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Investments

Why Owning a Broadly Diversified Portfolio Makes Perfect Sense

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At times like this when there is great uncertainty, wouldn’t it be great if we had the means to look into the future? Perhaps not some might argue. Unfortunately, we don’t know the future – no one does.

When it comes to investing, it can be tempting to run ‘what if’ scenarios in our heads, such as ‘perhaps I should move into technology and pharmaceutical companies – as surely these will do well’ or to pick out specific companies that appear likely to thrive in the future.

However, two challenges exist.  The first is that you won’t be the first person to have thought this and the combined views are already reflected in market prices. The second is that in making such focused bets you have a high chance of being wrong and missing out on the companies that actually end up driving future returns. Remember, 30 years ago Amazon and Google did not exist.

To get a feel for what these focused risks look like, academics are able to explore a vast amount of equity market data in the US, known as the Centre for Research in Security Prices (CRSP) database.

One such study[1] reveals some surprising and useful findings between 1926 and 2015.  Whilst investment wisdom and empirical evidence support the case that equities, in aggregate, outperform cash over longer periods of time, a closer look at individual equity returns tells a very different story. Here are some of the insights that the paper provides:

The median time that an equity/share is listed on the CRSP database is only seven years, during the period 1926 to 2015. That’s not long.

Just over 40% of all equities/shares have a holding period return that exceeds the return of cash (in this case one-month US Treasury bills) over the period that the equity/share was in the database. More than 50% deliver returns that are negative. The median lifetime return on any single equity/share was -3.7% p.a. That’s not good.

26,000 equities/shares have appeared in the CRSP database since 1926, yet only 36 survived the entire 90-year period. That’s not many.

US $32 trillion of wealth was created between 1926 and 2015, which has been generated entirely by the top 1,000 companies, representing less than 4% of the total number of companies listed over time. The top thirty companies (0.1% of all companies) accounted for around 30% of the total stock market’s wealth creation. That’s pretty concentrated.

This is why, at times like this, and in fact across all time periods, we believe it makes enormous sense to remain highly diversified, so as not to miss out on the next Exxon (the firm that has added most value to the US market ever), Apple or Amazon.

Now, let’s look at how the top ten US firms by revenue changed between 2000 and 2010 and again between, 2010 and 2020.  The results are so revealing.  Just look at the new companies making it into the top 10 in 2010 and then in 2020.  Look at the names which disappeared from the top 10 in 2010 and again in 2020.

Top 10 US companies by revenue over time (2000, 2010, 2020)

Source: Fortune 500

Correctly picking which few companies are going to be driving market returns over the next decade or two will not be easy, or likely. Even if you could, remember the majority of us are investing for more than 20 years.

At Wells Gibson, we believe it makes perfect sense to own the top companies by owning a broadly diversified portfolio which invests in thousands of companies.  Missing out on these companies, perhaps that don’t even yet exist, could make all the difference between a good investment outcome and a very poor one.

Please keep safe and don’t hesitate to get in contact if you have any questions.

[1] Bessembinder, H., (2017) Do Stocks Outperform Treasury Bills? WP Carey School of Business, Arizona State University.
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Sitting Out an Equity Market Fall

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For many of our clients, the purpose of accumulating wealth in a portfolio is to provide a sustainable income either now or in the future that is, at the very least, able to cover their basic needs and hopefully a bit more.

The level of portfolio-derived income required is unique to each client.  Some of our clients have pensions from final salary schemes and possibly other income from other sources, such as property.  Other clients need to rely more fully on their portfolios.

Portfolio income comes from the natural yield that a portfolio throws off in the form of dividends from companies and coupons (interest payments) from bonds, and capital makes up any shortfall.  When markets rise, as they have done most years since the Global Financial Crisis a decade ago, portfolios may even grow after an income has been taken, although this will not always be the case.  When markets fall, it can begin to feel a little uncomfortable as dividends may be cut and equity / share values may be down materially, as we have seen in the first quarter of 2020 (albeit, the upturn in April has helped).

The cardinal investment sin at these times is to sell equities when they are down and turn falls into losses.  To avoid doing this, income required above a portfolio’s natural yield can be taken from bonds or cash reserves.

