Broad Oak: your emotional support animal

Saturday, December 19, 2009

How should we invest if we're back to "boom and bust?"

Edward Harrison analyses the current financial situation, and thinks that governments will continue to try to stimulate their economies by increasing public debt. This will increase (or support) asset prices, but you can't rack up all your expenses on your credit card forever: another crisis will come and then it's time to pay the bill. The money base will shrink and asset prices will decline again.

The gamblers will try to buy into the false boom and sell before the bust, but this is a risky strategy. I haven't the nerve for it, though some would say you should be prepared to speculate with 10% of your investment money.

For the ordinary investor, it's a difficult time: holding cash will seem like a losing strategy, and he/she may be tempted back into the market at exactly the wrong moment - the moment when everybody thinks that "you can't lose". We saw this in the technology boom of the 90s, and the house price boom a few years ago.

What is clear is that the system is unstable. In these wild times, fortunes will be won by some, lost by others; but the prudent saver looking for secure and steady rewards will have to diversify and consider all sorts of safety measures. Let's look at common investment options, in what used to be thought of as ascending risk order.

If governments try to counter the downturn by producing too much new cash and credit, the result may be inflation and that will punish bank and building society accounts. The insurance company I started with in the late 80s used to have a handout on the effects of inflation: it showed the real purchasing power of money placed in a bank account for 10 years from the mid-70s to the mid-80s - even letting the interest accumulate in the account, your cash had lost 50% of its buying power in a decade. And the events of October 2008 have alerted savers to the fact that money in the bank is not a risk-free option - thank goodness for the limited (up to £50,000) protection of the Financial Services Compensation Scheme.

Government bonds (or gilts) are a problem, too - their yield (their annual income as a percentage of their current traded price) is very low, but when interest rates rise the capital value of gilts will fall correspondingly. There is also mounting concern about national credit ratings and the growing risk of default. For those who still have faith in the UK government's promises, National Savings and Investments claims to offer "100% security for your money" (actually, there is no such thing, but you know what they mean). For example, it is still possible to buy National Savings Index-Linked Certificates, to guard against inflation.

I suspect that with-profits funds will continue to face huge challenges in the coming years. They were set up to deliver modest but (most importantly) reassuringly steady growth; but the volatility of modern markets has stood up in their boat and is rocking it violently. Look out for further occasions when with-profits managers have to impose "Market Value Adjusters" (MVAs) - temporary discounts on the face value of your holding if you're trying to cash-out at a turbulent period. They're trying to preserve balance in an unbalanced time, and I fear they may not succeed.

Higher interest rates (maybe higher taxes, too) and increasing unemployment will tend to affect house prices. In a recession / depression, much commercial property will stand empty and so that market will decline, too.

When the money base shrinks and interest rates increase, businesses will suffer and many stocks and shares (aka "equities") will be hit. Already, professional investors have increased their holding of "defensive" stocks - shares in companies providing things we always need, such as energy and reasonably-priced food and clothing. You can reduce investment risk further by holding shares in more than one company and in more than one type of business; you can also diversify by including foreign equities.

Which brings us to another topic: currency depreciation. The British pound has lost some of its buying power abroad, in part a response by foreign investors to our problems with debt and a weakening economy. The pound has lost ground against the US dollar (not because the US economy is strong, but because the US dollar is still - for now - the world's trading currency) and the Euro over the last couple of years, so even if prices here in the UK seem stable, you might have gained by investment in other countries, or even just holding some money in foreign currency. Of course, the key questions are, which investments, which currencies, when to get in and out?

For the adventurous, there are commodities (everything from pork bellies to agricultural land, oil and gold), emerging markets (developing economies - remember the saying, "an emerging market is one from which it may be difficult to emerge") and specialist funds/shares, such as in technology and medical research.

Further up (or off) the scale are the outright financial gambles - futures and options, derivatives etc. These things - supposedly originally designed to cover and so reduce risk - are now the instruments that threaten our security. I think the main cause of the problem is that there seems to be no notion of "insurable interest", as with life insurance. Prior to the UK's Life assurance Act of 1774, it was possible to take out insurance on a complete stranger, whereas now you can insure only against the loss you might suffer if someone dies. If modern options trading was regulated in the same way, the market would be far smaller and much more secure. Perhaps that will come, one day.

This not the place for any recommendations, but if you are lucky enough to have any investments or savings, perhaps it's a good time to review them, maybe in consultation with your financial adviser. If you don't know which horse to back, then at least you can try to bet on a wider selection, or even all of them; for unlike racecourse betting, there is (most unfortunately) no option to stay out altogether; not unless you have nothing.

UPDATE

Z. O. Greenberg looks at ideas for diversifying investments out of the dollar. This would apply similarly to those who are chary of the British pound. But beware - some say the US dollar may strengthen soon.

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