Key Post The Cult of the Equity

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Dynamo

Guest
Sea Pigeon has raised this issue in his response to Brendan's Guide, and at the risk of boring AAM contributors further, I wanted to re-open an issue from an earlier thread (my interest was the vogue for Focus 15, and apparent blindness to its riskiness, which I'll now attribute to "the Cult of the Equity").

My starting point is that I accept that equities have historically given the highest returns. I also accept that it is probable they will so over any long-term timeframe. (I won't get into the hoary old how long is long-term problem.) But I still believe that for the typical investor, an equity-only fund is too risky. I would recommend a balanced fund (either active or passive, depending on preference) for most investors. The ability to sleep easily at night cannot be overlooked, and most investors, in my experience, are prepared to sacrifice a small element of returns to get it. Indeed, with-profit investors, of whom there are many (including Brendan himself), are prepared to sacrifice quite a bit to get it. This is NOT sub-optimal if sleeping at night is part of what motivates you.

I got, as Mithrandir has put it elsewhere, eaten without salt by some posters for this view. So I asked the brokers and advisors who contribute to AAM for their analysis of the typical investor, and his/her tolerance for risk. I also asked, as some vindication of this view, what proportion of defined contribution pension investors who have access to an equity-only fund actually choose it.

The thread moved on and my questions got lost (or maybe they interest no-one but me !). So, prompted by Sea Pigeon, I'll re-open it. What are other contributors' views on "the Cult of the Equity" ?
 
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Freddie Kruger

Guest
CoE

Hi Dynamo,

Might I be so bold as to ask, in what capacity you would recommend a balanced fund for most investors? As an intermediary,life assurance company employee,banker.....?

I suppose equity funds are inappropriately risky to your typical investor but I do feel that most of the contributors to AAM are seasoned campaigners when it comes to deciding what level of risk they are willing to take.

Perhaps, the equity based SSIA is part of an overall portfolio of investments and savings? Perhaps, the contribution to the SSIA is not their life savings? Perhaps, the saver does not have a specific purpose in mind for the payout in five years time? Perhaps, the saver has time on their side and, if markets are pretty depressed in five years time, they can wait and hope? Perhaps, the saver sees this opportunity as a relatively cheap way to buy baskets of equities long term, if that is what turns them on? There are Stock Junkies out there!

Sure, equities are not for everyone. I would hope that the intermediaries that recommend equity funds to clients are recommending them on the basis of how appropriate they are to those clients and that the risks are understood. Clients do not stay clients if there is any misunderstanding.

I suppose the new generation of savers/investors may consider it cool to have some form of equity exposure, but it should be limited. The mature saver/investor has probably graduated through the ranks of WP Bonds - Trackers - Index Trackers - Managed Funds and wants to know if they can get a better return by having a greater equity exposure?

This time last year I was getting more tips for stocks than I was for horses. The 'in the know' racing guys fell to the euphoria. Thankfully this ended a while back and they now get on with the business at hand.

Cult? Perhaps it's over. But, no doubt, it will resurface.
 
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Dynamo

Guest
CoE

Hi Freddie,

I'm an investment guy. I said I WOULD recommend balanced funds ... if people asked me, which they rarely do. However, I do meet and speak to both investors and brokers/advisors, and it is on those discussions that my views have been formed.

You're right, AAM contributors (in the main) probably are at the further end of the investment knowledge and experience curve. And you're right again, if it is only part of an investment portfolio, then an equity-only fund should indeed be looked at in a different light.

But my comments were made on the basis that, in my view, lots of inappropriately risky investments were made in recent years, presumably most of them on the basis of some form of advice, in specialised and/or concentrated and/or sector specific funds. So lots of people, it seems to me, were fairly blase about the nature of risk, until it actually happened.

The buzz does seem to have died down on many of these products (though as I said elsewhere, Focus 15 seems somehow exempt so far), so maybe it was just a bull market cyclical thing. In any event, no-one else seems too concerned about it, so I promise I'll stop harping on about it.
 
