Its Not Harry

Comment and opinion for retail investors in the UK

Portfolios

Yes! It does work!

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NotHarry’s approach to portfolio design is backed up by observations in very elevated places!

Below is an extract from Morningstar’s website, published yesterday.  I have read and highly recommend Daniel Kahneman’s (and his colleague’s)  book ‘Thinking Fast and Slow’.  It will go down in history as a seminal publication and be used in all sorts of university courses in the future. 

I certainly bear in mind his analysis and research now.  But I am very pleased to say that my articles on this web site and my recommended use of multiple portfolios to meet client objectives long pre-date my reading of the Nobel Laureate’s work.  It confused compliance people no end as they like to think that a client with risk score ‘x’ gets portfolio ‘y’, not that people are complex psychological units who want multiple things, sometimes in conflict, and don’t like disappointment.  Here is the article:

‘Finding out how people tick is a vital part of the investment process, Daniel Kahneman, Nobel laureate and author of Thinking, Fast and Slow, told the 30th annual Morningstar Investment Conference in Chicago.

He had this advice for financial advisers hoping to steer clients towards reaching their investment goals: “You need to find out what the client’s dreams are, what their fears are. And when bad things happen, you need to be there to help people stay on course.”

Kahneman, speaking with Morningstar behavioural scientist Sarah Newcomb, said that in in investing, research on behavioural biases can be used for good or evil. In the worst case, these biases could be used to exploit clients. In the best case, they could help a client develop and implement their financial plan and potentially improve their outcome

The first step is to decide what’s in the client’s best interest, Kahneman said. Then the adviser needs to find some way to develop a “regret proof” policy – a policy someone can live with when things go badly. This reduces the chance that a client will capitulate at the wrong time and possibly move to another adviser.

Kahneman described a practice he had developed with colleagues to improve investor outcomes. First, the adviser would try to determine the client’s loss aversion to create a measure of projected regret.

“We try to have people imagine various scenarios. We ask them, at what point do you think you would want to bail out?” There are some differences, Kahneman says, but he has found that even extremely wealthy people are loss-averse.

Two-Part Portolios to Manage Risk

The next step was to run client portfolios in two parts. One portfolio holds the assets the client is willing to risk, and the other is a much more conservative portfolio comprising what the client wants to protect. The portfolios are managed separately and clients get the reports individually.

This is helpful for clients because no matter the market environment, one of the portfolios is likely doing well. Of course, financially, it’s one portfolio, but framing it as two separate accounts helps clients understand and tolerate the risks better, he explained.

Asset allocation, in many ways, is the easy part. Helping clients set reasonable goals and adhere to their plan is the difficult part; it requires having in-depth, sometimes personal conversations with client. One element of the process taking a comprehensive look at the client’s present and desired future outcome.

“Individuals tend to do very poorly guessing what stocks will do. Admitting you don’t know is a very healthy step, but this admission leaves you with a great deal to do,” he said.’

 

Going to extremes or sensible hedging?

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Introduction

I am working on constructing a low volatility example portfolio for the members’ part of the web site and this is taking a long time.  The reason is that it is currently very hard to find assets that are cheap and likely to be steady low volatility earners.  Updating my knowledge of what the big fund management groups are doing to get returns on their fixed income (bond) and absolute returns fund confirms that more and more ‘innovative’ methods are being used – not  a good sign!

A gloat

Over a period starting about 18 months and lasting 6 months until mid 2017 I was fighting a lone corner as the senior member of my then employer’s investment committee, resisting inclusion of the M&G Global Macro Bond fund as a heavy weighting in the firm’s lower risk portfolio models.  The advice to include it was coming from the form’s external investment advisers and was based on the recent strong performance and the undoubted reputation of the lead manager.  They produced vast amounts of backward looking data showing how it would have  done better than what I proposed, had what I proposed now been included 3 years ago (not very logical, you will realise).

My objections were several but basically that the fund was a straight bet on the ongoing appreciation of the US dollar versus Sterling.  The big negative impact that strong US growth and possibly inflation would represent made the fund high risk in my view.

I was persistent and ultimately no doubt rather unpopular but in fairness to the committee and its chairperson, they declined to used the fund.

In 2017 the fund lost over 4%, fell from 10th to 85th percentile in the sector (Source: Morningstar) and the current top 10 holdings are now rather different.

What’s to learn and where are the dangers?

I am not suggesting of course that I am any cleverer than the highly regarded manager of the above mentioned fund or that he did something ill advised.  That is not the point.  He may well have never expected any advisers to use his fund as a diversifier in a lower risk growth portfolio.  He only works to his published objectives.  My point is that the people who recommended it did not understand how the recent past performance arose and what the implications of that would be based on what economic and financial conditions were at the time we were reviewing the fund as a possible recommendation.

