# The real problem for savers in Ireland: lack of prudent advice



## Marc (12 Dec 2010)

It is often said that the markets are driven by two emotions: [broken link removed].

We also know that on average savers and investors can be excessively  influenced by current events and led to believe that the risks are lower  than they are (for example as recently seen in the [broken link removed] market or  technology shares) or that they are higher than they are (like we see  now with savers panicing over their bank deposits)

Let’s be crystal clear about one thing..... 

Since the ECB and IMF funding has been put in place the banks in Ireland are *MORE* secure than they were – and yet *NOW* the fear sets in. This is not to say that money on deposit is *RISK FREE *–  it isn’t and never has been either in nominal terms (banks and even  countries can and do fail) or real terms (once inflation is taken into  account deposit accounts typically fail to preserve real purchasing power  over time)  

But depositors are safe in the sense that their deposits are well  supported by the ECB and IMF and therefore media comment encouring  savers to pull their money out of banks is at best irresponsible and at  worst is the root *CAUSE* of some of the funding shortfall for the banks. 

Savers are currently being told that they should move their money and  numerous alternatives for nervous savers are being set forth by all and  sundry with virtually no evidence to support the recommendations being  made and of course no recourse available to those following the  recommendations should it all go pear shaped! 

Alternatives to “traditional” assets such as equities and bonds often  come to the fore following a period of sustained poor performance (the  same thing happened in the 80’s when “experts” advised investors to load  up on “hard assets” right at the start of one of the greatest bull runs  ever for equities) so naturally options such as wine, art and forestry  etc have come back into vogue. Some of these are analysed in detail in  the following:

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In contrast, investments which have clearly served to preserve the wealth  of investors during the economic crisis such as [broken link removed] have come in for  the opposite treatment with “experts” stating that investors should  avoid gold because the price is sure to fall since it now in a “bubble” this view is  dealt with [broken link removed]  and equally claims that investing in gold is "very risky" have been put to rest with this post which shows that the volatility of gold is in fact lower than that of a random selection of equities.

The subject of attempting to time markets or taking advice on market timing from newsletters is dealt with [broken link removed]

 I’d like to point out something that might seem a little  controversial and that is that much of the media comment is designed to  sell newspapers and magazines rather than inform investors.

“*You make more money selling advice than following it.*
*It’s one of the things we count on in the magazine business – along  with the short memory of our readers”*
Steve Forbes, publisher Forbes Magazine at the Anderson School of Business UCLA April 15th 2003

Equally many of the posts on askaboutmoney are simply the opinions of the poster and rarely supported by references, sources or even elementary evidence in support of the recommendations being made.

This kind of speculation about what might happen in the future, while possibly  entertaining, should not be mistaken for prudent investment advice.

*Speculation      *

A hundred years ago French mathematician Louis Bachelier set forth the notion that  investors are always paying a fair price for publicly traded securities  in any market through market efficiency. He asserted that there is no  useful information contained in historical price movements of  securities, and that speculating on future movements based on past  movements would be a zero-sum game before costs, and negative after  costs. 

Bachelier’s work was largely ignored until the mid-20th century when  notable financial scientists found empirical support for the assertion  that prices reflect all information that can be known and that new  information (which is unknown) is the only impetus for changes in price.  

The body of work came to be known as the Efficient Market Hypothesis.
*
“Practically speaking, individual investors should treat the market as  unbeatable and realize that when they try to beat it because it is  inefficient, they are likely to injure themselves, rather than gain at  the expense of another..” *

- Meir Statman, Professor of Finance, Santa Clara University and  author of What Investors Really Want,“Meir Statman: Amateur investors  expect impossible”, 

So, let’s look at some evidence around what has been going on in the markets:

*Deficits, Debt, and Markets
*
As government spending hits record levels around the globe, some  politicians, economists, and pundits are warning that rising  indebtedness may drag down economies and financial markets. This issue  has raised concern among investors who assume that a government’s fiscal  policy is closely linked to the country’s economic growth and market  returns. 
 The graph below shows the projected state of indebtedness around the  world.1 Over half the Organization of Economic Co-operation and  Development (OECD) member countries expect to have debt-to-GDP levels  above 70%—and the US, Canada, and the UK project debt levels exceeding  80% of their economic output.

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Government efforts to stimulate these economies out of recession may  partly explain this level of borrowing, which is high compared to  historical levels. But longer-term trends such as aging populations,  expanding public pensions, and rising health care obligations are  compounding the fiscal challenges of these countries.

Global investors may be particularly concerned about the economics of  government spending in countries around the world. So how does public  debt affect economic growth and market returns? The evidence might  surprise you. Although rising levels of government debt create headwinds  for economic growth, a country’s deficit and debt levels do not seem to  adversely impact capital market returns. 

