Not waving but drowning

There’s been a lot of encouragement on social media over the last couple of weeks to post pictures from ten years ago. My own images from New Year’s Day 2010 are probably best left in the ether – I’d donned a pink polka-dot bikini to go for a dip in the Atlantic from a beach near Plymouth. I’ve forgotten which charity we raised funds for; I do remember it wasn’t nearly as cold as I’d expected – but it was a lot stonier. Running in was fine as the adrenaline and camaraderie drove me forward into the waves; I hardly noticed the sandy bottom change to rocks until I was waist deep and the pain of lumping onto a particularly sharp pebble drew me up short. Arms flailing, I tipped headfirst into the icy foam. I spent the next quarter of an hour tentatively picking my way back to the shore, staggering to my feet only to stumble on another rock or be bowled over by a wave. Top tip for anyone planning their own dip next year? Wear plimsolls.

In the financial world we were also staggering to our feet after two years of being tossed around by the stormy seas of the financial crisis. As Warren Buffet said at the time ‘It's only when the tide goes out that you learn who has been swimming naked’ and as the waves of the crisis receded there seemed to be an awful lot of people looking sheepishly for a pair of Speedos to hide their hubris. As we made our hesitant way to drier ground, it became clear that we needed to change the way we managed money – we needed a pair of financial plimsolls.

January 2010 saw the launch of our new approach to investment, which means we have ten years of performance data. Not quite the long term but certainly a good point to review progress.

The financial crisis had focused our minds on the need to properly overhaul our investment process. Previously we’d taken the view that the past was the best guide to the future and assembled client portfolios based on a range of historically out-performing funds. Having diversified portfolios meant clients were sheltered to a degree from the worst of the market turbulence but they were still hit more than we had led them to expect.

We went right back to first principles and developed an evidence-based approach. This meant we rejected the claims of fund managers who promised to be able to repeat past successes, instead accepting that most of the time markets are reasonably efficient; trying to beat them consistently is not the best use of anyone’s time – or money. Research suggested that sophisticated asset allocation based on deep analysis of past correlation patterns was no more effective than a na?ve approach – the important thing was that the portfolio was diversified rather than method of diversification.

We put our first model portfolio together using mostly low-cost passive funds as the building blocks for a globally diversified portfolio with allocations roughly based on market size. We took a target beta approach – beta is a measure of volatility and a proxy for risk. We wanted our core portfolio to have a beta of around half that of the market. In order to achieve this we started with a 50:50 allocation split between growth assets (i.e. shares) and defensive assets such as bonds and property. Equipped with this core portfolio meant we could adjust the ratio of growth to defensive assets to reflect a particular risk appetite and cashflow requirements.

A lecture by Cass professor Steve Thomas opened our eyes to momentum and the tendency for markets to trend, creating signals that can help manage downside risk. With the aftershocks of the financial crisis still at the front of our minds we decided this was something that deserved more consideration. A lot of very long spreadsheet analysis and a bit of toing and froing between us and Steve Thomas’s team converted us from sceptics who regarded technical analysis (basically, looking at charts) as little more credible than reading tea leaves to believers that it is a useful tool to have in our armoury. We follow the trends of the main equity markets and they have, indeed, proven to be worthwhile indicators. It also fired our enthusiasm for behavioural economics, which explains why markets tend to trend.

As the decade developed so did our understanding of markets. We have bolstered our team with more economics graduates, with each new appointment bringing fresh insights. We moved beyond momentum to embrace other persistent anomalies to the premise that markets are reasonably efficient, tilting our portfolios to reflect these factors of investment. We have also adapted our asset allocation to better reflect the relative productive capability of the economies we’re investing in rather than simply the size of their equity markets.

Ten years on we’re quietly satisfied with the results. We set ourselves two objectives – to not lose money over a rolling twelve-month period and to make a real return over three years. Of the 108 rolling twelve-month periods covered we have met the first objective more than 100 times; we have met the second objective all the time. We have achieved the core objective of investing – a materially improved risk/return ratio.

Comparing our core 50:50 model portfolio (including our investment management fee) with its direct benchmark (the IA Mixed Investment 50% shares) and the benchmark for the next risk notch up (the IA Mixed Investment 40-85% shares) shows that over the decade we’ve experienced lower risk than both benchmarks (a beta of 0.38 against 0.39 and 0.49 respectively, reflected also in a lower volatility figure 6.31 against 6.70 and 8.14) but an annualised return that is closer to the higher risk benchmark (6.49% against 5.96% and 6.72%).

Looking at the stats provides some interesting insight into how often you should look at your investment. Whether you are looking at our portfolio or the benchmarks, if you check it once a week then around 40% of the time you’ll be disappointed as it would have lost money – look every three years and you’ll be delighted every time!

Moving forward, we’ve adopted a similar ethos with our Socially Responsible Investment (SRI) portfolio. We decided against being too dogmatic; the deeper you look at the issues involved the more you realise two facts of life – ethical issues are rarely black and white and there is a lot of ‘greenwashing’ going on. Companies are simply presenting themselves as socially responsible with little justification. We accept our portfolio is not a pure SRI offering – we describe it as vegetarian rather than vegan - but we expect it to develop over time. We have been running it for two years and, to date, it has performed in a similar fashion to our original model.

Which is a good thing, because if we don’t start taking issues like climate change more seriously, we won’t need to go down to Devon for a dip in the sea, we’ll simply need to step out of our front door.

If you do, don’t forget your plimsolls…

Important stuff:

This article is intended for information only and does not represent personalised financial advice. If you require advice in respect of your financial planning, you should contact us.

Past performance is not a guide to future performance. The value of an investment can fall as well as rise and is not guaranteed – you may get back less than you paid in.

Performance data: Period: (01/01/2010 to 31/12/2019) – Return Period: Weekly – Benchmark: MSCI World Large Cap – Risk Free Rate: 3.5% - Annualised Ratios: Yes – Currency: Pounds Sterling