You first question might be, ‘How long might I have to do this for?’. 

The figure below, helps to answer this question.  It uses a range of regional (Europe, Asia-Pacific ex-Japan, Emerging and World) and major individual equity markets (US, UK, Japan) and plots the top 10 largest market falls for each and the time taken to recover back to the previous high, in, before-inflation terms[1].

Some overlaps obviously occur (e.g. the US is a material part of the World), but broad insights can be gleaned: most market falls recover within 5-6 years, some may take a up to a decade or so, and outliers can and do occur, such as Japan which took 27 years to recover (in GBP terms) from its market high in 1989.

Figure 1: How long will we have to wait?

Data source: Morningstar Direct © All rights reserved.

What is also evident is that, with the exception of Japan, these market falls all sat well within most investors’ true investment horizons.  Whilst Japan provides a helpful lesson that investing outcomes are uncertain, widely diversified portfolios do help to mitigate country-specific risks.  Even investors in their 80s should be planning to live to at least 100, giving them a 20-year investment horizon (today an 80-year-old woman has a 1-in-10 chance of reaching 98[2]).

The question of how much cash or bonds an investor should hold will vary depending on how important it is for them to meet their basic income needs and how important it is having more discretionary spending[3].  Using a sensible multiple of basic annual spending, and possibly additional discretionary spending, is a sensible starting point from which to reach a suitable minimum.  For those to whom certainty of income is critical this could be significantly higher and for those to whom it is less critical, it might be lower.  For all investors, it should be sufficient to ensure that they can sit out any market fall relatively comfortably, without having to sell their equities.

Sitting out an equity market fall is not so bad, when you know how long the wait might be and you come well prepared to sit it out.

As always please get in contact if you have any questions.

[1] MSCI World NR, IA SBBI US Large Stock TR, MSCI United Kingdom NR from Jan-72; MSCI Japan NR, MSCI Emerging Market GR, MSCI Europe NR, MSCI AC Asia Ex Japan GR from Jan-1988.
[2] https://www.ons.gov.uk/
[3] It will also depend on other factors such as their need to take risk, their risk profile, and their financial capacity for loss, all of which should be discussed in detail as part of the ongoing financial planning process.
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Responsible, Sustainable and Impact Investing

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Wells Gibson remains a strong advocate of systematic, evidence-based investing as this continues to stand the test of time and remains a robust, well thought through proposition which investors can understand and stick with, even in challenging market conditions.

For some time now, we have been eager to complement our standard investment proposition with the development of an ESG investment proposition and an Impact investment proposition. These are described as follows:

ESG investing has an increased focus on environmental risks (E); social sustainability (S); and good governance (G); and

Impact investing helps drive solutions to global problems and provides a material effect on important positive outcomes with regards to social sustainability and environmental risks.

The focus of this article is the development of our ESG investment proposition, and a further article will follow with regards to the development of our Impact investment proposition.

The Spectrum of Capital is a helpful diagram which summarises the financial goals and impact goals of different investment approaches, and you will notice this places a broad-based, traditional investment approach at the left-hand side, and, philanthropy at the other side. Wells Gibson’s standard investment proposition would fall into the traditional column i.e. the left-hand side.

Thanks to, UK National Advisory Board On Impact Investing, 2017 & Impact Management Project, 2017

Our ESG Proposition

Wells Gibson has now created an investment proposition which has an increased focus on ESG factors and includes funds whereby the investment approach is deemed to fall into the Responsible & Sustainable columns within The Spectrum of Capital.

We have sought to address the issues that are most important to environmentally focused investors, without compromising on sound investment principles, or requiring investors to accept lower expected returns.

Although this proposition has an increased focus on ESG factors, we will not compromise on the structural integrity of our portfolios because this can expose an investor’s capital to unwanted and unnecessary risks.  In other words, we are determined to apply our systematic, evidence-based philosophy to our ESG proposition.

We recognise there is no ideal single approach to ESG investing.  A number of offerings are continuing to develop such as negative screening; positive screening; a focus on the environment only; and a combination of E, S and G etc.

