Buy-hold strategy may have had its day…I don’t think so
Page 31 of the Australian Financial Review (AFR) today has an article suggesting “that the traditional buy-hold approach to owning shares is dead”…full text, with subscription can be found here. The article’s stated reason for buy-hold is that “in the long run, markets always go up and will provide investors with a good return on their investment as well as tax benefits, despite any volatility”.
Unfortunately, financial planners are placed in a dim light as usual, with ignorant comments like, “The buy-hold strategy is often sold by financial planners because it requires less management work – helpful for those with a large client base – as stocks selected are held for many years”.
Whilst there is a little bit if truth in each of the above statements, unfortunately the main reason behind the buy-hold strategy is ignored altogether. That is, that timing markets is very very hard and after transaction costs and potentially other costs are taken into account, there is more evidence to suggest that buy-hold is a far more successful method of achieving sharemarket returns than active management. This belief has the foundation in numerous academic articles, most notably Brinson, Beebower and Hood’s “Determinant of Portfolio Performance”, and the consistent failure of active managers to outperform benchmarks (see recent SPIVA results).
Unfortunately the AFR article suggests that in order to be successful at beating the buy-hold approach, signals such as momentum, timing markets (good luck!) and the ability to pick ‘high-quality’ companies using certain factors is all you have to do. If only it was that easy.
For the individual investor, picking stocks is largely a mug’s game…sure you might beat the market but I can pretty much garantee it will typically be more through good luck than any demonstration of skill and any outperformance will probably come from taking on more roisk (even unknowingly).
Personally, I like the idea of being dynamic with regards to investment portfolio. My approach is a little different and is based around designing portfolios to accept or not accept various macro risks…the likelihood of underperformane must be accepted and outperformance will never be guaranteed like some of these fund managers market but rarely live up to.
Bottom line…there is no silver bullet but the most efficient way to receive sharemarket returns will be via a very cheap index fund…and that is a buy-hold strategy and a very popular strategy of financial planners and for good reason.
Australian Goverment Bond Yield Curve…noisy improvement
Source: RBA
The above chart shows the latest Australian Government Bond Yield curve which is around 5 to 2obps higher than it was a little over three weeks ago. On the scale of yield curve movement over the last few months its largely market noise and is therefore relatively meaningless…the market is still pricing in further RBA rate decreases and the outlook for the Australian economy is still relatively weak…its currently difficult to find any strong economic growth driver that doesn’t carry significant risk of not fulfilling its potential and that includes China.
The change in outlook for the 2011 Australian Economy in one picture
Source: RBA
The above chart shows pretty much what happened to the outlook for the Austrlaian economy and why bonds were the best investment for the year.
It shows the longer terms yields (3 years and above) dropping by up to 200bps thus providing very large capital gains for bond investors who had the courage of buying long term bonds at the start of the year. This yield curve movement also indicated the declining outlook for the Australian economy thanks largely to the Euro crisis and its potential impact on the banking system across the world.
For the short term bond holders (terms of 1 to 3 years), yields dropped by up to 150bps still providing strong capital growth. Whilst the yield to maturity dropped enormously across all maturies for Australian Government bonds, the Reserve Bank took a while to start the decrease and then only decreased by 50bps by the end of December. This curve still suggests the RBA has a few rate decreases to come and the Euro crisis will probably be the main determinant of that. That is despite the weak retail sales and weak residential property sales that provide increasing evidence of our weaker than you know economy. The Reserve Bank are also forecasting lower commodity prices which doesn help our resources sector so the outlook for growth across our economy may be moving closer to a one speed economy than we think.
Anyway, the year 2011 was certainly a year where the conservative bond investor was a winner and whilst I haven’t seen the final numbers yet, it looks like the gross returns should be a comfortably in double digits.
Investment Thoughts for 2012
Firstly I think its appropriate to suggest that I intend to make no return predictions for this year as I do believe its pretty much impossible with litte upside for me. However, what I would like to do is simply point out a few facts, rules, and current issues that need to be considered when building or reviewing the investment portfolio.
- The big issue this year will once again be the Euro-sovereign crisis. This shold result in significant volatility for equity markets from time to time and daily movements exceeding 2% up or down will be relatively frequent. This type of volatility is the current norm for markets but whether those markets move up or down through to the end of 2012 is anyone’s guess.
- Now whilst equity markets appear historically cheap on a PE basis, this is not necessarily a buy signal as PE ratios should be low in the face of high risk and lower than usual earnings growth, so be very very careful. Despite this warning, cash and bonds are hardly attractive on their own simple value metric, yield to maturity.
