With the UK population being handed ever greater control of their pension pots, whom among the professionals might they reasonably pick as a role model when they think about investing their money? Perhaps not the world’s giant institutional funds, if the recent Financial Times article Big investors need to take more risk is anything to go by.
Highlighting this Bank of England report from last year, the piece suggests the willingness of life assurers and pension funds to bear investment risk has declined dramatically in recent decades, adding: “The proportion of investments held directly in equities by these institutions has almost halved since the late 1980s, from nearly two-thirds to just over a third.”
The article’s authors, Ian Goldin and Ashok Gupta, who were actually both part of the working party behind the report, point to “evidence that excessive reliance by the regulators, accounting bodies and the industry on mark-to-market and other short-term measures has exacerbated the impact of the economic crisis by encouraging life companies to act pro-cyclically.”
In the US, France and indeed the UK, it would appear institutional funds have “invested in the short term in a way that exacerbates market movements, or in the medium term in a way that exaggerates the peaks and troughs of asset price or economic cycles”. “The very institutions that might be expected to act as countercyclical balances in peaks and troughs are failing to do so,” tut Goldin and Gupta.
They go on to argue that “significant industry herding is evident within the world of defined benefit pensions”, much of which is driven by “two fundamental misreadings of the risks to which long-term investors are exposed”. One of these relates to liquidity and the other to many investors’ fixation with market volatility.
As Goldin and Gupta point out, a focus on the latter “fails to distinguish between the risk of permanent loss in the value of investments and asset price volatility. After prices have fallen significantly is often a good time to buy, even if market volatility is high. Yet this is precisely when mark-to-market principles make it hard for institutions to buy equities.”
In contrast to the life assurers and pension funds, individuals in the UK are becoming less encumbered by red tape and, as they gain more control over their pensions, they will be in a position to take a truly long-term approach to investing. With that in mind – and with a view to avoiding the mistakes of the institutions – we would propose Warren Buffett as a far better role model.
As it happens, the Sage of Omaha has addressed the topics of volatility and long-term investing in his most recent letter to shareholders in his Berkshire Hathaway investment vehicle. After acknowledging that “stock prices will always be far more volatile than cash-equivalent holdings”, Buffett points out that relationship can change once you factor in time and diversification.
“Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions,” he continues. “That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk.”
To Buffett’s way of thinking, the great majority of investors “can – and should – invest with a multi-decade horizon” and “their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.
“If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things.” Which rather brings us back to those institutional investors. It is of course your choice whether you follow their lead or Warren Buffett’s but, here on The Value Perspective, we have no doubt who we would prefer as a role model.