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monksfield

Guest
equities

I fail to understand why someone who has even reasonable familiarity with the stockmarket should put 20-30% of their money into Fixed Interest as part of a managed fund .
Yields on gilts are 4.5%-5% which means that the room for gain is very limited.To achieve any return worth talking about from this level would require a sharp recession/disinflation.If you think this likely I would suggest avoiding Equities altogether!

Certainly more and more FI is not in gilts but there is no free lunch in terms of credit/currency risk.

As an aside, I think that as a concept the 'Managed' fund is more or less dying- people who want to have a portion of their money in gilts/property etc can choose (or be advised) how much they want in each and tweak as they see fit or circumstances change.
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Like Tracker Bonds ,I believe Managed Funds are mainly being sold by the BankAssurers- the more discriminating investor has moved on.
 

Brendan Burgess

Founder
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45,787
What is risk ?

What do all you guys mean by "risk" ?

I think that you are confusing it with volatility.

A diversified portfolio of shares is highly volatile but not very risky in the longer term. It is certainly less risky than a deposit account which is subject to the risk of inflation and default.

It is quite possible that the history of the past 100 years of equities will not repeat itself and maybe over the next 100 years you will be better off in a deposit account. I think that this is highly unlikely.

Most of us have the majority of our capital invested in property. Equities make a very good diversification against this exposure to property.

Focus 15 is marketed as a high risk investment. This is very clever marketing because people with a little bit of knowledge have come to associate higher risk with higher returns. This association is false in the longer term. Equities which are lower risk provide higher returns than cash which is high risk.

Brendan
 
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Sea Pigeon

Guest
The Great Casino

You guys just don't get it, do you?

Buying a share from someone on the second hand market (euphemistically referred to as the Stockmarket) is an <!--EZCODE ITALIC START--> investment, it is a trade. One or other party will finish up having done well on that trade - it all depends on the price. During the last 100 years or so the second hand market has tended to underestimate the technology driven growth of Western economies and so buyers have tended to get the better deal.

There is no intrinsic reason why that should be so. and, as I have said before, Our Leader's Bible totally silent on any fundamental reason as to why it should be so, instead relying completely on past performance as a guide to the future.

It dramatically wasn't the case in Japan about 10 years ago when the second hand market had got used to building in a continuation of past economic growth into its pricing - P/E ratios soared to 80 and higher.

It wasn't so a year ago in the Tech sector when the second hand market was anticipating astronomical earnings growth in the future.

Dividend yields are now historically low, i.e. the prices in the second hand market are historically high. Maybe the anticipated growth will come through, maybe it won't.

In the capitalist system, actual investment happens in the primary market, not in the second hand market. In the primary market, new ventures look for venture capital which they will put to use and there are intrinsic economic grounds for believing that this primary investment sector is an easy touch in a growing economy. Unfortunately, these pickings are denied to Joe Public (sorry Joe, no offence I hope, don't report me to the Thought Police please :lol ) but instead it is divied out to a Golden Circle of HNW clients and of course to an elite cadre of stockbroker staff.

Today's second hand market is dominated by overpaid representatives of Joe Public who have probably priced out all the windfall gains which tended to be a feature of that the last 100 years.
 
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tyoung

Guest
The cult of Equities

There is no law of nature that says Equities must outperform other asset classes even in the very long run. Most of the recent outperformance has been due to an increase in Valuations(P/E, P/NAV etc), not an increase in underlying earnings or assets. Remember until the 1950's the dividend yield on equities was higher than the yield on 10 year Govt paper! You could argue that the past outperformance represents a gradual appreciation of the growth potential of the underlying companies. To assume that equities will continue to outperform, you must assume that that tha average P/E is headed continually higher(see the book "Dow 36,000").
Also the very fact that the past outperformance by equities is widely appreciated by most investors( and "Equities for the Long Run" is now the conventional wisdom suggests that returns will be dissappointing at least until some of that complcency is rooted out.
 
