saw almost complete agreement that the FTSE 100 in the UK was set to drive even further forward. Whilst some estimates merely predict a modest movement above the 1999 high of 6,930 (it's currently around 6,750) there are many who are predicting a further 11% uptick to 7,500, meanwhile predictions from Citibank suggest an 18.5% increase to the 8,000 mark are not out of reach. An article by Business Insider saw similarly bullish sentiment for the year ahead on the US market. Not one analyst asked predicted a fall in equities over the year, with most predicting at least a 7% return, a figure which would extend a rally already over 170% since the low of 2009. 

           Even Dr Doom himself, Nouriel Roubini, is sounding remarkably upbeat in his start of year predictions. He was one of the few to predict the 2007/8 crash and someone who continued to predict doom and gloom in both his post crash book Crisis Economics and subsequent articles. The more reassuring part of Roubini's article however is that it is more cautiously optimistic. Whilst he sees modest growth in the "advanced" economies, he still believes that most of these economies will still remain below the sort of growth levels required to drive forward into a full recovery and economic boom. He also believes there has been a stabilisation of what he terms "tail-end risks", the kind of risk such as a euro implosion or US debt default likely to plunge the world back into crisis. 

            The seemingly rosy picture painted by those "in the know" is often used by everyday investors that now is the time to pump their savings right back into the equity market which so burned pension funds and personal investments just 5 years ago. It's this exact reason why a note of caution needs to be sounded to all those preparing to do just that. It is at the point of most exuberance that bubbles tend to get carried away and investors feel the need to get in before it is too late. The cost of this is the all too familiar losses seen by many retail investors post 1999 and 2007. The fear at the moment is that whilst we seem to be moving forwards in terms of improving fundamentals this does not guarantee that things will be rosy for years to come. There are still items for concern which could affect the outcome of the next few years.

           Among them the US debt ceiling debate is still continuing to rage on with the current extension only providing enough funding until February 17th. Whilst it is estimated that there will be enough funds available to allow the Treasury to function for about a month after that, the issue remains that this is still to be resolved in a conclusive manner. If further dithering in early February around negotiations to extend the ceiling fails to lead to a comprehensive extension, it will continue to cause unnecessary uncertainty on a global level. The eurozone, whilst seeing a marginally improving situation, is still sitting on an employment level of 12.2%, with more than twice than percentage of 18-25 year olds unemployed. In order to see a true recovery (and avoid similar catastrophe in any further recession) they will need to work substantially to resolve the structural issues currently associated with having a series of entirely independent states sharing the single currency. 

              As the UK and US continue to push towards an improvement in terms of general economic conditions, there also remains the fear that rising market interest rates could halt any economic growth. I believe the reality is that whilst private consumption is seemingly helping to drive forward the current growth, a gradual rise in rates as confidence increases may help to improve an important part of the economy, that of business investment. Whilst rising rates increase the cost of borrowing, one of the current issues is still the reluctance of banks to lend. An increase in rates will enable banks to get a higher margin on their loans and as a result could see more companies able and willing to carry out the sort of capital expenditure required to provide the boost to the economy enabling it to reach the "escape velocity" level. In turn this should lead to the substantial increase in corporate earnings required to justify a further equity market rise.

               The recovery phase of the economic business cycle is often believed historically to last between 3 and 4 years, which in itself has led many to question whether the current recovery has much longer to run. However recent analysis mentioned by Lance Roberts of STA Wealth and Cullen Roche of Pragmatic Capitalism has suggested that the previous 3 recessions (focusing on the US) have actually seen longer more gradual recoveries. The suggestion for this is that the downturns themselves are less severe due to the active management by central banks once the crisis begins to unfold (like we have seen so far). The longest recovery was apparent in 1991 which saw an almost 10 year period of growth, with the following in 2001 being 6 years in growth. If this adjustment in the timing length of economic cycles continues to hold true it would suggest that the current improvement may still have at least a couple more years left. 

Such analysis would indeed suggest for now that the only way is up, but we should always be wary about relying too much on history to enable us to time market entry and exit (there is a reason they say past performance are not an indication of future returns). As mentioned, there are still factors at play which could ultimately cause the existing recovery to stall, but the current facts point to a permissible optimism for now. As always though in what we do, we must think for the long term and not lose sight of the realities. As I always like to say, if you're not prepared to lose it, then don't be prepared to risk it.