Our ESG Portfolios

In order to create portfolios with an increased focus on ESG factors, we consulted with Albion Strategic Consulting which provides Wells Gibson with ongoing governance oversight and is a member of our investment committee.

Using Wells Gibson’s standard, traditional portfolios as a sound template, our approach initially is to replace the existing funds used to obtain global, developed market equity exposure, with two new funds which stand out as being worthy of inclusion and are from investment firms we are very familiar with and trust, Dimensional and Vanguard.

We believe the rules based ESG approach of these funds is a step in the right direction, without materially sacrificing capital market returns:

The Dimensional fund [1] claims to reduce greenhouse gas emissions intensity by over 60%, and nearly 99% of emissions from reserves due to the systematic ESG weighting methodology; and

The Vanguard fund [2] excludes companies that do not align with the UN’s Global Compact principles.

As with our standard, traditional portfolios, the ESG portfolios will also invest in global short-dated bonds; global commercial property; and global emerging markets, however as new products emerge, these will be scrutinised before any decision is made to include them in our ESG portfolios.

We asked Albion to run an analysis comparing Wells Gibson’s standard, traditional portfolios to Wells Gibson’s ESG portfolios and this revealed:

A minor increase in cost;

A minor increase in share concentration; and

A minor reduction in the expected return (attributable to the reduction in allocation to small and value companies).

Our conclusion is that Wells Gibson’s initial ESG investment offering provides a meaningful and worthwhile progression towards a full ESG portfolio and will be used when requested by clients.

We continue to develop our Impact investment proposition and as soon as we have a viable solution, we will let you know.

Please don’t hesitate to contact Wells Gibson if you have any questions and if this is an area you would like to discuss please get in touch.

Long-term Investors: Please Don’t be Dismayed by a Recession

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Although we are bombarded by news telling us we are about to enter a recession, don’t be dismayed – remember, investing is a long-term pursuit and is not about speculating to make short-term wins.

With activity in many industries sharply curtailed in an effort to reduce the chances of spreading the coronavirus, some economists say a recession is inevitable, if one hasn’t already begun.1

From a market perspective, we have already experienced a fall in equities, as prices have likely incorporated the growing chance of recession – in fact, it’s often said the market is ahead of a recession.

Investors might be tempted to abandon equities and go to cash because of perceptions of recessions and their impact.  However, across the two years that follow a recession’s onset, equities have a history of positive performance.

Data covering the past century’s 15 US recessions show that investors tended to be rewarded for sticking with equities.

The chart below shows that in 11 of the 15 instances, or 73% of the time, returns on equities were positive two years after a recession began.  The annualized market return for the two years following a recession’s start averaged 7.8%.

Recessions understandably trigger worries over how markets might perform however history can be a comfort for long-term investors who are wondering if, now is the right time to move out of equities.

Remember, “the stock market is a device to transfer money from the impatient to the patient.”

Please do get in contact if you have any questions.


Downturns & Upturns

Growth of wealth for the Fama/French Total US Market Research Index

 

Past performance, including hypothetical performance, is not a guarantee of future results.

CHART

In USD.  Performance includes reinvestment of dividends and capital gains. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.  Growth of wealth shows the growth of a hypothetical investment of $10,000 in the securities in the Fama/French US Total Market Research Index over the 24 months starting the month after the relevant Recession Start Date. Sample includes 15 recessions as identified by the National Bureau of Economic Research (NBER) from October 1926 to December 2007. NBER defines recessions as starting at the peak of a business cycle.

GLOSSARY

Fama/French Total US Market Research Index: The value-weighed US market index is constructed every month, using all issues listed on the NYSE, AMEX, or Nasdaq with available outstanding shares and valid prices for that month and the month before. Exclusions: American Depositary Receipts. Sources: CRSP for value-weighted US market return. Rebalancing: Monthly. Dividends: Reinvested in the paying company until the portfolio is rebalanced.

FOOTNOTES

1 Nelson D. Schwartz, “Coronavirus Recession Looms, Its Course ‘Unrecognizable,’” New York Times, March 21, 2020; Peter Coy, “The U.S. May Already Be in a Recession,” Bloomberg Businessweek, March 6, 2020.