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monksfield

Guest
Cof E

Tyoung is correct in saying that it will take higher P/Es to produce (significant) outperformance from Equities going forward.

This is distinctly possible,even probable, due to the interaction of Supply and Demand.The demographics in the Western world ( and a growing awareness of the need to provide for retirement) are likely to result in very strong demand for equities over the next 10-15 years.Supply will expand to meet this if the price is high enough - e.g. more private companies will go public , more State- owned assets will be privatised etc.

I would re-state my own belief that the relative attraction of Gilts at current yields is not apparent to me - it will need a significant fall in yields to produce any decent returns over the next few years.With the Property Party looking to be at about 4 a.m.,what is the poor investor to do ?
Apart from the demographics ( I do realise this money does not have to end up mostly in equities) I derive quite a lot of comfort from the long term performance data which Brendan has quoted.
 
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Sea Pigeon

Guest
CoE

The last few posts suggest that I am not alone in realising that the stockmarket is just that a market. As with all markets, whether one gets good value depends on the price and, as has been observed, the price depends on supply and demand

Yes, demographics and changing attitudes to savings can, and are fueling demand. Maybe the short to medium term demographics are good - the long term scenario is very bad indeed.

Around about 2020 there will be a geriatric tidal wave of encashments to pay for all these pent up retirement benefits. The stockmarket will anticipate this sell off long before it actually happens.

The other driver of demand is sentiment. The all pervasive Cult of the Equityso worshipped in the Bible according to Brendan, the lack of appetite for boring old single figure gilt yields as articulated by Monksfiled, and the still fresh memory of the Roaring Nineties are causing an irrational demand for equities which is reflected in the still very high prices ruling in the market.

Consider this: The American Stockmarket added 5 times more value in the 1990s than in its whole previous history put together.

This was driven partly by unprecedented technology induced productivity gains in the Western economies but most of all it reflects a sort of peace dividend for the new Pax Americana

Saddam had been put in his box. Western oil supplies are secure. Capitalism's nemesis, the Soviet Union, came out with it hands up, begging gimme, gimme. Defence spending, for the first time in human history could take a more appropriate place in the economic landscape.

Hark to me!

There is no upside left - only some very sizeable potential bananaskins. What if there is a revolution in Kuwait or Saudi Arabia?, for example, that would be good for a 50% crash. What if the Soviet Union returned to its old ways? What if the Chinese seize Taiwan? And the Middle East, well?!

I am not referring to Nuclear Catastrophe here, we'll all go together if that happens! I am pointing out that we are at an unprecedented peak in human economic development and geo-political stability. The next seismic shift will surely be south! Hark to me!
 

Brendan Burgess

Founder
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C of E

Sea Pigeon

If you are that gloomy and fearful I don't think you should leave the stable in the morning .Would keep the money under the bed.

I do not think you have successfully undermined Brendan's pro-Equity stance.What may happen in 2020 is outside the vast bulk of investment time horizons and can be dealt with in advance.
 
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Dynamo

Guest
C of E

Glad to see this has stirrred up such a good debate.

Unlike Sea Pigeon, I do accept that equities will probably provide the best returns over the long-term. I do agree with him, however, that having got a lot of that return in the 1990s, there may be less of it around going forward.

However, my main concern is there here and now rather than the danger that there has been some kind of paradigm shift. Equity investments comprise other risks than simply volatility. There is the risk of capital loss, which has hurt many investors (even well-diversified ones) over the past two years. There is the risk of changing your mind, or of circumstances forcing you to. There is the risk of not sleeping at night, or giving yourself an ulcer worrying about your investments. There is the risk of panicking, or being panicked, out of equities at an inopportune time.

The reason I would (and do) put some of my assets into categories other than equities is for diversification. Not having all your eggs in one basket applies equally to assets as to stocks, sectors, and currencies. Sure you'll never do as well as the best single category, but you'll spread the risks of being wrong, and that seems a rational strategy to me for the typical investor. Property may perform well (as recently) even though equities are not. The yield from gilts (or cash) may be a useful buffer when equity markets tumble. If sleeping at night or not getting an ulcer is important to you, then you should build it into your investment mandate.

