A difficult year?
A difficult twelve months or a bolt out of the
blue?
by Russell Waite, senior investment
counsellor
| The third quarter of 2008 will
live long in the memory of investors, wealth managers and
professional advisers 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 2 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 one) 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 two 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 quarter, 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 professional advisers
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 professional advisers 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'.