Photo by Tommy Tang on Unsplash

‘Vox Populi’ and the Wisdom of Crowds

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Many of you reading this short note will have, at some time, travelled down to Devon for a lovely summer break amongst the rolling fields, moors and beautiful beaches of this somewhat remote county.  Incidentally, the beautiful and picturesque harbor village of Clovelly in North Devon is just beautiful.

Only a few will have ventured into Plymouth, the famous naval seaport and home to Sir Francis Drake (that famous Elizabethan pirate who so vexed our Spanish friends by stealing their gold) and the site of the departure of the Mayflower with the pilgrims on board heading to America 400 years ago this year.  Even fewer will know that it was the place of an amazing insight into the powerful nature of crowds, which provides us with a wonderful word picture of how capital markets operate.

In 1906 a Victorian gentleman named Sir Francis Galton attended a livestock fair aptly named The West of England Fat Stock and Poultry Exhibition in Plymouth.  One of the many attractions at the fair was a guess the weight of the ‘dressed’ ox on display (similar to the game of guessing how many cookies are in the glass jar).  The competition attracted 800 people all paying 6d (half a shilling) to write down their guess, name and address on the back of the ticket.  The nearest guess to the actual weight would win a prize.  The fair, as you can imagine, attracted many sorts, from the general public (old and young) to farmers and butchers.  Being a statistician, amongst many other things, Galton bought the used tickets off the stall holder.  Of the 800, 787 were usable.  Back home he analysed the guesses and published his finding in Nature, March 7, 1917 in an article titled ‘Vox Populi’[1].  His remarkable finding is illustrated below.

Figure 1: Guessing the weight of the ox – the ‘crowd’ got it more-or-less spot on.

 

Source: Copyright © Albion Strategic Consulting. All rights reserved.

[1] You can view the original article here: http://galton.org/essays/1900-1911/galton-1907-vox-populi.pdf

The range of guesses was wide (-133 lbs. below the average to +86 lbs. above it), the participants were varied, and the numbers involved were quite large.  The ‘crowd’ in aggregate showed ‘wisdom’ compared to its individual participants.

This story provides a great insight into how modern financial markets work.  The markets are made up of many players, from individual DIY investors, day traders, stockbrokers, hedge funds, fund managers, sovereign wealth funds, endowments and other institutional investors.

Each investor holds their own view on the future prospects for a specific security, such as the price of BP or Apple shares.  Some will like a share and others not.  They cannot both be right.  The market, given the vast amount of information available to it, settles on an equilibrium price for every share.  This price will move, sometimes dramatically, as we have seen recently as the ‘market’ reaches a new equilibrium price, given the new information that it has collectively processed.

At times like these, some investors are prone to running ‘what if’ scenarios in their heads such as: ‘if companies are in trouble because their revenues have been cut off, then they will renege on their property lease terms and the landlords will suffer.  It seems likely that things will get worse over the coming weeks.  If property landlords are in trouble that might lead to problems in the banking sector’.  It all sounds plausible.  They may then be tempted to sell out of property or banks or even equities altogether.  The crucial mistake is that they forget that they are not the only person to have thought this through and these very sentiments and views are already reflected in the current price of listed commercial property companies, bank shares and the markets in general.

Markets will move again, down or up, based on the release of new information, which in itself is random.  Second guessing random events is futile.  You might make a guess and be lucky but that is speculating, not investing!

Accepting the ‘wisdom’ of the market helps us to challenge ourselves as to whether we really have superior insight relative to everyone else.  It seems unlikely and as Charles Ellis, the wise sage of investing from the US, states, “In investing, activity is almost always in surplus.”

Activity based on guessing, particularly when it relates to shorter-term issues that sit well within your true investment horizon, is best avoided.

Next time you pass Plymouth on the A38, reflect on one of its great historical events, The West of England Fat Stock and Poultry Exhibition of 1906.

Note: if you are interested in this subject and have time on your hands in the coming weeks, perhaps take a look at The Wisdom of Crowds by James Surowiecki published by Greener Books.