Those who have been receiving my investment notes over the last four years will have detected some recurrent themes:
• We are in a period of structural change driven by the movement of wealth from west to east.
• The aftershocks of the credit bubble will continue for years.
• Good investment returns will come from active management.
• The Great Moderation is over, now for the Great Reckoning.
• Investment models in the hands of the ill informed are dangerous.
• The impact of demographic change.
It now seems timely to return to this final theme as a follow up to ‘Is Retirement a 20th Century Concept?’ which was written in June 2008.
I have advised people about their investments for over 30 years, and during that time have noticed that responses to events are determined by both generation and residence. Some are more disconcerted by current financial events than others. People who have seen this sort of thing before are less likely to be panicked by its occurrence this time around.
There is absolutely nothing wrong with being concerned about the current state of the global economy, dysfunctional political systems on both sides of the Atlantic, the fragile state of the banking system and the price of a loaf of bread. What matters is what you do about it.
During the Great Moderation, which lasted from 1982 – 2007, investment advice and investor behaviour was conditioned by good results. The more risk the better the return. Interest rates were generally lower than expected as was inflation. Governments were, broadly speaking, in control of economic policy, the Cold War had ended with the triumph of capitalism, markets were liquid and if you were short of cash you could always borrow.
The structure of the financial system and the investment management industry changed out of all recognition when compared to previous periods when risk takers were occasionally called to account. Academic research modeled markets and these models were adopted as “matters of faith”. Markets were believed to be efficient, if you bought something you could always sell it, diversification not only reduced risk, but could enhance return and the diversification benefit could be used to borrow and invest more. Finally, US Treasuries were assumed to be risk free and so the price of every other investment could be priced off this fixed point.
All reasonable, just so long as one remembers that they are assumptions. Science is littered with assumptions that were eventually pushed aside from Aristotle, who thought that the Earth was at the centre of the Universe, to Newton, who assumed that time was a constant. It took 250 years before Einstein came along to deal with this particular one. Investors would be well advised to be similarly aware. Unsurprisingly, however, transition periods, such as the one we are in at the moment expose those who fail to differentiate between theory and fact.
Anyone who lived through the 1970s in the UK will remember that uncertainty was endemic. A 1970 pound was worth only 30p by 1980 and the cost of a loaf of bread went from 1s6d to 33p. The financial system crumbled in 1974, with the secondary banking crisis, and successive Governments fought to maintain control. We suffered from a three day week and the IMF was called in. During 1975, six million working days were lost to strikes, about ten times the current level.
During this period, investors came to understand that success was driven by attention to detail, flexibility and an acceptance of change. The market as a whole was not going to make you money, but some of the components might if you were smart.
Those who who did not experience these times seem more disconcerted by current events than those who did. If your entire experience as an investor was based on Great Moderation assumptions, then investment must now be very stressful. US Treasuries are no longer risk free, US economic power has been diluted by a shift to emerging economies, borrowing money is hard and quite often if you make a bad investment you are stuck with it. The supply of “greater fools” has dried up.
In contrast, other generations are warming to the task of finding opportunity out of difficulty. The parallels with the 1970s are clear, but more interestingly the under 30s (Generation Y) are working out new solutions. In particular self sufficiency and an acceptance of change.
Where you live also has an effect. Try explaining to someone from Brazil or Argentina that Government Bonds are risk free or that the banks never shut their doors and they will laugh at you. In their recent collective memory middle class savings have been wiped out by some combination of seizure and inflation. The attitudes and skills developed to cope with these events are being put to good use at present. Transportable wealth and real diversification are regarded as cornerstones of a sound investment plan. How would someone from Switzerland react to challenges such as these? We have no idea, but probably not well.
In the wings are the Japanese experts. Strategies developed during 20 years of trying to make money against a background of deflation and poor equity returns are being finally put to good use, but in other parts of the world.
The UK generation that became adults during the Second World War were shaped by the Depression and faced huge uncertainty on a daily basis: death, loss of property and constant change to their personal plans. It has been my privilege to advise many from this generation, and have been influenced by their attitudes to risk and ability to cope with uncertainty. When someone who helped persuade Churchill to use scarce resources to buy Catalina Flying Boats to hunt submarines in the Atlantic made a comment about opportunity or risk, it was a good idea to listen.
The single biggest investment issue now facing many of us is how to retire with a combination of sufficient income and inflation protection. The solution is to make as much money as possible for as long as possible. This may sound simplistic, but there are no easy solutions. If a secure nominal return is not the answer, then what is?
Having an investment plan is a good start, but is only 50% of the answer. Implementation, whether this is security selection or timing is just as important. This is very different from the environment in, for example, the 1990s, when the plan was 90% of the solution. Investment attitudes more akin to those developed in the 1970s in the UK or more recently in other less stable parts of the world seem relevant.
Financial security in retirement will remain at the top of the agenda for the foreseeable future. Demographics will ensure this. The problems that are now apparent, insufficient saving whilst working and a rising dependency ratio (those working compared with those in education or retirement), will only get worse. Late baby boomers (aged 45 – 55 at present) are increasingly concerned that the old rules are no longer valid. In particular that loyalty to an employer will be rewarded with an index-linked final salary pension. Anyone younger already knows that they are on their own.
To put all of this in context. In 1925, when 65 was selected as the official retirement age, UK life expectancy at birth was 59. Retiring was an achievement worthy of a gold watch and a generous pension. Now, with life expectancy of 78 for men and 80 for women, the percentage of the adult population aged over 65 is approaching 17% or nearly 10 million people. Those retiring today at 65 might expect to live another 18 years and will undoubtedly experience the corrosive effects of inflation.
As head teachers vote to strike in protest at an increase in their retirement age they should consider that a few more years earning a good salary might be a good idea. Many who retired in 1970 with a good pension were impoverished by the inflation of the next decade.
Reflecting increased life expectancy and better health I would expect there to be a voluntary trend to extend working lives and to make better use of another ten productive years. Strange as it might seem a fixed retirement age might come to be seen as a curse not a reward.