1. How to overcome behavioural biases that make it hard for investors to make the right choices
2. The difference between strategic and tactical asset allocation
3. The importance of having a sufficient investment time frame for stock market investing
PRESENTER: Mike Coop, taking advantage of volatility sounds very attractive, but should everybody be doing it?
Why volatility can be a poor indicator of risk
MIKE COOP: Well for people who are happy to take risk, for people who’ve got a long enough time horizon, yes. For people who get very nervous when they see their portfolio value dropping, for people who don’t have a time horizon or who are really investing for income, it’s probably not so appropriate. So it’s very much a case of understanding how much risk you’re prepared to take in terms of being exposed to falls in value and whether you’ve got a long enough time horizon to wait for a recovery.
PRESENTER: You mentioned volatility and risk there; are the two synonymous?
MIKE COOP: People have tended to think they’re one and the same thing, and I think that’s partly because of how modern portfolio theory has evolved with efficient frontiers using standard deviation as the metric of risk. If you speak to investors, what you tend to find is that they don’t really respond to volatility so much as respond to loss. And what does you in as an investor is a permanent loss of capital that is large, because that sets you back. Even if it’s not a permanent loss in the sense that share prices fall heavily then might eventually recover, we’re generally not wired to deal very well with that, and the tendency people have is they feel a lot of pain when they see a loss, and what they naturally seek to do is to get rid of that pain by selling the asset.
So when we think about risk we think about permanent loss of capital. Volatility doesn’t necessarily mean that. It can mean that but very often you get that permanent loss of capital when assets become extremely expensive. A good example of that is what happened in the US in 1999 when tech stocks, the share prices went through the roof, and many of those companies, which still exist today, still make money, have never had share prices go back to the levels that we saw back then. So you had literally a permanent loss, quite a large loss, and that’s because the assets are very expensive. And the interesting thing about that is volatility didn’t tell you much about what was happening at the time.
When you get bull markets that reach very high levels you tend to get an upward trajectory of the price of the asset that’s quite smooth. So that tends to mean volatility as we measure it, which is really the swings, the short-term swings, you don’t get much of that. So often assets that appear to have quite low levels of volatility, because you’ve been in a long bull market, might look as if there’s not much risk there, but actually when they become extremely expensive the risk of you losing money is much higher. So there’s a distinction between risk as loss, volatility as fluctuations, and quite often volatility is in fact giving you the wrong impression about the future risk of an asset. And I mentioned one example which is where you get a bull market, a long protracted bull market that share prices go up; the other of course is that you get a sharp fall, a heavy fall in the price of an asset.
So the irony is imagine if you had a share price of this, this or this, at this point is might be trading at a P/E of 40, very high. It falls heavily in price. The way volatility is calculated all of a sudden volatility will spike. And as that asset falls heavily and it fluctuates at the bottom, it will appear to be very volatile. And if you think volatility means risk, you will miss out on what could be an opportunity to actually when we think about volatility we’re trying to work out is this asset actually risky or is it actually cheap? And quite often assets that become very volatile are actually worthwhile you looking more closely at to see if these assets have been sold off too much.
PRESENTER: So in a nutshell then higher levels of volatility are a flag there might be an opportunity. Does that tend to happen only after the fall, or do you start to get that higher volatility before an asset class falls off a cliff?
MIKE COOP: It’s a good question. So just taking a step back, of course when we compare different asset classes we know that shares are more volatile than property, and property is more volatile than bonds. So within that, you know, for asset classes there is a relationship between the volatility of an asset class and its potential for a large fall. Of course even saying that you have to allow for illiquid assets which by their nature don’t appear to fluctuate as much, but actually can hold just as much risk. So I’d say that relationship is still one that you need to be aware of and hold when you’re setting your strategic asset allocation. What we’re talking about here is if I look at each asset and say to myself how volatile is it compared to what I normally expect? And what I’m really saying is if you look at periods of crisis typically they’re associated with asset prices falling heavily, and when they fall heavily they can fall to levels that are low compared to their fundamentals, and can offer some attractive long-term buying opportunities. So at that point volatility is telling you something, and saying to you it might be worth having a closer look at this.
