The Future of Investing: Riddle, Mystery Or Enigma?
Investing has always been a game of navigating uncertainty and the only anti-dote to that is a disciplined research-led investment process with continual adjustments or rebalancing as the macro situation evolves

By Rehan Syed

Perplexed by the recent crisis, many ask me: how will investing change? A tall question, without a short answer. It is safe to predict that in the decade ahead risk will reprice (it already has), innovation will pause, regulation will rise, leverage will languish and, circling back, risk will be rethought. As the economist, formerly known as ‘maestro’ Greenspan testified recently, “The modern risk-management paradigm held sway for decades (but) the whole intellectual edifice, however, collapsed” in 2008. The decade ahead will surely be transformational, although we don’t fully know yet how. Markets can only be understood backwards, yet we invest leaning forward. One thing is for sure, “We can’t solve problems using the same kind of thinking we used when we created them”, said Einstein. Much must change and my prescription follows, centered around trust, innovation, globalisation and investment discipline.

Restore trust
This is clearly where to start. A lot was risked and quickly lost in recent years. Not just immense personal wealth but, more importantly, slowly-nurtured institutional trust. Eminent observers have eviscerated the banking industry as “evil concealed within a widely accepted business model” and an “administrative economic massacre of such proportion that it constitutes an economic crime against humanity”, in the recent stinging words of Shoshana Zuboff, a reputed retired Harvard professor. As many struggle to understand the chaos and call for a global banking renaissance, the words of Voltaire remind, “God is a comedian playing to an audience too afraid to laugh”; our residual risk is irreverence.

Redirect innovation
In the last quarter century of what was labeled the ‘Great Moderation’, we possibly saw more financial innovation than in the past century. Much of it was beneficial. Yet the undesirable crept in, leveraged up and overwhelmed. In the past generation, bank leverage ratios rocketed from 5x to 15x with some investment banking divisions running at 50x. The legendary Benjamin Graham’s famed “margin of safety” disappeared from the banks that once preached it. The financial services sector has expanded from four per cent of US GDP in 1980 to eight per cent of GDP in 2008, from having none of its firms included in the Dow Jones index of 30 to having 3, from weight of below 10 per cent in the S&P 500 index to a peak of 35 per cent in 2006 and back down to about 12 per cent today. The moral hazard of bailing out 30x leveraged long term capital management in 1998 came home to roost a full decade later with Lehman and AIG. Innovation must continue globally but on the axes of macro and micro risk management – especially fixing the mismatch between global finance and narrow national regulation. Previously ignored prescriptions on risk management must be revamped and implemented, such as those outlined by Yale’s eminent Robert Shiller in his research paper ‘Radical Financial Innovation’, published presciently early in 2004, or by the ‘messianic’ billionaire George Soros in early 2008 in ‘New Paradigm for Financial Markets’, again clairvoyantly penned before Lehman’s epic collapse.

Reaffirm globalisation
At the recent G20 summit the “G2” mattered most -- America and China are key to critically sustaining and extending globalisation. The once-soaring eagle must continue its awkward dance with the restless dragon. But the largest beneficiary of globalisation heretofore, China, is under pressure to revalue its currency and further open its consumer markets. With its centralised and opaque governance structure, there is justified fear about the corrective course it will pursue if its current aggressive stimulus programme fails to stoke consumer spending which is a key success factor for sustainable recovery. In the battered US, there is a push in Congress for some form of protectionism as payback for the electoral support of the unions; it will be Obama’s test and formidable challenge to stand up to the extreme left.

In the heart of capitalism, a credible US public opinion survey in 2009 produced incredible results: that only 53 per cent now believe capitalism offers a better economic model and 20 per cent prefer socialism. In red-capitalist China, which witnessed over 60,000 social protests in prosperous 2006, what will be the consequence of the twenty million and counting who have lost employment in the past year? As the French will confirm, most revolutions start off as bread riots. During times of terrible travail, societies make hasty, large and often poorly conceived decisions; Obama’s recent ‘Buy American” provisions are ominous and incongruent with the fact that over half of S&P 500 company profits are harvested overseas. The blunderous 1930 Smoot-Hawley act was enacted despite over a thousand professional economists and eminent business leaders, including the CEO’s of Ford and JP Morgan, lobbying and pleading against it. A painful four years later it was partially reversed with Roosevelt’s Trade Agreement as part of the New Deal, but it was not until the GATT agreement of the 1950s that global trade was fully resurrected. With global trade a far greater contributor to economic well-being today, we can only hope that this time around protectionist history will neither repeat nor rhyme.

Recommit to discipline
The more things change the more they stay the same. One constant in the investment world is that discipline pays. Since there are large uncertainties regarding the direction of innovation and the trajectory of global capitalism, our investment portfolios should be sufficiently diversified between risky and safe asset classes and at all times cushioned with risk-lowering hedging techniques. Consider the current debate about deflation and inflation and its implications for portfolio construction since the asset classes and financial instruments to own in these widely disparate scenarios differ substantially.

Which camp is fundamentally correct? The pessimists predict a near-Japanese-style extended period of deflation since they view the current stimulus plans as insufficient to bridge the wide macroeconomic output gap resulting in structural overcapacity for years. The optimists expect the recovery to take hold later this year and growth, albeit below trend, to sustain even past the one-time benefits of various stimuli. Yet these optimists will turn pessimist when inflation takes root a couple of years hence. Which scenario to account for in your portfolio? Depending on your risk profile and investment horizon, you might need a diversified portfolio which incorporates some hedges for both. If extracting retirement income from the portfolio over the next decade or longer is a requirement, inflation hedging and income immunisation strategies should be used. If the investment horizon is long and there is no income requirement, a growth oriented portfolio with a few deflation hedges can be created to take advantage of distressed market pricing.

In conclusion, investing has always been a game of navigating uncertainty and the only anti-dote to that is a disciplined research-led investment process with continual adjustments or rebalancing as the macro situation evolves. More so than ever before, what lies ahead is unknowable. As Churchill once opined about Russia, so can we today about the investment decade ahead, “a riddle wrapped in a mystery, inside an enigma”. The key is investor welfare.

The author is the head of portfolio management at the ABN-Amro private bank in Dubai. The opinion expressed here are personal and not necessarily those of his employer.

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