Decade in Review

As we enter not only a new year, but a new decade, for many it is the time for retrospection. Below are some of our thoughts moving into the 2020s.

The Bull Market Continues

The US share market continues to push upwards despite trade tensions, impeachment, tensions with Iran and economic growth concerns.

Share market returns have been strong across the globe, with New Zealand near the top of the pack. With such strong performance at home, even poor managers could deliver decent returns, if you focus only on the percentages.

Should we shift more of our investments to our local market following NZ's past returns?

NZ represents only 0.2% of the global stock market but makes up 5% of our share portfolios. This is an 25x overweight, implemented due to tax advantages for NZ investors.

We tend to focus on NZ more than other markets as we read about NZ companies in the news each day. In 2019, the share markets in the Netherlands, Switzerland and Ireland performed better than our own. We seldom discuss overweighting these markets due to past performance as they are never at the forefront of our minds.

These three countries are represented in our well-diversified global portfolios, along with more than 20 other developed countries. Through diversification, we can benefit from strong performers without guessing where they will arise.

Bond Markets - Slow and Steady

It is easy to overlook the performance of bonds, especially in a market where share prices soar. But bonds have continued to offer exactly what investors need in their portfolios; more steady performance than shares (for a lower return), diversification and better returns than the cash alternative.

Yet some commentators spent the decade gloomily predicting the collapse of bond markets, usually due to the policies of careless governments.

American adviser Ben Carlson says it best in his article for A Wealth of Common Sense. Below is a quote where he is discussing the performance of bonds for american investors.

“But those returns came with roughly 75% lower volatility than the stock market over this time. The largest drawdowns were just 5% and 11% respectively, for the Aggregate and TIPS while the S&P fell close to 20% on two different occasions.

And bond investors weren’t crushed by inflation, the death of the fiat currencies, government debt levels, or “money printing” by the Fed. These are all things the doomsayers were warning about in 2008, 2009, 2010, 2011, 2012, 2013, 2014, and you get the picture.”

— Ben Carlson, A Wealth of Common Sense

Bonds continue to play an important role, offering a way to customise a client's portfolio to better suit their goals. We expect them to continue offering long-term returns better than cash and the short-term stability needed by investors. These key characteristics apply in all markets, even during the current low interest rate environment.

Morningstar's Manager of the Decade

The 2000s marked a disappointing time for share investors. Two bear markets, due to the tech bubble and global financial crisis, led to the "lost decade" of subdued returns.

Some investment managers were able to buck the trend, delivering high returns in a stagnant market. With the end of 2009 during near, Morningstar, the monolithic investment research company, decided to honour some of the best performers with "manager of the decade" awards.

The manager taking the prize in the US share market category was Bruce Berkowitz. Berkowitz's Fairholme Fund had delivered more than 13% p.a. during the decade, while the average US share investor was in the negatives.

How did Berkowitz, the star of the 2000s, perform in the 2010s? The Fairholme Fund ended the decade with a return of 4.5% p.a. vs the index return of 11.8%. Over ten years, this means an initial investment increased by a bit over 50% with Berkowitz while the index tripled in value.

Could it be that Berkowitz reached top place due to chance, like the oracle animals I discussed previously? The outcome of the Fairholme Fund clearly shows how past performance does not always indicate higher expected returns.

We believe long-term returns are driven by key factors, identified by decades of academic research. This is why we implement this research in client portfolios, instead of chasing past performance.

A Guide to Losing an Astonishing Amount of Money Very Quickly

No investor sets out to lose money, but some past examples really set the standard. If you are looking to join the list of infamous investment losses, the following investors may have some lessons to offer.

Small beginnings

How to turn a small lump sum into a crippling debt

The first two stories are from last year about young, amateur "traders" using the online platform Robinhood. They each shared details of their strategies online prior to execution. The investments they purchased are incredibly complicated so I won't go into too much detail.