The importance of assessing an investor’s risk tolerance
PRESENTER: So when you’re running a fund, whatever fund it happens to be, is your job to get the highest returns you can, or to get a pattern of returns that persuades your investors not to leave in the first place?
MIKE COOP: Well each investor has their own level of risk that they’re able to tolerate. Each investor has their own timeframe and their own objectives. What we as fund managers do is to design multi-asset portfolios to allow investors to achieve their objectives, so whether it’s accumulating assets or whether it’s drawing down income in retirement. So that is the first thing people have to identify what’s appropriate for them with the appropriate advice. For us it’s then a job of saying look investors have identified that this is the amount of risk that’s appropriate, and we have funds that we run that are multi-asset funds from relatively low risk to relatively high risk. So what we’re then saying is not just what is the best return that I can get from taking that much risk, but also is it worth it? So I’m looking at the reward for risk.
To give you an illustration, it’s an exaggerated illustration just to demonstrate the point. I could invest in government bonds and maybe it gives me a yield of 1%. I can invest in high yield corporate bonds, and let’s just say that high yield corporate bonds only give me .25% more than government bonds. So it’s not giving me very much but it is giving me a higher return. I have to ask myself is it worth taking that risk? So it’s not just a case of going yes I’m going to put my foot to the floor in terms of putting the accelerator down on the car and drive as fast as I possibly can because my car allows me to drive at 200mph. The parallel being I’ll take the maximum amount of risk that I can take, that the investor wants me to take. I have to ask myself the question is this the right time to take risk, am I being rewarded for taking that risk?
Now there are points in time when everything’s very expensive and you have to think twice about whether it’s worthwhile taking that risk. And you may actually be better off not taking the most risk, and in fact taking as little risk as you can within the range that the investor or the fund that you’re running has been set for you. Because actually everything’s expensive, and when it’s really expensive we know from history that it’ll eventually revert back to more normal levels of valuation. And when it does if you don’t have cash there or defensive assets that you can use to buy it, you won’t be able to take advantage of it. So I guess what I’m saying is we don’t just run the maximum level of risk taking that is relevant for that particular multi-asset portfolio, we think hard about what sort of return are we getting for that risk, how much extra return am I getting by taking a bit more risk? And that’s where in our process it’s important not just to get the long-term strategy right about the right sorts of assets, and having enough of those assets to achieve your goals; it’s also having some latitude to take advantage of extreme conditions.
Generating income in a low yield environment
PRESENTER: We’re seeing at the moment with investors who are looking at income funds as distinct from long-term growth funds. Depending on those income or those growth mandates, how does that affect how much you as a manager are looking to take advantage, or avoid market volatility?
MIKE COOP: Well the spectrum of income funds ranges from let’s call it perfectly matched portfolios, which are designed to produce a specific level of promised income. And as anybody knows who’s looked at annuity funds, you know, that ultimately is driven by the yields that are on offer for assets that are relatively safe. So there’s not an awful lot of leeway there on those ways of generating income, but we also know that because yields are so low on high quality debt that actually there’s a greater focus on using multi-asset portfolios as ways of generating income as well, because you can obviously get income from equities, from real estate, as well as from bonds and indeed from some alternative investments like infrastructure.
So increasingly you need to think about that as a way of generating income, and when you get into that domain the same issues apply in terms of managing portfolios and managing risk to achieve client objectives. So it’s both the income and also the risk that you’re taking on the capital value of the portfolio.
Buying low: the disciplines needed
PRESENTER: And all this talk about taking advantage of market volatility, it tends to apply buying things cheaper than you normally would do. Isn’t that a bit of a mug’s game trying to time the market?
MIKE COOP: There’s graveyards full of investors who’ve tried to do it and come a cropper. So yes it’s a difficult task. And the reason it’s a difficult task is because, not everyone, if everyone bought at the bottom you wouldn’t have a bottom of the market. If everyone sold at the top you wouldn’t have a top. You’re effectively going against the crowd at extremes. The behavioural finance literature tells us all the biases that we have, and how hard it is for us to act independently, how hard it is for us not to get caught up in the over-optimism and excessive pessimism by extrapolating what’s happened to us recently, by being overconfident, by looking for evidence that confirms our expectations, rather than trying to find, to see whether how could we be wrong, and why could we be wrong, and having that rigour and discipline.
