A difficult year?
January 2009
A difficult twelve months or a bolt out of the
blue?
The third quarter of 2008 will live long in the memory of
investors and wealth managers alike. A very difficult year quickly
deteriorated into a potentially disastrous one and the world's
financial system teetered over the abyss as central banks,
governments and regulators fought to bring order and calm to
capital markets which had descended into chaos. A year which began
with fears over investment bank losses suddenly became a year with
the loss of investment banks.
The third quarter of 2008 will also live long in the memory of
sports fans as the world was treated to a fabulous Olympic Games,
hosted by China in the city of Beijing. From the architectural
marvels of the Bird’s Nest stadium and the swimming pool Cube to
the record breaking achievements of Usain Bolt and Michael Phelps
in those inspiring venues, one could not help but be impressed by
the event. The tremendous performance of Team GB was the icing on
the cake and the national mood was lifted as we watched our
cyclists, rowers and yachtsmen and women do especially well.
Having read these words, and referred to the title of this
article, I am sure you are asking what the link can be between the
recent events in global capital markets and the feats of Usain
Bolt, the Jamaican who won gold medals and set world records in
both the 100 metre and 200 metre sprints. The answer lies in a
short journey through modern portfolio theory and an insight into
the world of ’freakonomics’.
The architect of modern portfolio theory is the Nobel Prize
winner Harry Markowitz and his work, published in the 1950s,
created a fundamental change in the methods used to build and
manage investment portfolios. One of the pillars of the theory is
the concept of diversification minimising risk and this affords an
investor the opportunity to maximise risk-adjusted returns. The
benefits of diversification are linked to how two or more assets
behave in the same environment or, put differently, how correlated
their investment returns are under identical market conditions. The
range of these returns reflects the volatility of the assets and
this is commonly expressed as a standard deviation number. This is
simply a statistical measure of how likely the return of the assets
will vary from their historic mean (or average) return. The
higher the standard deviation number, the more volatile or
unpredictable, and therefore 'risky', the asset is.
Markowitz’s theory demonstrates that 95% of the time the returns
from an asset are within two standard deviations of the
average rate of return. This means an investor can use this data to
model the expected risk and range of returns for a given portfolio
of two or more different assets.
This is all very well but what does this really mean? At this
point we need to explain the idea of ‘freakonomics’ taken from the
book of the same name Freakonomics: A Rogue Economist Explores the
Hidden Side of Everything by Steven D. Levitt and Stephen J.
Dubner. Steven Levitt is an economist at the University of Chicago
with an enviable skill for applying complex academic theories to
the real world and bringing them to life. The statistical argument
presented above can be equally applied to a set of data relating to
height, weight, or even exam results, as well as the returns from
assets. Statisticians demonstrate that when a range of outcomes is
plotted on a graph a simple bell curve (Chart 1: Modern portfolio theory
- normal distribution curve) is produced.
Following Usain Bolt's Olympic sprint success, the Freakonomics
team at The New York Times applied this same statistical theory in
an attempt to calibrate where Bolt's 200m run sat in the history of
the event. Chart 2 plots the times achieved
by Bolt and Michael Johnson, the athlete whose world record he
beat, and compares them to the 262 fastest times ever recorded for
the 200 metres. The shape of a bell curve is evident but it is also
immediately apparent both Johnson’s personal best (19.32 seconds)
and Bolt’s world record (19.30 seconds) are significant outliers or
freaky, extreme events. Their times are several 'standard
deviations' away from the mean and it is easy to understand why
Bolt's achievement has been proclaimed as one of the greatest
sporting displays in Olympic history. Previously, Johnson's record
was expected to stand for many years to come given it was so much
faster than had ever been run before. For Bolt to come along and
beat it was truly 'freakish' from a statistical point of view.
To return to the events in global capital markets over the last
half of 2008, it is safe to say they have been extraordinary.
Statistically speaking, many of the events we have witnessed are
several standard deviations away from what could be reasonably
expected, and therefore budgeted for, during the risk management
process within portfolio construction. Traditionally uncorrelated
assets have behaved in a remarkably similar way and the benefits of
diversification have, at least temporarily, disappeared.
Just like Usain Bolt’s achievement, this behaviour in capital
markets can be referred to as freakish. This in itself does not
provide any comfort but investors can take some solace that these
types of event are very rare and, in time, markets will normalise.
In the interim, those managers who work within flexible mandates
and can focus on capital preservation have been well placed to
weather this storm. Managing assets to a relative benchmark
commonly restricts firms from building overweight cash positions –
instead committing them to being fully invested with that
benchmark. The recent environment has not favoured this type of
mandate.
Looking ahead, irrespective of their mandate, calmer markets
should allow asset managers to return to the sound and trusted
theories which have delivered investment performance in the past.
Some will also keep alive to the lessons of ‘freakonomics’ and be
prepared for the next 'Bolt out of the blue’.