KEY POINTS:
Turmoil in financial markets has caused concern to many investors. Sharemarkets worldwide have fallen heavily, significantly affecting portfolios, and confidence in the US financial system is weak. It is not every day that major investment banks go broke.
Financial decisions in a downturn can affect our wellbeing for years to come. We can't control markets but we can control how we respond. Let me share with you how my group, which manages some tens of billions of dollars for clients through New Zealand, Australia and Asia, is trying to make sense of the turmoil and to get through to better times.
How did it come to this?
Sharemarkets, jumpy for 12 months, recently fell further and are now well off their highs. The issues are complex but the cycle is simple:
* Low interest rates and slack lending policies make home loans freely available. This works fine while house prices are rising. But US house prices have now fallen, by up to 15-20 per cent in some areas.
* Many borrowers can't repay their loans.
* Portfolios of mortgages held by investment banks and other institutions plunge in value. Some firms that are over-exposed and have too much debt go under.
* Confidence disappears - a classic "credit crunch" ensues.
Casualties in this cycle have included Bear Stearns, Lehman Brothers, mortgage providers Fannie Mae and Freddie Mac, and American International Group (AIG). Merrill Lynch fast-tracked its sale to Bank of America to avoid a similar fate. The US Government has acted swiftly, bailing out some and proposing a US$700 billion ($1.2 trillion) fund to help others. Their aim is to prevent a Wall Street event from causing a deep recession.
While this is a real possibility, there are also some pluses to note - lower oil prices, lower mortgage interest rates and globally co-ordinated government action among them. The world economy has been resilient and remains so.
What to do?
In the past 25 years, we've guided investors through six different downturns, including readers of my column in this newspaper during the turbulent 1980s. The truth is, we know only one sensible way to get through such a difficult period: stay focused on the longer-term fundamentals, be well-diversified, ignore "noise" as much as possible and get good advice. Here's some of what we're doing to manage investment portfolios:
* Staying diversified. While diversified portfolios have lost ground, maintaining a wide range of investments mean disastrous results from one or a few have a small effect. Remember that the vast majority of companies supplying each of us with the staples of our everyday lives will survive this period, as will we.
* Managing to long-term asset allocations. The evidence of history is that knee-jerk reactions - like major switches to cash when sharemarkets fall heavily - can be very costly. Moving to cash will mean losses are locked in. At current interest rates it will take many years to recover paper losses in the stockmarket by switching to cash.
* Rebalancing. We continue to rebalance between different investment types so we routinely buy asset classes that have fallen in value, and sell those that have risen. This effectively means that over time we consistently buy cheaper assets and lock in the profit of more expensive ones.
* Uncovering opportunities. Good investments usually emerge from periods like this. Banks that make it through will be better regulated and may end up with fewer competitors. Compelling opportunities are likely to emerge but risks will also need to be closely managed.
Everyday companies haven't stopped performing well just because markets are down. Fisher and Paykel Healthcare's underlying growth remains reassuring. Mainfreight has been a solid performer this year and Michael Hill International is a quiet achiever.
There will be winners from the current turmoil in global financial markets. For example, Lloyds TSB is a large and stable British bank with a diversified business model and broad retail base. They have purchased HBOS (Halifax Bank of Scotland), which was hit by the current crisis. Lloyds was previously prevented from similar acquisitions. Lloyds will eventually profit from increased market share and improved efficiencies.
What does history tell us?
Most forecasts of market direction are worth less than the paper they're written on. But there are typical market behaviours during and after most downturns:
* It's different (and the same). Every downturn is different but financial institutions have failed before. The system normally emerges stronger but never foolproof.
* Markets typically do recover. When markets have fallen sharply - the 1987 crash, dot-com bubble, 1970s oil crisis and so on - they have typically recovered. Sometimes recovery is surprisingly quick, other times it takes years. Only those who are invested participate in the return.
* Recovery may come without warning. No one holds up a big sign saying "market recovery", so parking too much in cash may mean missing a rebound. Markets often recover from a downturn six to nine months before the economy.
* Markets are cheaper post-fall. At times like this, good stocks are thrown out with bad. Currently, share prices in many markets are below long-term averages. A combination of fair economic conditions and lower prices sets up diversified portfolios to deliver reasonable returns in the coming years.
What can you do?
* Keep perspective. While the last year has been tough, even including this poor recent performance, the past five years have still been good in many markets. Shares have a very good track record of recovery in the year following a downturn.
* Try not to be affected by daily news. We don't attempt to downplay the very real challenges facing markets in the period ahead, but reacting to daily news may be a bigger threat to long-term success than a fall in the market.
* Remember why you did what you did. At some point in the past, with the help of a financial adviser, you established a portfolio to assist in supporting the life you want to live. Unless you've changed your goals, think very carefully - and consult your adviser - before changing your portfolio.
* Get good advice. If advice is important in good markets, in tough times it's essential. Work with your adviser so you make the right choices.
Finally, it's worth reflecting on the comments of Warren Buffett, published recently in the New York Times. He said that as the markets have fallen he has kept investing his personal money in equities and intends his portfolio to be 100 per cent equities if the falls continue. Of those who have invested in cash, he says: "They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts."
It has been his clarity of thinking and use of aphorisms to allow common sense to shine through confusion that have helped Buffett achieve his legendary status as the world's most successful investor.
So, to let Buffett have the last word: "Let me be clear on one point: I haven't the faintest idea as to whether stocks will be higher or lower a month - or a year - from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over."
Arun Abey is executive chairman of financial planning firm ipac, head of strategy for AXA in the Asia Pacific and a director of the Spicers Portfolio Management advisory board. He is also the author of How Much is Enough?
www.howmuchisenough.net