So in order to do it you have to recognise that you’re taking that on, and you have to ask yourself whether you’re wired to cope with that, and put in place processes to try and manage that risk of getting effectively caught up. The second thing you have to do is analytically be able to answer the question is this really cheap, is this really expensive? And people typically start off that exercise by simply looking at history and looking at averages of various metrics. The challenge with that approach is that you have to understand the history well enough to know how relevant it is for the future. How relevant is that average P/E level or average yield, whatever metric you’re looking at, for the future. And that’s not as easy a question as might first appear to be. So for some economies, markets that have changed fundamentally, some of the emerging markets and China in particular, you could put the case strongly forward that that’s the case.
So you need to do your homework, you need to think carefully about the history and how relevant that is for the future. So you can make the mistake of just extrapolating history when it’s not relevant. The other mistake that people tend to make is it’s different this time. And that tends to occur, that thinking tends to occur at the very, when markets have been in a long bull market and prices have gone up a lot over a long period of time, or indeed they’ve fallen heavily over a sustained period of time. And that’s when people’s thinking gets influenced by the recent price history. And that’s also a pretty big trap. So in order to deal with that you have to both set yourself up analytically to try and understand what’s happened and why, and the relevance of history – to put it in a nutshell what you’re trying to do is, Warren Buffett very succinctly described as being greedy when others are fearful, and fearful when others are greedy.
So this is the challenge. It’s not easy to do because you have to have a certain amount of patience. And if you’re a fan of Nassim Taleb you’ll be familiar with the idea of randomness in terms of what happens, how people behave and how difficult it is to forecast the future. And you need a degree of humility. If you’re familiar with Ben Graham and his advocates of value style, you’ll also be familiar with the notion that you can get it wrong, and that what you’re looking for is sufficient margin of safety in the analysis. Such that even if you’re wrong, even if you’re unlucky and if there’s a certain randomness that you can’t forecast that works against you, that the odds are still sufficiently tilted in your favour such that if you take, if you buy things or indeed sell things in general the outcomes overall are likely to be favourable.
So these are the challenges that you face in trying to set yourself up to undertake this activity. It’s not something that you want to necessarily start off thinking that everyone can do, but if you want to go down that path there’s no reason you can’t do it. As Buffett says it’s simple but not easy.
PRESENTER: Well have you got an example of how you would do things say at the Prudential Portfolio Management Group, because you must have in that room a massive collection of incredibly talented people, more PhDs per square foot than most places would have. People have got a sense of responsibility for money there. People’s salaries, bonuses, lives depend upon getting it right. How do you take all of that emotion, potential overconfidence, and put a system in place that stops people behaving like humans when they shouldn’t?
MIKE COOP: Yes, well there’s a certain focus of our analysis on trying to understand investor sentiment. Let’s call it how, what investors are expecting, how they’re positioned, and in general trying to ascertain the level of optimism or pessimism. And to produce research and analysis that allows us to do that in a systematic way so that it’s not a case of just walking into the office and trying to guess that; we’re really trying to instil an independent, more objective form of analysis that indicates to us whether there’s a degree of excessive optimism or pessimism. You have to be sceptical about your ability to do these things, and look at this from a wide variety of angles. As well as that you also have to do your fundamental economic and cashflow analysis on assets, and understand the longer term environment you’re in. And we’ve had conversations around the high levels of debt that there are around, the low level of interest rates, the growth environment, the challenges that are posed from monetary policy etc. etc.
So some understanding of the environment you’re in, and the ability to analyse both what that means for economies, for the earning power of companies, for inflation. Those are the sorts of analysis. You need to be honest with yourself, you need to be prepared to debate and discuss these things. So these are some of the things that we do to help us with that task of identifying extremes that we think are overdone and provide opportunities that we can take advantage of over a medium to long term basis.
Building a diverse portfolio
PRESENTER: It sounds it’s an environment where you want to be imperfectly right rather than precisely wrong is what you’re going for. How many bets do you want to take at any one time around an issue such as market volatility?