- If you think you can pick stocks better than the professionals, I’m afraid you cannot. Even the professionals, backed by massive amounts of resources and always very very intelligent people, frequently fail to beat the market so if you are looking to accept any equity-like risk make sure you are very well diversified and use an index manager or an active manager who is not taking on too many risky bets (remember, noone really knows at this point in time how this European situation will ultimately impact markets)…just because your only stock Telstra outperformed the market this year does not mean you are a good investor…it actually suggests the opposite
- The only free lunch in investing is diversification…this means don’t just invest in Australian equities (or Telstra), spread your investments across other investments such as Global equities, local and foreign fixed interest, local and global property, commodoties and if possible other alternative investments…but make sure the risk you accept is within your comfort zone
- The sharemarket performance of specific countries has very little to do with those countries economic growth. Two of the worst sharemarket performers this year were China, yes China, and India!!! Sharemarkets go up if information is more positive than expected and vice versa…this has nothing to do with economic growth…its expectations so if you can predict the future you’re looking good if you can’t, you’re possibly in trouble (unless you diversify)
- If you are retired and want your money to last for the rest of your life…you can do this by either buying an annuity (lifetime or term certain which very long) or invest in a diversified portfolio of share, property, bonds, cash and don’t draw out too much each year (for example 5% or more linked to inflation). The financial services industry has talked many retirees into investing a very high proportion of their investment portfolio into shares (e.g. greater than 50%) and sold the concept of “over time the sharemarket outperforms”…whilst this is often the case in savings mode, it unfortunately doesn’t apply in drawdown (or pension) phase…you’ run a very big chance of running out of money before you know it!!!
- You cannot get 10%pa return on your money without taking on a lot of investment risk. Cash and Bond interest rates paid by the Australian government are at most 4.25% (and that’s the cash rate)…so if you need to earn more than 4.25% you must take on more investment risk than the Australian government…so that will mean shares if you need to earn a lot more than 4.25% or may mean bank term deposits of you only need a little more than 4.25%.
- Australian houses have dropped in price over the past 12 months…this is not an argument to suggest they are cheap. Interest rates may be reasonable but compared to our average household income we still have the most expensive housing in the world ( and don’t listen to what the banks say…they’re behind on their home loan budgets and need new business)
- The best investment for anyone’s money will always be to pay off your non-tax deductible debt…so that includes your home loan, personal loan, and perhaps that loan that was taken out to contribute to superannuation (I know quite a few people did this in 2007 and they need to pay out those loans asap…but I’m sure they know that already). Non-deductible debt is a risk-free high return that compares to no other investment…if you don’t have non-deductible debt, fantastic and half your luck … and I’m happy for you to pay off my home loan!
I’m sure there’s many other little tidbits but I’m sure that’s more than enough to read for now and if I think of anything I’ll obviously let you know!
Corporate Credit…maybe
Source: RBA
Despite the above chart being a few weeks old, the above chart shows credit spreads have widened significantly over the past few months such that at the end of November, both A and BBB rated corporates have spreads in excess of 300bps. When you consider that the historic default risk is much much lower than these spreads I do believe accepting this type of risk in a well diversified portfolio (that is, with a fund) is an investment that could provide good returns over the next few years. The biggest issues with this type of portfolio relates to liquidity and the ongoing volatility.
Liquidity, or the potential lack of, is why the spreads are as wide as they are. So holding credit investment for as long as possible or through to maturity is recommended. Volatility risk is expected to be quite high as the correlation will be strong with equities. So whilst there is potential for short term falls in value for corporate credit, as long as defaults don’t hit very high and significant record levels, this type of investment should provide a decent return over the next few years. So now that I’ve written it, I guess finding a relatively passive credit fund is the next challenge.
The last thing I want to say regarding corporate credit spreads that are reflected in the above chart is the fact that there is probably a high proportion of banking and other financial services debt included in there. Because it is Australian and our financial institutions appear to be much much stronger than our international counterparts, at this stage I’m not particularly concerned…but it is the financial institutions that will create the volatility in this index thanks to the European situation and the difficulty in raising overseas capital.
Australian Government Bond Yields…there’s now a 2 there
Source: Bloomberg & RBA
Thought I’d check the Australian Government Bond yield curve to see if the market is confirming my bearish sentiment on the Australian economy and it looks like it is. 3 Year bond yields have dropped below 3%…that’s an ugly indicator for our economy.
A few too many ‘China Hard Landing’ stories for my comfort
I’ve read a few too many times how Australia is well positioned because of its exporting links to China and how this should help us escape any serious economic issues flowing out of Europe. Obviously our markets haven’t quite agreed with that with bond yields dropping massively over recent months and our equity market continuing to show high volatility and dropping arond 20% since recording 2011 highs around 5000 back in April.
Overnight we have just had three articles from prominent economists indicating concerns about China …
- Will China Break? – Paul Krugman
- China: Hard landing in sight? – Patrick Chovanec
- China: Lots of News signifying nothing new – Michael Pettis
Of course, a seriously troubling Euro crisis will spill over everywhere including China. Our economy is nowhere near as secure as many commentators or fund managers indicate and I have to admit to being the most bearish on our economy for quite some time…my perceived complacency and frustration with government and opposition focusing on budget surpluses is driving me nuts.
