Kuta Beach

Kuta Beach

Saturday, 20 March 2010

The Temptation of High-Risk Investments

The Australian published an analysis (Cash the Safe but Sorry Option) on the performance of super fund investment options on 19 March 2010. The article strongly denounces those investors who switched from shares into cash right after the GFC, claiming that they lost because they missed out of the post-GFC rally.

In my opinion, if you are in cash, bonds, or any other safe investment and a rally occurs in a non-cash or non-bond asset and you did not have the opportunity to exploit it, you should not feel bad. The reason why is because there will always be opportunities missed. For example, last week somebody won the lottery and with it millions of dollars. Had I known which numbers to pick, I could have won millions. Should I regret it? I don't think it's worthwhile to regret not having won the lottery because there is no way I could possibly know which numbers will appear. The same applies to investments. There is a massive random component to investing that makes investment results as random as the outcome of a lottery.

The article quotes someone named Warren Chant, principal of research house Chant West, who said the following: "It ... shows the value of taking a long-term view of investment markets when faced with volatility."

This idea that holding shares for a long time wil somehow decrease risk is one of the most puzzling aspects of investment and perhaps one of the biggest cons of all time. Professor Zvi Bodie has the opinion that buying and holding shares for a long time does not reduce risk (read Critique of Buy and Hold). In my opinion, I will assume that holding shares for a long time does not decrease risk and I will wait for evidence to show me that it is true. The burden of proof is on the investment to prove to me that it can perform well. Otherwise, I will diversify. There is insufficient evidence to prove that buying and holding shares for a long time will be safer than holding shares for a day or two. One argument given is based on historical prices. Shares indices like the S&P500 and Australia's All Ordinaries have gone up over many decades. Therefore, a simple risk analysis of statistics shows that there is more upside risk than downside risk. However, this is silly. If the price of an asset goes up considerably, that is not evidence that it will continue to go up. In fact, history shows that often when prices of assets go up sharply, it is followed by a sharp fall when the bubble bursts. If you invest based on past performance, it is highly likely you will buy into a bubble.

Many mutual fund managers claim that their mutual fund of diversified shares constitutes high quality investment because share indexes have gone up a lot over the long run. However, if past performance is the best indicator of future performance, you should not invest in diversified share mutual funds. You should invest in specific shares, e.g. in Westfield Group. Today (2010) the Westfield share price is $12.20 and in 2003 it was around $2.00, which is a 510% increase. The All Ordinaries in 2003 was 2900 wheras today it is 4890, which is only a 69% increase. Therefore, Westfield shares outperformed the All Ordinaries. Mutual fund managers will likely counterargue by saying, "How would know that back in 2003 the best investment would be to buy Westfield? It's better to diversify by investing in multiple shares via a mutual fund. Westfield may have outperformed the market in the past but that is not a guarantee that the market won't outperform Westfield in the future." Exactly! And that applies to shares versus other investments like cash and bonds as well. Even if shares have performed better than bonds or cash from one period to another, how would we have known back then that shares would have outperformed bonds? Shares may have outperformed cash in the past but that is not a guarantee that cash won't outperform shares in the future. Notice how share mutual fund managers argue for diversification when arguing for diversified share mutual funds versus specific shares but ditch this same logic when arguing for diversified share mutual funds versus cash or bonds.

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