mySixSense: Investment lessons from a bumpy ride.

Business Times - 27 May 2009

MONEY MATTERS: Investment lessons from a bumpy ride

Investors should not shy away from investments and leave all their money in cash as the latter has lagged the returns offered by equities and bonds.

By ERIC SANDLUND

OVER the last 10 years, the world's capital markets have presented investors with opportunities as well as many challenges. In 2000, the rapid rise in the valuation of technology stocks and their even more dramatic decline a year later preceded a three-year slump in the global equity markets. After 2003, when stock markets succumbed yet further on the news of an outbreak of Sars, there followed a period of leverage-inspired spending that contributed to increased earnings that drove stock markets to the unprecedented highs of the fourth quarter in 2007.

Of course, this has come to a shuddering halt and the consequences are plain to see. The resulting credit crunch has led to the world's longest recession since the 1930s and, understandably, many investors have been rocked by their recent experiences. But it's not just equity investments that have suffered. In the current financial environment, investors across all asset classes except for cash and government bonds have experienced declines. While gold has proven to be a relative safe haven, returns for corporate bonds, commodities, hedge funds, and property have all posted notable falls.

Unsurprisingly, in response to the tumult of the capital markets, investors have shifted a high proportion of their portfolios into cash, as many have taken the view that cash is definitely king. While there are, without doubt, certain periods when holding cash is a safer alternative, it should not be forgotten that, historically, cash has lagged the returns offered by equities and bonds. The long-term performance of equities has provided investors with the highest returns, followed by returns from fixed-income. And we believe that the capital markets are now entering a period when it is time to start investing the cash currently held.

The collapse of Lehman Brothers in September 2008 signalled a loss of trust in the financial system. And as financial institutions lost confidence to lend to their counterparts, the rapid widening of interest rate spreads that resulted meant lending activity slumped to worryingly low levels. With the world's central banks responding forcefully by slashing interest rates in an attempt to halt the decline in lending and in investment and global trade, it was against this backdrop that the US Federal Reserve reduced its Federal Funds rate to between zero and a quarter of a per cent.

Subsequently, risk-free returns collapsed, with three-month Treasury Bills closing with a yield of 0.17 per cent and it is as a consequence of this that we believe that capital markets are moving away from the cash is king mentality. The credit crisis has provided investors with invaluable lessons that will shape their investment preferences for the future. Over the last year, we have witnessed enormous pressure on certain sectors of the global economy that has culminated in many bankruptcies.

The consequences for holders of the associated equity and fixed-income instruments have been severe and have served as a reminder to investors of the risks of single-issuer investments and the advantages of diversification. Investors have also re-learnt the sometimes painful lesson that it's best to invest in things you understand. While we do not expect investors to avoid derivative instruments in the future, we expect greater caution going forward regarding buying them. This should include exhibiting greater awareness of their leverage.

It will also lead to greater care when using that to extrapolate trends. Typically, during times of crisis, investors show a greater home bias: they tend to have increased confidence when investing in the countries and regions they know best. In Asia, this has been reflected by foreign investors' net selling of the region in 2008. This indicates that domestic investors have increased their rate of participation in the region's markets.

Moves experienced by Asia's stock markets have been rapid and sharp and leads to the question of when is the best time to buy. Asia ex-Japan markets appeared to find their floor in late October 2008, yet, investors who missed those lows must have felt pleased by early March 2009 when the US equity markets dived to their lowest levels in the current cycle. That satisfaction has probably shifted to dismay as equities have staged a powerful rally over the last three months. This experience reminds investors of the perils of trying to time the market. As Bernard Baruch, the great American financier of the 20th Century, said:

'Don't try to buy at the bottom and sell at the top. It can't be done except by liars.'

Another lesson investors have learnt is the need to correctly understand their risk tolerance and to target more realistic returns on capital levels while avoiding over-leveraging their capital base. Investors now also understand the importance of their own liquidity requirements so as to allow for times of market corrections and illiquidity. While it remains uncertain whether global equity markets have reached their bottom, there have been encouraging developments.

Indeed, UBS Wealth Management Research recommended going overweight in equities in October 2008 for the following reasons: governments were responding to the credit crisis forcefully with increased spending and interest rate cuts; equity valuations looked compelling on a through-the-cycle basis; dividend yields had moved above risk-free rates; and sentiment had moved from the greed seen in 2007 to fear. Recently, UBS Wealth Management Research shifted to a neutral position on equities. This reflects our view that, although we still see long-term value in equities, the recent sharp equity market rally appears temporarily overextended.

In conclusion, the crisis should not make you shy away from investments and leave all your money in cash. But do take note of some of the lessons from the crisis which should better position you in your investment journey, going forward.