Learning from the past, looking to the future

Recent years have taught many investors an expensive lesson. PHILIP MACALISTER looks at what has been learned.

You've been bombarded with the "start saving for your retirement message" and finally decided it's time to do something. But what?

It's odds-on that, even if you've decided to take the leap and get saving, you'll get cold feet as soon as you look at the markets, and decide it's far more fun to splash out and spend your money.

Because what you see when you look at markets lately has been described by some as "carnage".

World sharemarkets, which delivered fantastic double-digit returns through the 1990s, are experiencing one of their worst downturns.

The United States, which makes up about half of the world economy, provides a sobering view.

Sharebroker JBWere says the present US bear market is now one of the worst of the nine big bear markets the US experienced last century. With the exception of the Great Crash, in which investors lost 79 per cent in real terms between 1929 and 1932, other big bear markets have sliced stock prices by between 25 per cent and 51 per cent in real terms. So far, investors have lost 52 per cent in this decline.

Not many people want to invest $1000 and get back less than $500.

But one of the important things to know is that it's vital to look beyond the short term (more on this later), and not to get waylaid by the doomsayers who try to paint as ugly a picture as possible.

Perhaps the worst recent offender here is Green Party co-leader Rod Donald, who has waged a public campaign against the Government Superannuation Fund and its decision to move from a portfolio of very safe (and low returning) cash and Government bonds into a diversified portfolio including international shares.

Donald's argument was that the fund had lost $315 million on those international shares and that this was a bad thing.

However, he chose to ignore the fact that the fund's money was spread across many types of investments; some did well and others, like international shares, have had a bad run.

By spreading its investments the $3.5 billion fund recorded an overall return of negative 2.27 per cent for the year to June 30. While a loss is never nice, it's one of those things that investors have to face occasionally.

The first lesson for anyone starting an investment programme or wondering what to do with their existing investments is to spread their money around.

One of the hardest decisions, though, is deciding exactly where you should place your money. Or, more precisely, how much of it you should put into each particular type of investment.

The commonly accepted view from mainstream investment experts is that for a medium-risk investor the split should be something like two-thirds of your money in "growth" assets (shares and property) and the remainder in income-producing assets (cash and fixed interest).

And, when it comes to deciding between New Zealand and the rest of the world, the view is that between half and two-thirds of your money should be overseas.

However, it would be difficult to find people who were sticking exactly to that formula at the moment.

All the statistics show there is a tidal wave of money going into cash, capital notes, other types of fixed-interest investments and mortgage funds - the present beauties on the beach.

Right now, shares are more like the 90lb weakling who gets sand kicked in his face.

Also, people have been embracing alternative investments, particularly "hedge funds", which use a variety of tactics to try to make money whatever the general direction of the markets.

As Economics New Zealand managing director Donal Curtin says, while the theoretical asset allocation models are fine, people need to tweak them for the conditions that prevail.

"There are large, medium term, macro-economic influences on asset prices that can, and should, be factored into investment planning."

He points out that during unusual periods, such as the technology bubble of the late 1990s, it can be difficult to tell what is happening. It is only several years later, with the benefit of 20/20 hindsight, that the picture becomes clearer.

Because of that delay, it is very hard to correctly time investment decisions.

Curtin points to an example from 1996, when US Federal Reserve chairman Alan Greenspan famously warned about the sharemarket's "irrational exuberance".

Greenspan has (eventually) been proven correct, but it took three years and another 3000-point rise in the Dow Jones index, which measures the strength of US share prices, before the crash.

The lesson from all this is that, to be a truly successful investor, you have to have a long-term focus.

Taking and keeping that long-term focus can be difficult, especially if you look at your portfolio and see lots of losses.

It is in these times that professional financial advice can really help. As the winner of last year's Financial Planner of the Year Award, Jordi Garcia, says, it is when the markets are down that investors need the most help.

"The most value I add is not when markets are going up but when markets are going down," he says.

When they are rising, things are easy and everyone is happy. Right now financial planners are spending most of their time talking to clients, explaining what is happening and encouraging them to keep that long-term focus.

"Behavioural finance" - the study of how psychology affects financial decisions - shows that people change their attitudes depending on the circumstances. So, when you started your investment programme you told yourself it was for the long term, but as soon as things turned sour, fear of more losses makes you feel like abandoning that long-term focus and selling up.

As JBWere points out, the biggest mistake people can make in this environment is to sell; if you sell and the markets rebound quickly, you will miss out on a significant portion of the gains.

And only when you sell do you suffer a real loss. As long as you remain in the market, your loss is only on paper.

There is evidence to show that big bear markets are followed by rallies. JBWere research shows that:

* Following all the big market drops came 12-month real advances. In itself, this is hardly surprising; by definition, a trough has to be followed by a rise or it wouldn't be a trough. But the size of those gains is interesting: from 7 per cent to 160 per cent, with an average rise of 45 per cent.

* The decade after the trough also delivered superior long run returns (averaging 12 per cent after inflation).

So, should investors be "contrarian" - go against the herd - and buy? Yes, but don't expect to pick the bottom of the market.

Perhaps the other big lesson to come out of the past few years is that markets don't move in a straight line. Often graphs depicting the long-run performance of the US sharemarket are produced to convince would-be investors that the sharemarket is the best place to be for good returns.

True. Over the long term shares will clearly outperform other types of investments. However, a closer examination of the graph will show that there are many up and down periods along the way.

What's worse is that right now the ups and downs (or volatility as it's known in technical terms) are far more pronounced than we've been used to in the past.

One story used to illustrate the present environment (courtesy of fund manager Invesco) is the one about the famous cliff divers of Acapulco.

The secret to the divers' survival is to hit the water when the incoming wave has raised the water to its maximum level. To do this, the diver must jump when the outgoing wave has reduced the water level to its shallowest level.

In other words, the diver must jump in when conditions appear the worst. Some of the market's greatest buys occur when conditions appear to be most perilous.

To be successful, investors must learn to jump in during market corrections and assume that the next bull wave is already on its way.

Are you ready?

* Philip Macalister is the editor of Asset magzine and online money management magazine Good Returns.

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