Let’s explore these issues by addressing a few popular questions about sovereign debt:

*Do rising deficits drive up interest rates?
*
Yes. As borrowing increases, a government must offer higher interest  rates on its debt to compete for capital. The public sector consumes  savings and investment that may have otherwise fueled private sector  growth—a displacement of resources known as the “crowding out effect” in  economic theory. Additionally, as debt levels rise, market concerns  about higher default and inflation risks put additional upward pressure  on interest rates.

Consistent with this theory, our analysis shows that current interest  rates reflect expectations of future deficits2 but that current  government deficits and debt do not predict future interest rates or  bond returns.3 So, long-term interest rates rise when the market expects  future deficits to increase. However, today’s interest rates and bond  prices already reflect information about current government spending,  and markets quickly incorporate new information.
*
Do higher deficits hamper economic growth?*
 It depends on a country’s debt level. Using World Bank data from 1991  to 2008, we compared current deficits to future GDP growth in  sixty-seven countries and found an increasing interactive effect between  deficits, debt, and economic growth. High-debt countries that run  deficits are more likely to experience lower economic growth over the  next three years. But numerous forces may affect a country’s economic  direction, and deficits explain only a small fraction of the variation  in future GDP growth. The combination of high debt and deficits can  create headwinds for economic expansion, but slower growth is not  guaranteed. 
 So investors are justified in having some economic concern about  higher government spending and borrowing. But the impact on investment  returns is less clear. Let’s now consider the potential effect on equity  markets.

*Does low economic growth result in diminished equity returns?
*No. This relationship can be tested by comparing a country’s  GDP growth to its equity market performance in subsequent years. We  conducted this analysis using all the developed countries in the MSCI  universe, divided each year into high-growth and low-growth “portfolios”  based on growth in real GDP. There was no statistical difference  between the annual returns of equity markets in high-growth versus  low-growth countries. In fact, low-growth countries had slightly higher  average returns than high-growth countries. 
 The graph below illustrates this relationship in terms of a dollar  invested in high- versus low-GDP growth portfolios from 1971 to 2008.  The low-GDP growth portfolio’s higher annual return would have generated  slightly more wealth for the period. The chart details the average  annual return and real GDP growth for both groups.
 [broken link removed]

Applying the same methodology to the MSCI emerging market countries  shows an even greater return difference, although the data period is  much shorter (2001 to 2008). The return of the high-growth country  portfolio averaged 19.77% (with 2.5% GDP growth), versus 24.62% for the  low-growth portfolio (-4.94% GDP growth). 

Other research has confirmed a weak relationship between a country’s  economic growth and its stock market returns.4 Several factors may  contribute to this decoupling effect. For one, with globalization, a  multinational company’s stock price in its home market may not reflect  economic conditions in other countries. Also, the fruits of economic  growth do not accrue exclusively to public companies, but also to income  earners, non-public businesses, and private investments.

Finally, consider that risk, not economic growth, determines a  stock’s expected return. Research indicates that this principle also  applies to a country’s stock market.5 Similar to value and growth  stocks, markets with a low aggregate price (relative to aggregate  earnings or book value) have high expected returns, and markets with a  higher relative price have lower expected returns. Consequently, while  holding a “growth market” may be a rational investment approach,  investors should not expect to earn higher returns by tilting their  portfolios toward countries with high expected GDP growth.

*Do fiscal deficits lead to currency depreciation?
*No. It is commonly believed that large fiscal deficits and high  debt cause a currency to depreciate as the government borrows more from  foreign sources, and investors who are concerned about inflation and  default risk flee the currency. Although recent developments in the US  would seem to support this relationship, there is less convincing  long-term evidence that deficits affect currency rates. During the 1970s  and 1980s, the dollar strengthened while the government increased  deficit spending.6 This observation is consistent with academic studies  concluding that exchange rates appear to move randomly, and there are no  models to date that can reliably forecast currency returns.7

*Conclusions
*Some economists claim that developed market countries are  moving into an era of high government deficits and lower market returns.  While higher deficits and debt may impact a nation’s interest rates and  economic growth to some extent, the investment implications are not  easily discerned. History does not offer strong evidence that current  deficits predict future bond or equity returns in a country’s financial  markets, or anticipate short-term currency movements.

Investors should assume that stock and bond prices reflect all that  is currently known and expected about government spending and debt,  economic growth, risk, and other issues affecting performance. 

*So, what should savers and investors do now? An approach based on prudence*

Reaching understanding on the right way to invest often starts with  studying bad investment decisions. These lessons would be far less painful if they were built on others’ experiences. As I often say to clients;"the market has a habit of handing out expensive tuition bills to those who fail to heed the warnings".

To a greater or lesser extent, we are all suffering from the poor investment decisions made in Ireland in recent years.