This is the point missed so often by portfolio designers.  I think it was J M Keynes who said that ‘when the facts change, I change my mind’. If an event that was great for your investment holdings has ended (eg a sharp change in relative currency values), it is naïve to assume that the same performance can be repeated – in fact there is more likely to be some claw back.

The dangers I am currently identifying is that even experienced fund managers with excellent past performance records are struggling to find assets that can make money after the overly long period of value increases in fixed income assets.  I read today that prior to the change of government in Italy, Italian government debt was paying a net negative real yield.  It has now turned positive.  The facts changed – Italy has an anti-euro government.  Some famous fund managers lost very large sums in their bond funds the week of that election result.

It is almost as if, if you invest in bonds, you are being asked to be a bank – lend your money at risk – but unlike a bank, you also pay the borrower a fee for making use of your money!  Bizarre and surely a danger signal?

It seems that fund mangers are, perhaps out of desperation,  investing heavily in derivatives of various sorts.  I looked at a newish Absolute Return Bond fund and the top holdings were ALL CDSs (Credit Default Swaps).  These featured heavily in the 2008 financial crisis, being a major contributor to the insolvency of the huge American insurer AIG.  They are a legitimate insurance element in diversified  portfolios and maybe some people actually want to buy a managed portfolio of CDSs.  But a fund branded as an Absolute Return bond fund will sound to most people like it is very cautious.  I think they would be disturbed to find out how it is constructed.

Not what is says on the label

One of my friend recently posted on Facebook that he had bothered to read the ingredients list in an Activa sugar free yoghurt and found a huge number of ‘unexpected’ additives.  Yet this product is advertised as being for a healthy life style.  What you are led to expect by marketing psychology may be very different to reality.  The Food Standards Agency has just made this point in a report.

The same applies to investments these days.  You often don’t get what you might expect.  If you don’t pay attention, your financial health is at risk!  Read the label, or in this case the fact sheets.

I would suggest people who are not comfortable with investment risk might actually do better not investing at all at the moment, or only a modest proportion of their available assets, but I will keep working on some other options.

Cash as an asset class

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Introduction

In various places on this web site, I suggest that holding cash as an integral component of your portfolio mix is a way of diversifying risk.  In the briefest terms possible, keeping cash on hand lowers volatility, saves you selling at the wrong time and gives you the opportunity to buy cheap assets without notice.  In essence I prefer what is called the ‘cash plus risk’ investment approach to the traditional portfolio construction based on the assumed non-correlation between equity shares and fixed income or loan stocks.

Where to keep it?

In practice there are 3 main ways you can hold cash as part of your investing strategy:  in your bank, building society or other deposit taking institution (or in your sock, if you really must!), as part of your platform or wrap assets, or in the control of the fund managers you select.

It is worth mentioning that the managers of funds that list as a primary objective investing in stock markets assets have inconsistent views on holding cash within their funds:  some say it is not their job to hold cash and they will always be fully invested, others say they must hold cash to manage liquidity (common for property funds) and a third group hold cash as a tactical asset (especially in absolute return funds).  If you get a ‘drill down’ analysis of your funds portfolio from your adviser or platform supplier, you may well find you are more into cash than you thought!

Holding cash in money market unitised funds that invest in deposit like instruments like floating rate notes or synthetic zero dividend preference shares (that can still fall in value but are low volatility) only works if the long term returns are better than bank interest rates after tax plus the fund fees.  That is sometimes the case, but the best funds will show losses for periods, albeit they recover over time.

Holding cash in private accounts is the favoured approach of most investors because they are in control, can keep an eye out for the best products from banks and building societies and have instant access.  Tax favoured offerings from National Savings are a good bet at times depending on Government policy to borrowing direct from the public which varies a fair bit.

Keeping cash in your platform or wrap account is ideal if you are going to use the money for dealing quite soon, but interest rates on such money may currently be negative after fees are taken into account, so I would suggest such holdings would usually be short term.  The better platforms do offer access to fixed term deposit accounts to squeeze a bit more interest out of the system, but of course that may constrain an opportunistic quick buy of an asset you just decided was priced where you liked it!

My view

I think only modest amounts, intended for dealing (possibly raised from recent asset sales) should be kept on platforms.  I think your cash ought to be in your control, but that you ought to know that “investment cash” is separate from your day to day funds and any emergency reserve for unexpected capital items that you like to keep.

It helps if you keep that portfolio strategy cash noted in your records with your other portfolio asset data if you want to measure your returns accurately.  In good times, the cash holding will be a brake on performance and there will be a psychological ‘itch’ to invest it but when markets fall, it will be something you can access while you wait for things to get better and the psychology will all be positive!

Actually, in my opinion, holding a good cash reserve is not really a brake on good performance long term, because you can make the assets you do invest in that bit more adventurous and over time that will generally pay you back with better returns.  Recent research supports this supposition over more time periods than not.