The first anonymous trader, posting online under the name 1R0NYMAN, started with $5,000. The strategy he used is called a box spread. It involves taking out a number or derivatives (contracts agreeing to buy or sell investments now or in the future) which, 1R0NYMAN claimed, couldn't lose.

In January, he put his plan into action. A few days later, his account was worth nearly -$58,000, a return of about -2,000%. As with most "no-risk" strategies, the idea didn't hold water. You can't make a return with no risk in this world.

The reason for the loss is a bit too much to explain here, but the other trader, going by ControlTheNarrative, followed a slightly more straightforward path. His strategy relied on a loophole to gain potentially infinite leverage.

How did he do this? Starting with $2,000, the platform allowed him $2,000 in debt. He used the total of $4,000 to buy shares and then, using covered calls, agreed to sell them at a later date at a set price. These covered calls offered a premium paid immediately.

Here is where the loophole comes in. Robinhood saw the cash in his account from agreeing to sell the shares but still included the shares themselves in their estimate for account value. So ControlTheNarrative went back to step one, taking on more debt, used it to buy shares, agreed to sell those shares, took on more debt... Until he had $25 debt for every $1 he started with.

He used all of this money to bet Apple shares would dip at the end of the week using another contract. They went up instead and his account fell to about -$60,000 within minutes.

These two traders pretty clearly illustrate how to lose money with highly leveraged, complicated strategies and the dangers of derivatives. But they aren't experienced traders, surely Wall Street professionals wouldn't be so bold?

Upping the Ante

How to turn a big lump sum into a potential financial crisis

If the idea of losing tens of thousands isn't exciting enough, we have good news. Start a hedge fund and you could lose billions in months! 

Amaranth Advisors started 2006 with US$7.4 billion in assets. By August, it was at $9.2 billion. And a month later, the fund's value had plummeted to $3.5 billion before liquidation. What was the recipe for this disaster?

Amaranth were placing large bets with high leverage, just like the two young traders. Their bets were made on the price of natural gas rising and were leveraged 8:1. So when natural gas prices fell, their losses were huge.

Another investment manager, James Cordier, incurred huge losses with natural gas bets in 2018. His strategy involved contracts to sell natural gas, of which he owned none, at a certain price in the future. When the price rose 20% in a single day, he was forced to buy high and sell low to cover his contracts.

James Cordier lost all $150 million invested by nearly 300 clients in one day. Tragically, after losing all their capital, some clients were actually left with a debt owed, because the contracts were in their names.

Taking the cake for losses on Wall Street is Long Term Capital Management (LTCM). Their strategy was focused on bond trading, where margins were small but believed to be consistent. LTCM maintained leverage of 25:1 (!) to take advantage of these small margins.

In 1998, the Asian and Russian financial crises obliterated their balance sheet. Losses were approaching US$4 billion. To make matters worse, other Wall Street firms were so invested in their fund, the Federal Reserve believed LTCM's collapse would bring on a financial crisis.

The Fed, with support from other major investment banks, organised a $3.625 billion bailout for LTCM in late 1998.

If you want to lose as much money as possible, instigating a financial crisis must be the loftiest goal imaginable. Yet, with the right strategy, even that is achievable.

A Recipe for Disaster

Takeaway tips for a DIY money sink

So what do these examples teach us about losing money? First thing you want to do is take on as much debt as possible. Leverage your initial capital as much as you can. You could take the fraudulent route, such as ControlTheNarrative, or start a hedge fund, like our friends from Wall Street.

Once your debt level is terrifying enough, use all the funds to buy risky derivatives. Don't diversify or hedge your bets, this will reduce the potential losses in your account. Also, if possible, make your strategy as convoluted as possible to stop anybody (including yourself) from understanding it.

Now you've created your time-bomb, wait for your bets to turn sour and your account to become worthless. If you are leveraged enough, you may even turn that capital into debt!

And if you aren't interested in losing money, maybe avoid derivatives, leverage and get-rich-quick schemes entirely, including those who specialise in them.

False Positives And False Negatives

We often make mistakes, often due to poor decision making and often with negative consequences.

