Ten years ago the world’s financial heartbeat almost came to a stop and the far reaching consequences were felt within every sector and across every economy. Businesses closed down, workers lost their jobs, economic growth stopped dead and many investors watched the value of their life savings plunge. Ten years on those same investors could have made multiples of their money, but the reality for many is the scars of that dreadful experience have left them so suspicious and distrusting that they struggled to reinvest. Looking back, and forwards, what can investors do to protect themselves from another GFC?
1. Your risk profile matters
A critical step in constructing your portfolio is to be mindful of how much risk you’re prepared to take with your money. Financial markets go up and down, it’s a fact of life. We all feel great watching our investments go up but you have to think long and hard about how it’ll make you feel to watch your portfolio drop in value.
Unfortunately the only true test of your attitude to risk is when your portfolio loses a big chunk of its value in a relatively short space of time, like what happened during the GFC. Way too many investors discovered they weren’t able to cope with the stress of watching their wealth disappear, with that horrible knotted feeling in the pit of the stomach leaving them unable to sleep at night.
There are three aspects to risk you need to think about:
- Risk requirement: how much risk do you need to take to meet your lifestyle goals?
- Risk tolerance: how much up and down (volatility) in the value of your portfolio can you really handle?
- Risk capacity: what’s your ability to absorb the risk and bounce back without jeopardizing your future?
These considerations form one of the most important parts of constructing your portfolio: there will inevitably be a point where markets get hit by volatility and the road of miserable financial experiences is paved with people who couldn’t handle the stress of unrealised losses and sell out only to find if they’d held on they would have made their money back plus a whole lot more.
2. Valuations matter
In the years leading up to the GFC some asset classes boasted returns far above their historical average, but higher than long-run average returns usually means lower returns are on their way. For example, between 1983-2001 US house prices rose an average of about 4.5% compounded per annum, but between 2001-2007 the rate of increase was almost double that. Then house prices fell 30% over the next five years.
Likewise, the Australian share market rose at about 8% per annum compounded over the ten years 1995-2004, then jumped to 14% per annum over the period from the end of 2004 to October 2007. Then it dropped 50% in 18 months. Periods of strong returns tend to run headlong into the rule of mean reversion, meaning they’re followed by a period of weak returns. In other words, when markets get expensive they tend to correct. (For some really eye-popping perspective, the Australian listed property trusts index had increased at a compounded rate of 4% per annum between 1995-2003, then hit 33% per annum in the four years to February 2007! It then fell 80% over the following two years.)
Another way of looking at how pricey the Australian stock market got is the “CAPE ratio”, which is the ‘cyclically adjusted price to earnings ratio’. It’s a way of looking at long-term stock market valuations by using 10 years of inflation-adjusted earnings. Chart 1 shows the Australian market’s valuation was way above its US and European counterparts leading into the GFC. In fact, at 33, the ASX200’s CAPE ratio in 2007 was the highest it’s been in the period from 1982-2018 (the second highest was before the 1987 crash when it hit 29) and compares to the average of 20.
Chart 1: the Australian stock market was expensive going in to the GFC
So investors who were solely exposed to Australian shares were bearing a great deal more risk than they probably expected, or by and large appreciated. The lesson for investors here is that trees don’t grow to the sky: any asset class can get expensive, you need to somehow be able to get a perspective on that.
3. Asset allocation is critical
Asset allocation is simply how much of your portfolio you put into different types of asset classes, like Australian versus international shares, or bonds, or property, or cash. Vanguard analysed 580 Australian retail superannuation funds over 25 years and found that asset allocation accounted for 89% of their returns, while market timing and investment selection was only 11%!
Not only does asset allocation go hand in hand with your risk profile but it’s also a key part of avoiding being overexposed to overpriced markets. With respect to your risk profile, the less you’re able to cope with volatility in your portfolio the more you need to be allocated to defensive assets, like bonds and cash. There were a lot of ‘balanced’ investors who went in to the GFC holding nothing but Australian shares, because some stockbroking houses basically promoted a balanced portfolio as one that just needed to hold both banks and resources.
To be clear, shares are a growth asset, not a defensive one, and so is property. They can both be highly volatile. Bonds often (but not always) go in the opposite direction to shares in a crisis because of the old flight to safety idea; so in 2008 when shares all over the world were doing a swan dive Australian bonds returned 4% and international bonds 9%.
If you’re looking after your own portfolio and don’t know about asset allocation, then learn. We follow what’s called a ‘dynamic’ approach, and we use a consultant to help us decide which asset classes offer the best relative value and, more importantly, which asset classes are expensive. We then allocate more money to those areas that are relatively cheap. Chart 2 shows how allocations change over time. Critically, you can see how the allocation to Australian shares dropped from 40% in 2004 to about 10% in 2008, while fixed income went up from 15% in 2004 to 20% in 2007and cash went from 5% to 35%, so 50% of the portfolio was in defensive assets by the time the GFC really hit.
Chart 2: dynamic asset allocation changes weightings to different
These days most Australian portfolios have at least some diversification into international shares, but given the US has by some measures just hit its longest ever bull market run and its CAPE ratio is now 31, it warrants examining what weighting you have to it.
4. Be wary of the noise
This is more a post-GFC lesson. Since share markets bottomed in 2009 the US has risen more than three-fold, Japan’s more than doubled, the UK’s up 90%, and Australia’s up 85%. Unfortunately though, many investors have missed out, partly because it’s human nature after a life changing scare to worry there could be another one coming any moment and partly because they paid too much attention to ‘experts’ who reinforced those fears through constant warnings of the next imminent crash. Chart 3 highlights some of the atrocious calls these ‘experts’ have made since 2009, there are literally dozens more that could be added to the list.
Chart 3: bad calls by ‘experts’
The post-GFC share market bull run has been called the most unloved bull run ever because of the amount of cash that’s sat on the sidelines and never got invested.
It pays to remember the media knows scary headlines attract more attention than benign ones. Basing your investment strategy on headlines can be a costly strategy.