Six questions to consider before investing

Investors have a natural tendency to lose faith in asset classes or strategies that have not been working.

Mon, Nov 29, 2010
The Business Times

By Teh Hooi Ling

Senior Correspondent

WE ALL tend to form our opinions based on the most recent data. And according to Ben Inker, director of asset allocation at GMO, which has US$150 billion (S$194 billion) under management, in 2000 we were apt to hear quotes like the following from institutional investors:

'Bonds are wasted space in our portfolio, and we want to have as few of them as we can get away with.'

'We are long-term investors, so we should have an equity-dominated portfolio.'

'International diversification is overrated. When you need diversification, correlations go to one.'

In 2010, we are hearing the following:

'Our portfolio should be first and foremost about matching our liabilities, not seeking returns.'

'Equities will play a smaller role in our portfolio going forward.'

'Equities are growth assets. We should put our equity money into faster- growing economies.'

The comments in 2000 were made after the S&P 500 rose 18.2 per cent a year in the preceding 10 years, far outpacing non- US equities, which themselves outpaced bonds, which returned 6.8 per cent a year.

In the decade to 2010, however, the S&P 500 fell 1.3 per cent per year, with bonds giving decent returns of 6.5 per cent per year. Within equities, only emerging markets made any real money for investors, with a return of 9.1 per cent per year.

Investors, said Mr Inker, have a natural tendency to lose faith in asset classes or strategies that have not been working - and gain confidence in those that have. Investment managers and consultants capitalise on this by selling products around themes that are hot.

Investment managers, consultants, and Wall Street are not going to change. So how can investors avoid doing in 2020 what they did in 2000 - and may be doing in 2010?


Mr Inker thinks a crucial part of why investors find themselves swayed so much by the winners and losers of the last cycle is that they lack a strong anchor to their investment beliefs. So to help investors think about their portfolio, Mr Inker came up with a list of six questions in his paper entitled Back to Basics: Six Questions to Consider Before Investing.

The six questions are:

Would investors rationally buy this asset if they did not believe it would give returns above cash?

Where do the returns from this asset come from, and who funds them?

Why would the funder of returns for this asset be willing to offer a return greater than cash in the long run?

Have historical returns been consistent with the risk premium we expected?

Have the sources of the returns been consistent with the returns achieved?

Has something important changed to make us doubt the relevance of the historical returns?

Mr Inker then applied these questions to various asset classes starting with equities, to bonds, to commodities, to private equity and venture capital.

When it comes to equity, any rational investor would not buy it if they believe the return will be below cash - unlike bonds, which can be matched to certain liabilities, or commodity futures, which may offer inflation protection.

Equities are volatile, have no legally mandated cash flow and are the lowest rung in the capital structure in the event a company gets into trouble. Returns from equity come from the cash flow of the issuing companies. The cash flow is in the form of dividends or share buybacks.

Issuing companies are willing to offer a return above cash to shareholders in the long run because equity is safe capital for them. It allows them to make long-term, risky investments with less risk of bankruptcy. There is no refinancing risk. So companies should be willing to pay a premium for equity.

Mr Inker then tested whether the historical returns for US equities have been consistent with the risk premium expected by investors. The average equity risk premium for the rolling 10-year periods since 1930 until now has been 6.4 per cent.

There have been a number of decades in which stocks have lost to cash, but the general level of the risk premium has been high, Mr Inker noted. None of the periods of underperformance have been excessively long - although the 1974-83 period is a bit long for comfort. All in all, the returns have been consistent with the risk premium the market expected.

I tried to test with data from the Singapore market. Using the five-year T-bond rates, which went back the furthest, I generated Chart 1. I used a monthly five-year rolling return for the Datastream-calculated Straits Times Index (STI) and compared them to the five-year T-bond rates.

Between 1988 and now, in 46 per cent of the rolling five-year periods, equities yielded less than cash. But in the periods when equities outperformed cash, they outperformed quite significantly. And that lifted the average and median outperformance of equities over cash sharply.

Meanwhile, holding periods of seven years seem ideal for Singapore equities, as they outperformed cash some 95 per cent of the time. And the outperformance average has been a significant 6.4 per cent.

However, staying in the Singapore market for 10-year stretches doesn't do much for one's portfolio. In fact, one would actually have underperformed cash 62 per cent of the time. And the underperformance averaged -0.1 per cent, with the median at -1.2 per cent. It is said that a financial crisis happens once every seven years.

In Singapore, or Asia, in the brief history that we looked at, it's more like once every 10 years. And one wouldn't want to be holding equities when a crisis hits.

The above returns did not include dividends. Including dividends, returns from equities would be boosted by more than two percentage points.

Mr Inker's next question is: Have the sources of return been consistent with the equity returns achieved? According to Datastream, dividend yields averaged about 2.5 per cent for the STI since 1973. That's about the return above cash that equity investors who held for 10-year periods received.

For the US market, dividend yields averaged 4.3 per cent - lower than the average 6.4 per cent return from equities since 1930. The return came more from earnings yield that averaged 7.1 per cent during that period, Mr Inker noted.

According to Bloomberg, the estimated price-earnings ratio of the S&P 500 is now 14 times, or 16.56 times before extraordinary items. That works out to an earnings yield of between 6 to 7 per cent - within the long-run average.

As for Singapore, the PE ratio and the dividend yield currently approximate the 37-year average. The only difference is that the one-year interbank rate now - at 0.56 per cent - is way below the 25-year average of 3 per cent.

So has something important changed that makes us doubt the relevance of the historical returns to stocks? Well, there may be a bigger backlash against unbridled capitalism following the recent crisis.

That may result in more government regulation and corporate earnings may be crimped as a result. Interest rates, of course, are not likely to stay this low over the long run.

On the other hand, we now have vast new markets that are opening up in China and India and elsewhere. All in all, the return for equities seven years out should still beat cash comfortably.