Recent events in Ireland provide case studies on what can go wrong  when a wealth-building strategy is built on too much debt, too little  diversification and too little awareness of risk.

Ireland in recent years, for whatever reason, became heavily  dependent on a couple of industries – namely construction and banking.  The IMF 8 in a report this year described the causes of these imbalances  as “rapid credit growth, inflated property prices and high wage and  price levels”.

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Now, an economy is clearly much more complex than any individual and  the ability of governments to control the composition of growth is  limited. But there still are lessons here for individuals if they fail  to spread their wealth-building strategies across different asset  classes and diversify within those asset classes. 

Becoming more diversified leaves you less open to idiosyncratic risks  that are related to one sector or one company or one asset class. And  you can do this without significantly compromising your expected return.

Another lesson from Ireland is not to base your investment strategy only  on what happens during the good times or only in the bad.

Real interest rates in Ireland were very low before the crisis, which  encouraged people to load up on debt. That debt now has to be repaid in  an environment of falling prices, higher real interest rates and  sluggish growth. The problem was too much focus on return and not enough  on risk.

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For individuals, the take-home for this is that leverage, while  increasing the potential upside in boom times, magnifies the downside in  the bust. So people swing from greed to fear and back again.

A better approach is to have a realistic, measured and long-term  approach to risk. This means that during rising markets, you don’t take  on more risk than you originally intended. And it means that during  falling markets, you don’t become more risk averse than you first  planned.

A third lesson is the importance of liquidity. This means you can quickly turn your investments back into cash if you need to.

Ireland’s banks got into trouble because their loan portfolios were  dominated by speculative property ventures. When the crisis hit, their  recourse to short-term funding dried up and they were unable to call in  loans because of the illiquid nature of the assets.

For individuals, the lesson is there is value in having portfolios  with sufficient liquidity. That means publicly traded equity and fixed  income securities that can be turned into cash if needed. 

The lessons of the past:
• Holding concentrated portfolios exposes you to risks you don’t need to  take. Diversification is the answer, both across and within asset  classes.
• Basing your strategy only on the good times means you can end up  taking more risk than you intended. And grounding your strategy only on  the bad times means you can miss real opportunity. A balanced approach  to risk and return is the answer.
• Finally, staking everything on illiquid assets can leave you high and  dry when you need quick access to cash. So keep a proportion of your  portfolio in liquid investments.
• All these strategic decisions are ones you should make in consultation  with an adviser who understands your risk appetite, personal situation  and goals and preferably operates on the basis of a transparent fee.

Endnotes:
1.  The Organization of Economic Co-operation and Development (OECD) is  an international economic organization of thirty-three countries founded  in 1961 to stimulate economic progress and world trade. It defines  itself as a forum of countries committed to democracy and the market  economy.
 2. Today’s interest rates reflect expectations of future deficit  levels. The analysis compared five-year US deficit projections (as a  percent of GDP) to yield spreads (five-year US Treasuries minus  three-month US Treasuries) from 1992 to 2010. The yield spread increased  29 basis points for every one percentage-point increase in projected  deficits. Data sources: Baseline projected deficits from the  Congressional Budget Office; yields from Federal Reserve Bank of St.  Louis.
 3. Today’s deficits do not predict tomorrow’s interest rates or bond  returns. Regression results show that current deficits do not reliably  predict changes in the five-year US Treasury yield spread (1982 to 2009)  or future bond returns (1947 to 2009). Data source: Federal Reserve  Bank of St. Louis. 
 4. MSCI Barra Research Bulletin, “Is There a Link Between GDP Growth and Equity Returns?” May 2010.
 5. Clifford S. Assness, John M. Liew, and Ross L. Stevens, “Parallels  between the Cross-Sectional Predictability of Stock and Country  Returns,” Journal of Business 79, no. 1 (March 1996): 429–451. Their  research uncovered strong parallels between the explanatory power of  aggregate book-to-market and aggregate earnings-to-price ratios for  country stock markets.
6. Another common assumption is that current account deficits and  currency appreciation are related. (The current account balance is the  difference between a country’s receipts and payments to the world. This  account is composed mostly of the balance of trade, with net income and  foreign aid playing a smaller role.) Academic research yields equivocal  results on whether this relationship holds.
7. Richard A. Meese and Kenneth Rogoff, "Empirical exchange rate models  of the seventies: Do they fit out of sample?" Journal of International  Economics 14, no. 1 (February 1983): 3–24. Kenneth Rogoff and Vania  Stavrakeva, "The Continuing Puzzle of Short Horizon Exchange Rate  Forecasting" (National Bureau of Economic Research working paper No.  14071, June 2008).
8. IMF Country Report No 10/209, Ireland, July 2010


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## flatfish (12 Dec 2010)

Well done MARC.  Great article.  I hope to re read it when I have finished my vinyage wine investment .


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