Tuesday, September 1, 2009

Lessons learned

"Financial crisis of past year offers many lessons," reads the CFA Institute's lead story in today's e-mail news brief. The story is from The Wall Street Journal and points out how "we are nearly six months into one of the most impressive bull markets in memory," with the DJIA up 46% and the NASDAQ up 60% since early March. While some trepidation remains, many seem relieved that the worst appears to be over. Good timing, perhaps, because many firms will soon begin their budget planning for 2010.

The past year has provided us with the opportunity to discover how our formulas behave when markets are really down ... so far down that they caused 36-month (and longer) cumulative returns to be negative, which in turn resulted in some occasional strange looking results. Both the Sharpe and Information ratios seem to be in error, as they appear opposite of what we might expect. As a result, there are a few of us who are beginning to pursue some suggested rules as to how one might address this situation, should it occur again. This might be one of the lessons we learn from this crisis.

1 comment:

  1. The recent market downturn has also helped to reinforce the fundamental principle of investing: diversification. It's odd that some have drawn the opposite conclusion, saying that "diversification didn't work" because we experienced a global equity downturn where only safe investments in high quality bonds had positive returns, given the flight away from risk. Why such opposite perspectives? It's really a matter of your outlook. First, do you really have a long term outlook? Three years is short term; so is five years. Arguably, ten years begins the long term, but I think that this is still too short.

    Look at the ten year returns ending July 2009: S&P 500 down 1.2% (that's per year, not cumulative!) But what about a globally diversified portfolio? If you held foreign developed stocks you had a +1.8% return and if you held stocks in emerging economies you earned a whopping 10.5% return! What about real estate? In spite of all the handwringing of recent months, its return via REITs was nearly 7 percent. Of course, some bonds would have also helped, with broadly diversified investment grade bonds earning 6.4% and high yield posting a 5% return.

    So, why all the long faces and the calls for changing our perspective on investments? A good deal of this comes from the performance world's current preoccupation with a single product focus. If the only thing you focus on is U.S. equity, then you're probably feeling pretty grim. But a look at how each product helps to build a diversified portfolio makes things look completely different - and better! Turns out that a review of the old lessons is what is needed before we start looking for new ways to measure and evaluate the short term results of bits and pieces of portfolios.

    The second lesson is to put our focus on the real purpose of investment portfolios: to help clients meet their financial goals. When clients hold diversified portfolios and spend an appropriate, sustainable amount, they tend to build surpluses that sustain them through these cyclical downturns. Returns may be negative, but they are simply spending down the "rainy day fund" that accumulates in good times so that we are preserved through the bad times that will come.

    Negative Sharpe ratios for single products? Not really the issue. At least, not the only issue. Surprised that the market rewards safety and not risk at times of stress? Well, that sort of makes sense, doesn't it? It brings to mind the single most ignored risk that's part of every portfolio but not included in anyone's risk model: LIQUIDITY. That's the last piece of the investment puzzle. This market downturn was like the tide that went out and revealed who wasn't wearing their (liquidity) pants! Hopefully, the result of an increased awareness of the role of performance analysis will be to show those who are swimming in the "all together" that they need to get some swimming trunks BEFORE the next crisis. The "trunks" I'm talking about are: diversification, liquidity, a long term focus and an eye toward whether we are meeting the client's true financial goals.


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