MIKE COOP: Well the way that the investors who’ve been able to continue to do this well have typically done it is it’s a combination of understanding and focusing on the bigger opportunities that present themselves, and allowing yourself to do the deep dive that you need to do to check whether you’re right and cover all the bases, and have the patience to be able to continue with those positions. So that requires quite a lot of time and effort and analysis to build conviction to the point where you’re prepared to take positions and be patient, and not get buffeted by short-term moves. There aren’t that many of those sorts of opportunities. Then I think there are probably other sorts of opportunities as you cut the world into smaller and smaller pieces.
So imagine if you started off just going oh well I’ll think about the world as one equity market, one bond market, one currency, and then you broke the market into increasingly granular pieces to see if you can identify mispricing. And so once you go down that route then I think it is possible to uncover a broader range of opportunities within asset classes, and potentially across asset classes and geographies.
Strategic and tactical asset allocation
PRESENTER: And we hear a lot these days about tactical asset allocation, strategic asset allocation, how do you think about them at the Pru, are they part of the same process, are they very separate disciplines?
MIKE COOP: I think we start off putting ourselves in the shoes of investors who will see an asset allocation. And they don’t care which bit of it’s strategic or which bit of it is tactical; they’re just going to see that asset allocation and then they’re going to see the impact it has on their returns. So we have to look at the total portfolio outcome, and that’s what we’re focused on, is the client’s asked us to do a specific job for them. So that’s the first thing to take into account. Our strategic work is all about looking far and wide across the world at assets that are suitable for whatever that broader objective is. And because we’re multi-asset investors and because we are fortunate to have operations that are based all over the world, across most continents with teams on the ground covering equities, property and bonds, it does give us the ability to have a look and get access to some of these investments.
So we I guess look by having a broader range of assets globally as we can get access to. We look to combine those in a way that will achieve a client’s end goal of the amount of risk they’re prepared to take and the returns that, or the good reward for that risk, and then there’s ranges that are set to accommodate the fact that you can get mispricing. We would be the first to recognise that there’s inherent margin of error in any of the numbers that go into that type of exercise when you’re analysing strategic asset allocation.
So that’s really how we think about it. It is an asset allocation at the end of the day. And whilst it might consist of looking at opportunities that seem extreme to us outside of what we’d normally expect, and that’s really what those ranges are for, and people refer to that as tactical, but I think sometimes the jargon the industry uses can confuse people. People might have a different sense of what that means. And there are some fund managers who operate a very short-term asset allocation strategy, where they’re seeking to eke out returns every day from very short-term movements. That’s an extremely challenging thing to do. And a lot of those hedge funds that have attempted to do that have really struggled. I think it’s a very challenging exercise.
So for us it’s more about total portfolio outcome, it’s one of the ways in which we look to add value, where we can see a significant sized opportunity within the context of those strategic ranges that have been set, which is really all about trying to get the best likelihood of meeting the client’s goals, and getting the best reward for risk.
The importance of a long-term timeframe and a stable capital base for investing
PRESENTER: You were mentioning there back in the tech boom extraordinary P/Es on the market, but if you lived through it that was quite a long period. If you looked at the, I mean one thing all this behavioural finance doesn’t tell you is when the crash is going to come. How do you set yourself up, even if it might be a two-year period, you’ve got to live every working day of being wrong until you’re very right. How do you size a bet like that?
MIKE COOP: Well there’s no perfect answer. What you’re looking to do as an investor is not to be betting everything on black. Not having everything riding on one decision that you’ve made, or one view you’ve got. So you’re looking for diversity in the portfolio, and diversity in views that you’ve got. And in an ideal world you’d have a whole range of things that you’ve identified which are independent of each other. That’s the ideal world. Quite often though markets don’t present you with a wide range of opportunities, and quite often you have to be aware of the fact that other investors might have the same idea. I think the ability to hold positions for a longer period of time comes down to your starting point. Do you have long-term capital that you can invest? Are you set up in an institution that is prepared to take longer term views? And I think you can rightly say that Prudential has had a history of doing that. And it has articulated that to its clients in terms of what it’s seeking to do.
