15 February 2008
These turbulent times may feel different but when it comes to investing, it's still the same game and it pays to look at what's gone before.
Investment markets move in cycles and investors should think long term and understand the lessons of economic history.
Some young investors are fresh to the market, having ridden the rising tides of market momentum, but haven't felt the cold winds of a bear market yet.
Economic historian Charles P Kindleberger points out that financial crises are associated with the peaks of business cycles and that crashes or panics are historically common. 1
Stated simply, the market moves into a growth phase and then after a period of time corrects itself.
These stock market corrections - technically a 10 per cent rapid fall in the market - can be more severe as shown recently when share markets in developed countries dropped up to 20 per cent. And when sustained, can lead to a bear market.
Markets can drop like stones
There have been a number of corrections over recent years.
At the time of the 1974 OPEC oil crisis, the markets dropped 50 per cent and it took two years to recover.
During the October 1987 crash, the All Ordinaries Index fell 25 per cent in one day, and continued to fall for the next five months. It took over six years for the market recover.
In 1997, the Asian crises sparked a ten percent fall on the All Ordinaries Index. It took only one year to recover.
Only three years later in 2000, the 'tech wreck' created havoc on NASDAQ. However, Australian markets weathered the storm.
With a spate of corporate scandals, and a hangover from the tech wreck, the September 11, 2001 attack caused a 12 per cent drop on the All Ordinaries Index. The market took over 12 months to reach a new high.
And recently the share market was battered by the sub-prime fall-out and dropped dramatically.
Since the early 1600s, markets have risen dramatically and then fallen, catching many investors on the hop.
The investment markets are cyclical and it really does help to be attuned to bull or bear cycles.
And realise that along the way, there will be asset bubbles.
Speculative bubbles include The Tulip Bulb Mania in the1630s, the 1969-nickel splurge through Poseidon and the above mentioned technology shares in 2000.
Here, investors came to believe there were more legs to the investment than was actually the case.
And when the correction comes it is usually dramatized as "Black Thursday" of 1929, "Black Monday" of 1987, and recently "Black Tuesday" of 2008.
But more importantly, the recovery of markets has been quicker since the great crash of 1929, particularly in the last decade.
So what should investors look for?
With all these facts in mind, investors should think about diversification, which reduces the risk of timing, as it is virtually impossible to predict market cycles.
Every investment is subject to some risk level. The key test is to know your risk profile.
In reality of course, the pain threshold is reached when you lose money you can't afford to lose.
Past experience comprises part of your risk profile. But for those just starting out with managed funds, here are a few useful questions you should ask yourself.
Is my investment objective clear?
How much do I plan to invest and over what timeframe?
How important is capital protection? What would you do if an investment dropped 25 per cent?
Am I investing to make money quickly? Or am I looking for long-term growth?
Do I need income from my investments?
What type of assets - equities, property, fixed interest, and cash - do I feel most comfortable investing in and why?
Do I have the time to research my direct investing or should I delegate this to a professional fund manager?
Do I understand the investment strategy of the fund, its performance, risk profile and the fees involved? Have I read the fine print?
Do I really understand the risks involved with this fund?
For example, the current bull market has been around since 2003, so it may be sensible to think about more defensive strategies rather than assuming double-digit returns will still come your way.
The past has a clearer view than the future
It pays to a look at the long-term performance of each asset class.
The ASX/Russell Long-Term Investing Report looks at various types of investments over the past 10 and 20 years to end of December 2006.
The study found that the top performing investments (all figures before tax and after costs) over the ten years were all ASX listed investments:
Australian listed property achieved 15.8 per cent; and
Australian shares achieved 12.8 per cent
Residential property achieved a return of 11.7 per cent.
And over the twenty years:
Australian listed property recorded 13. 2 per cent; and
Australian shares recorded 11.1 per cent
Residential property again achieved a return of 11.7 per cent.
Obviously tax will have a big impact on the net returns and leveraged shares will have a better outcome due to franking credits.
Investors with endurance and composure and a penchant for low risk will look at growth assets such as shares and property or diversified managed funds.
The parting thought from history's annals is to have patience.
Take the example of John Maynard Keynes. He was an avid 'bargain-hunter and focused on identifying stunners - those stocks that offered 'intrinsic values'…enormously in excess of market price'.
And during the depression he followed his own analysis rather than the market and became enormously wealthy.
He said "the intelligent investor, therefore, focuses on the future earnings ability of a particular stock."2
Wealth creation is not an overnight sensation. It takes time, effort and research to accomplish it.
1Manias, Panics and Crashes - A History of Financial Crises, Kindleberger, John Wiley 1978
2The Keynes Mutiny: Justyn Walsh, Random House 2007 pp118