Monksfield - yes, I accept you could construct such a mixed portfolio yourself. But why would you want the hassle of doing so, and of monitoring and shifting the mix constantly, when you can do so cheaply and effectively using a balanced fund. If you don't trust any single investment manager, then use a consensus fund which samples all of them.

Brendan - yes, if you have other diversified assets, then by all means invest only in equities. Your house isn't an investment, though, any more than a holiday home is. Less so, in fact.

Monksfield - if the sophisticated investor has moved on, then why do pension funds (not just in Ireland but also in the US and UK), which are well-advised and have longer timeframes and more predictable liabilities than most individual investors, still hold a balanced spread of assets (with a strong bias towards equities, certainly).

Finally, even if Monksfield's demographic argument is correct, given that the details are readily available to investors, shouldn't an efficient equity market have already priced in the likely effect of it on stock prices ? A large part of what has proved to be 'irrational enthusiasm' in the US market in recent years was justified by the 'everyone will be buying till 2020 argument', I seem to recall. And at what point will an efficient market work out that everyone will be selling after 2020 and reflect that in stock prices too.

Just some random thoughts after a hard day. Sorry if they're a bit jumbled. Maybe all this means is that I am a more risk-averse investor than either Brendan or Monksfield, but I don't think that's all there is to it.
 

Brendan Burgess

Founder
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45,787
Should you consider your house as an investment ?

Dynamo

You say Your house isn't an investment, though, any more than a holiday home is. Less so, in fact.


I used to adopt this approach, but I don't anymore.

Let's say that I have £400k in cash. I can buy a perfectly adequate home for £250k and I invest the remaining £150k in equities. You say to ignore the home and therefore my investments are worth £150k.

Now let's say I buy a more than adequate home for £400k. Are you saying I have no investments ?

And it is a perfectly reasonable strategy to rent a home and invest the entire £400k in the stockmarket. Now I have £400k of investments.

Or let's say I buy a home for £600k - do I have a negative investment of £200k ?

Many people trade down when their children leave. Even if they don't trade down, they can borrow against their home or do some other form of equity release scheme.

If I have my entire assets in a home which I might trade down from in 10 years time, I am probably overexposed to the property market. If I am renting a house and I have all my money in equities, I am overexposed to the stockmarket and underexposed to the property market.

I think you must consider your home as part of your long term investment planning.
 

Brendan Burgess

Founder
Messages
45,787
Why should the stockmarket go higher ?

Sea Pigeon

I like your analogy of the stockmarket as a second hand market. I have gone blue in the face explaining to people that trading in shares does not create value - in fact, it destroys value. I must think a bit more about this second hand market analogy.

I often wonder if the stockmarket is totally overvalued. I have wondered about it since I started investing 20 years ago. Anyone who acted on these worries is seriously out of pocket ...at this stage. They might look very smart in the long term.

Presumably the price of equities must, over time, reflect the profitablility of the large corporations. It seems that the world economies are on an upward growth path and the companies themselves are continuously reinvesting their profits and these profits are going to rise in the longer term.

From time to time, the stockmarket is going to be overvalued or undervalued. I have given up worrying about it. I just don't know. I guess that the risk from staying out is greater than the risk from staying in.

Of course, there are going to be shocks to the system- the Iraqi invasion of Kuwait was a fairly serious shock. But you can't get much bigger shocks than two World Wars. In the history of the stockmarket, the two world wars were just a temporary blip. Not so for the unfortunate depositors in Japan and Germany who were effectively wiped out.

And that is the crux of this very interesting issue - you have to invest somewhere. You have a choice of equities, cash or property. History, and I know it's only history, suggests that cash has been the riskiest. I think property is next as it is very difficult to diversify adequately. Equities appear to be risky, but, in the long term, I don't think that there is much risk.

