Last updated: February 28, 2014 1:45 pm
We’ve got five years, what a surprise,
We’ve got five years, my brain hurts a lot,
We’ve got five years, that’s all we’ve got.
– David Bowie, 1972
Next week, the great rally that followed the 2008 crash will reach five years. It has been a great time to be in stocks.
This is quite a surprise. Five years ago, visions of the future bordered on the apocalyptic. The prognosis for 2014 looked as bad then as 1977 appeared to David Bowie when he recorded Ziggy Stardust five years earlier. But the economic pain has been far more limited than feared, while the return on stocks has been remarkable.
However, the crisis has dented investors’ psyche. That shows up in their attitudes to risk, as revealed by an exhaustive survey of large institutions across the world conducted by BNY Mellon. It found that they had universally upgraded their risk management since 2009.
But all is still not well, according to Harry Markowitz, who has guru status within the investment industry. A Nobel economics laureate, he came up with “Modern Portfolio Theory” in 1950 (he is very happy that it is still considered “modern”). That allowed investors to balance risk against return. Adding securities to a portfolio, if they were not correlated to the original securities, could help move towards an “efficient frontier”, by reducing risk without reducing return.
Mr Markowitz, now in his eighties, suggests politely that the concept, used almost universally by institutions, is not applied quite as he envisaged.
“Sell-side analysts will say: ‘I have an asset class here that is not correlated’,” he says. But the “goal of diversifying a portfolio by adding exotic asset classes has sometimes proved quite disappointing, and predictably so”.
For an example, look at the rush to buy emerging markets and commodities before 2008. Previously uncorrelated, both crashed with everyone else once liquidity dried up.
Mr Markowitz also frets that investors are “always fighting the last war”, when in fact “all crises are different”. The risks against which investors have raised their guard are “derivatives volatility, extreme market shifts, liquidity, financial market contagion and credit and counterparty default risks” – all emblematic of the last financial crisis.
“[The year] 2008 wasn’t an outlier. I personally am shocked that the industry found 2008 so shocking.” Statistically, he says, it was only a one-year-in-40 event, or something that can be expected to happen once in a working life.
And yet it has changed attitudes profoundly. First, investors no longer seek to beat a market index but just to match their own set return target. For pension funds, this increasingly means that they seek to match returns to their liabilities, so that they have enough funds to meet their pension promises.
This is healthy. With less attempt to beat the index, there should be less crowding around the index – which means less risk of bubbles. And investors will look for the most conservative path to their target, which again reduces the risk of bubbles.
Second, and less encouraging, institutions hold far more alternative investments, such as hedge funds and private equity. These used to be sold on their chance to generate a higher return. Now they are bought because they can lower risk, by being less correlated to the market. But can those low correlations be sustained?
Mr Markowitz’s comment on this: “One lesson from 2008 is that if it’s very complicated and you don’t understand it, maybe you shouldn’t buy it.”
Anyone with a simple rule that required them to keep 40 per cent in bonds and 60 per cent in stocks would have “rebalanced” – bought stocks – near the market’s nadir five years ago, he points out. “Those who were too clever by half suffered tragically.”
One cause for comfort is that every respondent was worried by “the interest rate and current yield environment”. All perceive risks in weaning the world off the low rates generated by the Federal Reserve’s QE bond purchases.
This is good to know. When something is thought to be a high risk, people guard against it. This limits the damage if the risk comes to pass. Events discounted as no-risk – such as a national fall in US house prices – cause the most damage.
But it is alarming that investors show no great concern about politics. More than a third said that they did not measure political risk at all.
Political risk is imponderable and markets are collectively unable to measure it. Cliff-hanging episodes in the US Congress and elections in the EU have threatened renewed market crises in the past five years. Politics, not the world of finance, may pose the greatest risk of a new financial crash.
After the past five years, you could be forgiven if your brain hurt. But some principles are constant. There is still a hunger for the complex and a focus on what has just happened. Looking for simplicity, and imagining what could go wrong in future, would make more sense.
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