So I think having that longer term timeframe gives you that ability to hold positions and hang in there, but it’s still a painful exercise to go through, and markets can stay at irrational extreme levels for years. So it’s a balancing act. But I think if we feel that the reward for risk is particularly extreme, then it’s worthwhile being patient.
PRESENTER: So really it comes down to having diversification and a big spread of bets, so that even if one’s not coming off today you’re still generating the risk-adjusted returns elsewhere in the portfolio to allow you to keep it in place.
MIKE COOP: I think that helps, but you have to have a stable base of investor capital. You have to have an organisation that’s prepared to be patient. And if you don’t have an organisation that’s prepared to be patient, and you don’t have stable capital, your investors will leave you or the management will close the positions out before they’ve had time to pay off.
Sell disciplines and cash buffers
PRESENTER: Well I was going to say if you are putting money into the markets to take advantage of market volatility, you’ve got to take it from somewhere. How do you work out what to sell to move on to the next position?
MIKE COOP: So history quite clearly shows that when assets become very extremely overvalued future returns are a lot lower than usual. It also coincides with assets falling the most in price when they become very expensive for reasons that aren’t necessarily apparent at the time, just because those prices were so unsustainable. So typically you’re looking to see which assets look particularly overpriced. And they would tend to be your starting point for things that are going to fund or provide you with some cash. It’s also fair to say if you’re fully invested at all time with no cash and no liquid defensive assets, it’s pretty hard to buy things when markets selloff, because you’ve got nothing that you can sell because everything you own in your portfolio has also sold off.
So the uncertainty about when things return back to fair value when they get extreme, means that you do need to be able to hold a certain proportion of your portfolio in cash and liquid defensive assets in order that you can buy things when they become cheap. And if you don’t have that then you end up with returns that look like this. Whereas I think for investors who want to accumulate assets, if you can take out some of that rise, still have, over the long run good outcomes, but what you’re looking for is a smoother ride, I think being prepared to leave a bit of money on the table when assets get extremely overpriced allows you to reduce the loss that happens when markets revert back to more normal levels. That’s really important for investors who are accumulating assets, because a large loss in the portfolio is going to really set you back.
PRESENTER: Are you a big fan of rebalancing portfolios periodically if you’re a believer in mean reversion?
MIKE COOP: Yes, I mean rebalancing is a basic discipline that means you are retaining the exposures that you think are appropriate. It’s really when conditions get extreme that you need to consider whether you really should be using the full extent of your range to position your portfolio like I said. So if you think equities are extremely expensive then you won’t be automatically rebalancing to your long-term exposure. So you would naturally have a lower exposure than that.
Experience and understanding history
PRESENTER: Given as you see fund managers coming through, investment teams coming through, given the environment we’re in today, as they come into the market today, does that leave them well prepared for what markets might throw at them in the future in terms of the range of experiences that they’ve seen, what experiences they’ve gone through?
MIKE COOP: The challenge that any investor has is that they have experienced whatever’s happened during their working life. And that means it’s more difficult to conceive of other scenarios that can happen. But we know that there can be a big difference in scenarios and outcomes from one 10-year period to the next. So it’s all case of how investors prepare themselves for that, whether they become students of history, which I think we all need to be. Have a good understanding of the structural and long-term changes that are occurring that have ramifications for how assets are priced and the growth and inflation and earnings and interest rates. So there’s no getting away from that, but it’s certainly the case that investors are quite prone to extrapolate the conditions that they themselves have experienced in their working life.
So whether you happen to have a few old people around who have been through a few market cycles, or whether you do the analysis. And the good thing is financial markets in the form they are now have actually been around for several hundred years. There’s quite a rich history that you can tap into about the different types of things that’s happened. And it’s the case that the same things tend to happen over and over and over again with slight nuances around the way in which they happen. And so to that extent you can, if you put the time and effort in, get some sense of a broader range of scenarios and what that might mean than just what you’ve personally experienced.
The changing sources of market volatility
PRESENTER: We’re coming to the end of our time on this, but I just wanted to ask whenever I talk to fund managers they always, the last few years they’re always saying a period of higher volatility than normal. Are we in a period of heightened volatility at the moment, and if so what’s causing it?