The great thing about The Askaboutmoney Guide to Savings and Investments is that it will reflect the Counterview. And if you or TYoung would like to write a measured piece about why the stockmarkets might be overvalued, I would be delighted to include it.

Brendan
 
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Sir Ivor

Guest
Re: Why should the stockmarket go higher ?

We are all agreed that shares are bought and sold on a stockmarket - a very sophisticated market - but a market nonetheless. Whether at any point in time shares are individually or collectively a good buy will only be known with hindsight (except for insider trading) and that will depend entirely on the price< at which they were bought and subsequently sold.

The Cult of the Equity can be restated as a belief that Equities tend always to be underpriced by the psychology of the market. The empirical evidence of the last 100 or so years of modern stockmarkets suggests that the traders do indeed seem to have been endemically disposed to underprice shares.

But WHY? This is where the "Book" frustratingly leaves off. It states an empirical observation on past behaviour and posits that this will continue. As has already been mentioned in this thread there are certain arguments why past behaviour might be a very dangerous guide at this point in time. It is my contention that the markets have reached the asymptote or maybe even dangerously overshot it!

Certainly in earlier times stockmarkets were dominated by private investors. PIs instinctively require compensation for uncertainty (volatility? risk? whatever?) The received wisdom pre the 1950s was that there should be a "Yield Gap", i.e. punters should get a higher dividend stream for investing in equities. This now seems incredibly naive. The stockmarket "investors" expected and got higher cash flowandthe prospect of capital gains for taking the risks. This, with hindsight, was money for old rope.:hat

Today's market is dominated by highly paid reps of Joe Public. For these HPRs the Utility Curve is wildly different from that of a PI. Their big nervousness is being out of line with the other HPRs. Now if all the HPRs are being intraveinously fed on the narcotic Cult of the Equitythen we have a dangerous possibility that they have got it all wrong, certainly the "Yield Gap" has been put into reverse big time

Repeating an earlier point, it is hard to see the next big upside from our current Zenith but plenty of scary downsides. The risks do not look worth taking for the ordinary PI, charges are almost irrelevant to this enigma.

I'll stop there, I am sure I am boring the vast majority of AAM readers.
 
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Sir Ivor

Guest
The Great Enigma

This is all about utililty curves.

Everybody with a few bob to invest should ask themselves the following question:

Imagine you are propositioned with an investment which has the following payout profile in a year's time:

40% chance you lose the lot;
60% chance you double your money.


How much of this little baby would you buy?

The Actuaries will tell you that the expected return on this investment is 20%. Pretty good return! Do you put the lot into it? Do you borrow to invest in it? I don't think so! There is still a 40% chance that you will lose everything!

This is what Utility Theoryis all about. The Bible according to Brendan may or may not be Gospel truth, but punters should always ask themselves when investing in equities: What If?
 

Brendan Burgess

Founder
Messages
45,787
Expected returns and utility

40% chance you lose the lot;
60% chance you double your money.

I am not sure of the relevance of this argument. It certainly does not reflect the returns on a balanced investment in the stockmarket. It might well reflect the returns on a single investment in a share.


Brendan
 
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Dynamo

Guest
CofE

Glad to see this debate is still motoring along.

I don't have time now to consider the more technical posts added over the weekend, but will have a think about those.

Brendan - I think you should reconsider your position on whether your house is an investment. Yes, of course your house should be included as part of your financial planning, but I'd argue that it should not (in most circumstances) be included as part of your investment portfolio. I'd accept that in the circumstances you describe, where you buy more house than you need, then the excess might be considered an investment, albeit an incredibly undiversified one. (Just wait till the local authority plans a motorway or an incinerator next door.)

But most people surely do exactly the opposite. They buy as much house as they can possibly afford, using predominantly borrowed money to do it. Until such time as you can realistically state that you will not need to replace your house with one that will cost a similar amount (ie you COULD actually trade down), then you should not consider equity in your house as an investment. Whereas you can always sell a holiday home if you need to.

