In many things we do, we find ourselves looking at the past for answers, context, and in a more general sense, a guideline towards something that has been tried and tested. Regardless of the contrasts of superimposing the set of elements from the past into the present or the future, this can be a source of wisdom, however imperfect it may be.
The allocation of a personal portfolio revolves mainly according to the personal situation of the investor – this includes whether they are seeking income or growth, and what level of risk they will take to reach their objective. This has to be measured against the options available on the market. These are a composite of an array of factors attached to the global economy that dictate the level of opportunity and returns.
In the eyes of the investor, the fear of significant losses are an equal or overweight detractor, as much as returns act as a magnet for attracting capital. It is often said that in order to know your strength, you have to face your gravest fears. Investors can characterise this through what happens during periods of recessions, bubbles and crises, which put investors’ portfolios at risk.
The question of what we can learn from these events is a very relevant question, which can impart important lessons.
Each of these events can be captured in a set of criteria that eventually lead to a market calamity that impacts different investors at various levels and degrees. The most common factor in these events is irrationality. This refers to the market reflecting the true underlying value of factors within the economy in its prices. The great recession of 2008 and the tech bubble of the early 2000s are clear pin-up examples of this. In both cases, asset prices, namely of real estate in the lead-up to the great recession, and valuations of internet companies in the lead up to the tech bubble, had increased with an exponential rate.
The trouble here is not mainly the significant increase in prices, but the lack of increase in values of the supporting factors, such as incomes and demand in the case of the great recession, and profitability and sustainability in the case of the tech bubble.
The case made back then was that these valuations could not be interpreted through the classical valuation techniques, but required new methods that could justify the value. The implosion of these two rallies is a reminder that irrationality will be quashed at one point or another, at the expense of those who buy into it. The second red herring common in these events is the mania, or the velocity by which investors buy into the asset or security.
The implosion of rallies is a reminder that irrationality will be quashed at one point or another, at the expense of those who buy into it
Another facet of these adverse economic events stems from government policies. These tend to be manifested as national debt crises and currency crises. This can be captured in the European debt crisis of 2011 whereby excessive debt undertaking by peripheral countries put the monetary union at risk. It turns out that excessive spending by the state has to be sustained by revenues. The recklessness of national governments and their unwillingness to take control of their national economies in order not to lose political capital, deteriorated the already weak European economy.
On the other hand, currency crises, such as the Russian and the Argentinian crises of 1998 and 2001, stem from reckless economic policies and mostly fixed exchange rates which have today given way to free-floating exchange rates.
In the great recession of 2008 we learned that crises can be contagious. In one of the defining episodes of the crisis, the UK banking regulator is said to have blocked British bank Barclays from acquiring the now defunct American investment bank, Lehman Brothers. This deal was blocked on the concern of the British regulator that in allowing this deal, it would import the financial turmoil that was being experienced in the US. This could not be further from the truth, as the mortgage-backed securities traded across the globe, spread the recession on a global basis.
Despite the mentioned adversities, investing in debt, equity and alternative markets remain the go-to instruments for those who wish to generate returns in excess of capital-guaranteed products. One needs to understand that the trade-off for these excess returns is the risk of his or her portfolio, which he or she carries, to gain the excess returns. Regardless of the length and the severity of any of these adverse effects, what holds true is that markets have always recovered and delivered excess returns, beyond the previous highs. Also, despite how odd it sounds, these events do actually have positive effects.
First, recessions represent a buying opportunity. With asset prices at significantly discounted levels, investors could buy a bargain when investing in corporations that are priced below their value.
Investors who invested after the 2008 recession experienced significant gains from purchasing deep discounted equities of household corporations, and high yields from debt. Secondly, recessions allow the realignment of an economy. The correction of prices, or the restructuring of debt, will allow an economy to break away from the shackles of recession. The new normal allows the economy to start functioning again, as confidence is slowly restored, hiring and capital spending start to increase, and a new cycle starts over again.
Periods after recessions usually herald more controls, while spurring productivity higher. This implies that recessions are good antidotes against market and industry complacency, and in the long term generate a net positive outcome.
The takeaway from this is that when investing for the long-term, one is bound to experience these market phenomena at some points. Unfortunately some investors tend to abandon their investments in face of volatility that exceeds their expectations. This would normally occur as investors suppose that the adverse economic effects will persist over the long term. Such view is as negative as assuming that a positive market cycle will continue perpetually. It is imperative that investors hold true to their commitment of investing long-term, and are able to tolerate these market fluctuations when they occur.
Additionally this underlines the importance of conducting reviews with professional advisors. The outcome of such reviews will be the ability to change the portfolio composition to suit the forecasted market outcomes. As a matter of fact, for example, a possible view could be to take a more defensive stance in the current market environment to protect against growing political risks.
This, however, is no blanket recommendation and always has to be viewed in context of the market and the needs of the client.
This article was prepared by Daniel Gauci, HnD Management, CeFa Investments, an investment advisor at Jesmond Mizzi Financial Advisors Ltd. The article does not intend to give investment advice and the contents therein should not be construed as such. The company is licensed to conduct investment services by the MFSA and is a member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Ltd of 67, Level 3, South Street, Valletta, on 2122 4410 or e-mail daniel.gauci@jesmondmizzi.com.