MIKE COOP: Well there’s been little outbreaks of volatility around certain events that have happened. But the general level of volatility is not high if you look back at the levels that were there in the ‘80s or the first half of the ‘90s. And if you look at markets as they stand today, you know, implied levels of volatility are not high. Certain markets you could say have become more volatile, but the volatility is probably transferred to some degree to currencies. As monetary policy is reaching the end of the road in terms of interest rate changes, that’s having more impact on currencies. Obviously around Brexit we had quite extreme volatility around in particular domestic plays in equities. But it’s not the case that across the board we’re seeing an extreme level of volatility.
PRESENTER: And are the sources of volatility in markets changing given the world of QE that we live in?
MIKE COOP: That’s a really good question. I think there’s two interesting features of the current environment that are a bit different from the last 20, 25, 30 years. One is the rise of China, which has a large savings pool. And that savings pool is being invested elsewhere and is going through fundamental changes in its own economy that are impacting the exchange rates with knock-on impacts elsewhere. The scale of that is so large, and you have to go back a very long way in history to think of a comparable situation. And that is not as visible as would be the case say with the US. So that is really quite different from what we’ve been used to. And so understanding that and calibrating that is important to setting your views about the environment you’re in and how things will behave.
Secondly, yes, the action of central banks and the extent to which they’ve been involved, particularly in bond markets, has been quite different in developed markets than what we’ve been used to in the last 25 years. Actually it’s not that different to what people who follow emerging markets have seen. So to that extent it’s not unusual; it’s just something that we haven’t seen for quite a long time in some of the developed markets.
PRESENTER: So if you had to sum up your thoughts on volatility, if you had three take home lessons for people on the back of it, what would they be as to how to take advantage of market volatility?
MIKE COOP: So the first would be that if you’re looking at shares in isolation, volatility does not mean risk. Risk is permanent loss of capital. Volatility is just swings of the share price around a fundamental. So the two are different, they’re not the same thing. Now there are times when very volatile share prices can be associated with losing money, but that’s usually after share prices have fallen heavily. So volatility and risk are not the same thing would be the first thing. Volatility of asset prices is higher than – so if I buy shares and I look at how dividends fluctuate and earnings fluctuate, share prices do fluctuate a lot more than the underlying cashflows of companies. And that is, and the reason for that is to do with behavioural biases that people have about extrapolating. There’s also decisions that are made that are flow based that can cause money coming in and going out. So that’s certainly a permanent feature of investing. And the question for investors is whether they can tolerate that.
For some people who are nervous or who don’t like to see short-term fluctuations, no. It means that volatility is not going to present them with opportunities because they won’t have the stomach to take advantage of them. And those opportunities, the volatility are typically going to be assets that have fallen heavily in price. That’s when you get a pickup on volatility as measured by historic returns, as measured by implied volatility typically when it happens. But to us it means that there’s something interesting going on with the asset. If it’s fallen very heavily and volatility is extremely high there might be something in there in the form of a bargain worth looking at. So to us it’s a flag, but you have to psychologically be the sort of person who’s comfortable buying things that fall in price where there might be terrible news around it. So that’s the opportunity if you like, volatility can be associated with assets that have fallen heavily, and there might be some bargains in there.
The third thing is if you’re going to do down that route of trying to use volatility, particularly to try and identify opportunities, then you have to be aware that it’s psychologically quite tough because you’re buying things that are falling. That means you’re likely to be seeing your assets fall in value. We know that the pain of losing money is very real. It’s akin to being assaulted, people don’t like it, and so it’s difficult to hang on to those positions. And typically when you get a large fall in the price of something, that’s essentially with bad news coming out and everyone reacting to it. So you have to ask yourself whether you’re prepared to cope with that psychologically. Secondly you have to also be able to do the homework and the hard work to work out whether something really has become extremely mispriced and extremely cheap, and offers you a good opportunity. And that requires quite a bit of analysis and hard work, as well as patience. And that’s if you get it right.
PRESENTER: We have to leave it there. Mike Coup, thank you.
MIKE COOP: Thank you.