I have the habit of leaving my umbrella at home, thinking I will be able to get from the bus stop to work before it rains. I get caught in the rain often. My decision is based on the expectation it won't rain in the brief time I am outside.

In the scientific process, this is described by type 1 and type 2 errors. A type 1 is a false positive; a type 2 is a false negative. In other words, a false positive would be expecting it to rain but it doesn't. A false negative is expecting it to not rain but it does.

What are the implications for me? Well a false positive means I end up carrying an umbrella I don't need, not such a big deal. But the false negative, which I always suffer from, means I don't bring my umbrella and I get soaked.

While this is a light-hearted example, type 1 and type 2 errors are essential considerations in a range of applications, including law, medicine, business and investing.

High Standards of Courtroom Evidence

A new entertainment trend is the "true crime" story. The stories revisit high profile murder cases, presenting the timeline of events and usually implying guilt or innocence of the accused. Even the infamous Bain family murder case is being made into a mini-series.

Two popular examples are the dramatised recounting of the O.J. Simpson trial in The People V. O.J. Simpson and the story of Stephen Avery in Making a Murderer. Although these shows follow the same formula, the distinction is the first implies a guilty man went free and the second implies an innocent man was found guilty. A false negative and a false positive.

I certainly don't know enough to comment on these cases. However, they do illustrate a key underpinning of the legal process and our society's ethics as a whole.

The idea of innocent people being found guilty is considered a higher cost than the possibility of a guilty person being found not-guilty. Hence the high burden of proof in the legal system, requiring evidence to support the guilty verdict "beyond a reasonable doubt".

While many believe the justice system fails in these high profile cases, the high standard exists to stop the "false positives", where innocent people are declared guilty.

Reliability of Medical Testing

Imagine you are a researcher producing cheap tests for a certain cancer. You have produced two methods; method one produces false positives 5% of the time and method two produces false negatives 5% of the time. What are the implications?

If a patient uses the first method and is incorrectly given a positive result, it would be nerve-wracking for them, but they would continue with the more expensive yet accurate testing. Sure, more costs are incurred, but the patient receives the correct diagnosis eventually.

More dangerous is the second method, where a false negative is produced. The patient in this example would be incorrectly diagnosed as healthy and sent home, which is much worse.

Similar to this example is how NZ police use breathalysers to keep drunk drivers off the road. The handheld versions aren't very accurate, often giving false positives for BAC being over the legal limit. These tests are followed by more rigorous methods if they are to be submitted as evidence.

Sensible Investing Decisions

How does the idea of type 1 and type 2 errors apply to investing? It is all about how they add to the decision making process.

One idea commonly held among NZ investors is that stock picking is more effective here than overseas. The reasoning is we have a smaller market where pricing is less efficient and savvy investors can take advantage of this.

This has been largely disproven by Professor Bart Frijns of AUT, in KiwiSaver funds at least. But lets say you are considering an active strategy due to this idea.

First the false positive; we've taken the word of the stock picker and (as the evidence suggests) they are wrong. What are the consequences?

Professor Ken French, one of the academics who pioneered evidence-based investing, published a paper showing US investors incur an additional 0.67% of fees each year using active strategies over passive. The consequence is a reduction in expected returns of 0.67% p.a.

Now the false negative; we decide to forego stock picking in favour of indexing. We're assuming what is true in every other developed market is also true in NZ. But in this hypothetical, we are wrong. What are the consequences here?

The stock picker has already started with a handicap of 0.67% each year in fees. They would need to outperform by at least this amount to have added net value. If they were able to consistently add 1% of value, a very impressive feat, they would still only be 0.33% above the passive strategy.

Simply put, being wrong about indexing is likely to have smaller consequences than being wrong about stock picking. Given all the evidence is in favour of passive strategies, why place faith in the arguments for stock picking?

Evidence-based investing reduces the chances of type 1 and type 2 errors by relying on the highest standard of evidence, peer-reviewed research. We only include strategies in portfolios which are verified through the scientific process, all with the goal of improving investment outcomes for clients.