For investors, finding good investment return potential is very difficult indeed and takes some courage. Equity markets still carry plenty of downside risk let alone the usual day to day volatility, bonds have yields in the 3%s, and with an economy looking to slow more than we hoped, property looks scary, and even commodities are bound to drop signficantly in the face of a slower China.
I’m sure the focus of investors will continue to be capital protection over capital apreciation for some time yet. So I can only imagine that cash and term deposits will continue to be the investment of choice…particularly whilst term deposits continue to pay 1.5% to 2% over government debt. Personally, I believe if you can handle the volatility and hang in there for a while I tend to think corporate debt, which on average is paying a significant premium above governemnt debt, should provide the best return potential…only record default levels should stop a decent return on corporate debt (not that its out of the realm of possibility) in the next few years so ensure the portfolio is well diversified and be prepared for a bumpy ride.
Euro Summit…far from a resolution
I’m not completely familiar with all details coming out of the Euro summit a couple of days ago so I thought I’d cheat a little and point out some conclusions from a couple of my preferred econobloggers, Paul Krugman and Felix Salmon.
Firstly Krugman…
European stocks are up today, and I have no idea why. …this looks like a disastrous meeting. More austerity, more posing of the crisis, wrongly, as being all about fiscal deficits; no mechanism for ECB funding. Somehow southern Europe is supposed to deflate its way to prosperity, while everyone runs a trade surplus, presumably against that potentially habitable planet we’ve discovered 600 light-years away.
and Salmon…
It all adds up to one of the most disastrous summits imaginable. A continent which has risen to multiple occasions over the past 66 years has, in 2011, decided to implode in a spectacle of pathetic ignominy. Its individual countries will survive, of course, albeit in unnecessarily straitened circumstances. But the dream of European unity is dissolving in real time, as the eyes of the world look on in disbelief.
Europe’s leaders have set a course which leads directly to a gruesome global recession, before we’ve even recovered from the last one. Europe can’t afford that; America can’t afford that; the world can’t afford that. But the hopes of arriving anywhere else have never been dimmer.
Obviously pretty negative stuff. I guess the fact that both Italian and Spanish 10 year bond yields didn’t move too much also suggests the bond markets aren’t quite as confident as the equity markets, which increased an average of 2% across most places on Friday, at this point in time. Should be another interesting, i.e volatile, week coming up.
Australian Government Bond Yield Curve…no change in 2 weeks
Source: RBA
As the above chart shows the yield curve dropped significantly from the start of August through to towards the end of November and at the end of yesterday after the RBA dropped the cash rate another 25bps to 4.25%, the yield curve is basically the same as it was two weeks ago.
Whilst Australian equity markets have had a decent couple of weeks (the ASX200 was below 4000 on the 25th Nov) the same can’t be said for government bonds. Either way, its still about Europe and with so many uncertainties ongoing sharemarket volatility is bound to continue. I must say, that whilst 3 and 4 year bonds are just above 3%, you can still find term deposits around 6% which is a very attractive margin. Financial institutions are clearly prepared to pay a premium for capital so I’d be surprised if too many pass on the RBA rate cut to us mortgage owners!
Australian Government Budget Surplus…a very poor decision
Normally I don’t like to comment on actions by the Australian Government but with the announcement of a cut in expenses in order to obtain a budget surplus I have to.
Its widely recognised that the level of Australian Government debt is very low by world standards. If you look at my last post on Australian Government Bond yields you can see that there is also little concern from markets about the size of government debt because yields are so low. Yields are also very low because the outlook for the Australian economy is not particularly strong.
The level of unemployment is a reasonable indicator of measuring the relative quality of life the average person has. Obviously, if we are out of work then our income’s are lower and our quality of life suffers somewhat. One of the primary objectives of the Reserve Bank is in fact the maintenance of full employment, along with currency stability and economic prosperity and welfare of Australians. No doubt these objectives equally apply to the implementation of fiscal policy also.
The fact that yesterday’s decision will result in higher unemployment in order to control an already well controlled level of government debt is ridiculous.
The simple approach of any government over time should be to save during the good times (which occurred in the Howard years) so it is in a position to spend when times are tough (which occurred during the Rudd years). Taking this approach increases the chances of achieving smoother levels of employment, economic stability and therefore increased prosperity for us all.
By the government’s own admission, unemployment is expected to increase and if the government is reducing expenses then this will be a significant contributor to this increase…hardly improving our economic prosperity.
The Australian economy is operating at two speeds and if Europe gets worse then it will be one speed and that speed is slow. With our debt levels low, cutting expenses in the hope of a budget surplus given the fragility of our economy in the context of global macro uncertainty is unlikely to help. When times are tough, cutting expenses is likely to reduce revenue and this won’t help our debt position at all…it will make it worse.
The problem with the budget over the last 6 months has been lower revenue and increasing revenue (such as through a resources tax in these incredible resource boom times) is far more important and its clear the government does not have the courage to implement this.
It is obvous the budget surplus is simply addressing a political agenda which is independent to our prosperity as a nation and the fat cat miners win again at the expense of the rest of us.