Accept 'new realities' of the investment game

Published February 5, 2009

ANALYSTS have had to face a fair amount of criticism over the past year for having been completely blindsided by the collapse of the US economy. At the beginning of 2008, for example, when the sub-prime crisis was into its fourth month, every single investment house projected the Straits Times Index (STI) to end the year above 3,100 - with one foreign broker even setting an astonishing 4,800 target.

As it turned out, the index finished at 1,761, resulting in margins of prediction error so embarrassingly wide that they have probably served as a deterrent to would-be forecasters this year since, to the best of our knowledge, no house has ventured an end-2009 STI target yet.

In defence of brokers, they were not alone - central bankers, politicians, regulators, supposedly independent research houses, fund managers and many 'expert' commentators were also to blame for failing to foresee the imminent devastation.

Lessons to learn

What lessons might be gleaned from the 2008 fiasco that could aid investors this year and help preserve their capital?

First, relook that central tenet on which many investment recommendations and decisions are based: that markets are efficient.

This supposed pillar of finance is founded on the belief that the brainpower of thousands of analysts, investors, dealers and fund managers is sufficient to ensure that, at any one time, prices are a true reflection of economic reality.

They are not - for the simple reason that a large majority of associated personnel are biased and not objective.

(There is also systematic bias or artificial support introduced by persistent hopes of government bailouts as well as insider leakages, but we'll leave that aside for now.)

Although the industry and regulators will not admit it, research is heavily influenced by corporate finance deals and the 'Chinese walls' or ethical barriers that are supposed to ensure impartiality are often as thin as the paper on which the final reports are written. It is this bias - and also the complacency wrought from upward momentum - that led most analysts to underestimate risks throughout 2007 and 2008 while overestimating possible returns.

Investors should thus operate from the standpoint that markets are in reality hugely inefficient and view any claims that after, say, a year of a bear market, 'all the bad news must be in the price' with a generous dollop of scepticism.

This then helps demolish a second pillar of finance - namely, that in a properly functioning capital market, returns are commensurate with risk. They are not, the reason being that the investment community has a vested interest in concealing or underplaying real risks through obfuscation, legalities and convoluted disclosures while always overplaying the money that can be made in order to entice the entry of more investors.

Hapless buyers of various structured notes such as High Notes and Minibonds would have discovered the truth in this observation to their detriment over the past six months but it's a lesson all others should also bear in mind. As seasoned fund manager Marc Faber put it in a recent interview, 'nobody is an investor anymore, everyone should be a trader and their own central banker'.

(You could easily rephrase that to read 'shorten your time horizon to as little as possible and look to always sell into strength'.)

A third area that deserves attention is the belief that the US government can fix things through sheer volume of money printed or liquidity injections or whatever euphemism happens to be fashionable at the time to describe rescue packages.

Preserve capital

It is this thinking - born no doubt from the Alan Greenspan school of economics that contributed significantly to the problem to begin with - that has kept Wall Street afloat despite there being no sign that the billions spent so far (close to US$1 trillion) are having any effect, even as the entire US banking and auto industries threaten to sink without a trace.

The upshot of all this is that market participants should today expect, and be content with, mainly low returns within a high-risk, high-volatility environment in which disclosure will in all likelihood be poor and is likely to remain so for the foreseeable future.

Claims that the worst is over should be dismissed because markets are as biased and inefficient as ever, and it would be a mistake to pin hopes of survival on continued bailouts from the US. Because of this, capital preservation should be the number one priority of every market player.


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