Monksfield - on mature reflection, as they say, I think I was too kind to your demographic argument in my last post. It has one critical flaw that is common to most 'momentum' investment strategies - it ignores the value of the asset in question. That thinking was evident in the dotcom stock boom, and also in the recent boom in Irish house prices - "sure demand is such in this market that all I have to do is buy and wait for it to go up". The problem is that this kind of strategy takes no account of the inherent value of the asset, and its success is predicated on the assumption that no-one else ever will either. But they pretty much always do at some point.
 
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Monksfield

Guest
C of E

I did not realise my innocent quip had caused offence - no malice whatever was intended towards the noble Sea Pigeon.
Sir Ivor makes some interesting points most notably in asking the question WHY the past experience should be extrapolated into the future.
Everyone is entitled to question the overall stockmarket valuation and a case can be made almost any time that stocks are overvalued( Philips & Drew told us in 1995 that UK Equities were more expensive than at any time in the 20th century).
As I have pointed out before, valuation is a function of many things but most especially the interaction of supply and demand.Today's FT shows that stock buy-back programmes worth $220billion on average were announced in each of the last 5 years.How many people had any idea that something on this scale was at work in the (second-hand !)market ?As an aside the managements of many of these companies have been shown to have a poor feel for market timing as the shares could in very many cases have been bought back more cheaply since.
Profit growth over the next 5/10 years may well be sluggish and a poor driver of performance ,but with strong demand and low inflation, investors will be willing to pay more for those earnings( back to basics /DCF using bond yields) .There are other 'fair winds' behind equities in particular increasing interest on the part of company managements in delivering Shareholder Value in Europe and Asia - it is even catching on in Japan!).
Ultimately the case for Equities is as much a philosophical one in terms of belief in the capitalist model which allocates capital to those who look capable of using it efficiently.

One final point I meant to tackle previously - Brendan's advice about buying & holding the top 10 Irish stocks strikes me as bizarre- why should people tie up their savings/pensions in Elan rather than other pharmaceutical companies many times its size ?
Also what is the argument for Smurfit a cyclical/commodity business with well-publicised corporate governance issues.
This is extremely blunt and IMHO questionable advice.
 
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Sir Ivor

Guest
Re: Expected returns and utility

Quote: I am not sure of the relevance of this argument. It certainly does not reflect the returns on a balanced investment in the stockmarket. It might well reflect the returns on a single investment in a share.

The example was deliberately exaggerated.

Let's try and make it more real.

Take the top 10 Irish Equities. What is the prospect for this portfolio on say a 5 year time horizon?

Let's accept for argument that equities are a good investment and that the average expectationis for 10% per annum - not bad - certainly better than inflation eroded deposits!

But what are the downside risks? For example, what is the 10% worst case scenario ? Let me suggest that on a 5 year view the 10% worst case scenario is that the above portfolio will lose 25% or more.

Many people would not like these odds. The 10% risk of losing 25% outweighs the fact that on balance the bet looks worth taking from a purely statistical viewpoint. (Which of course I do not necessarily concede in the first place):rolleyes

I think Dynamo rather more succinctly made the point under the description of the "sleep easy" factor.

Brendan, off the top of your head what do you think is the 10% worst case scenario for your recommended portfolio on a five year view?

In fact maybe this is worth a topic of its own. I think it would be a useful piece of information to have a sense of the consensus on the amount of risk involved in this portfolio.

For my part, even if I accept that it is a fair bet to begin with, I think that the odds against this portfolio being 25% south in 5 years time are about 10%.
 

Brendan Burgess

Founder
Messages
45,787
Why the top 10 Irish stocks ?

Apart from one or two Buffetts, there is just no evidence that stockpicking works. You can make a great case for investing in Elan - someone else can rubbish that case. I say to pick the top 10 Irish stocks and hold onto them, but you can pick the top 10 American or British or European stocks. The key is a diversified selection of stocks.

Brendan
 
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