Don’t be a pig!

I had (another) argument with my mother-in-law recently when she stated that it was a “scientific fact that sons are always taller than their mothers” (it helps to know an example where this is not the case). While this may be generally true, it is not always the case, in fact, if a wife is taller than her husband, then it is likely that she will be taller than her son. And if a father is taller than his father, then it is likely that his son will be shorter than him. It is all part of the wonderful phenomenon known as mean reversion which was initially proposed by Sir Francis Galton (a distant relative of Darwin). His “thesis” was summed up as follows “It appeared that the offspring did not tend to resemble their parents in size…to be smaller than the parents, if the parents were large; to be larger than the parents, if the parents were small.”

This simple concept of reverting to the average applies to many things in life and one of the very useful places is investing, and more specifically asset class returns. According to the principle of mean reversion, while there may even be extended periods where asset classes produce incredible returns, they will eventually revert to the average return for that asset class.

So I read with interest, the report in business day recently that stated that the FAIS Ombud has declared that Sharemax was nothing more than a “Ponzi Scheme” and she has ordered the advisor who sold the investment, to compensate the investor (http://www.iol.co.za/business/business-news/sharemax-nothing-but-a-ponzi-scheme-1.1462323). While this potentially has massive implications for the financial advisor fraternity, it is not why it caught my eye.

In the article, the Ombud is quoted as saying “The directors of Sharemax and FSP Network were aware of the fact that the scheme was both illegal and not commercially viable and yet they recklessly took investors’ funds.” The journalist then added “FSP Network, trading as Unlisted Securities South Africa (USSA), was set up to market Sharemax products through a network of brokers and was responsible for the conduct of their representatives, who almost without fail “targeted pensioners ” (emphasis added).

While it is true that many pensioners have been victim to yet another scheme, to say that they “targeted pensioners” is probably a bit unfair and this is where the significance of mean reversion comes in. Many pensioners who have been fearful of markets (remember 2008/9) have left their funds in cash and have not been able to generate enough interest on which to live. In an environment of (historically) low interest rates Sharemax was offering a very attractive yield. In fact, too good a yield. Desperate investors (pensioners) threw caution to the wind and jumped in “boots and all” (the higher commission just made it more attractive to advisors to sell).

While there are many directors and advisors who will be held responsible, it is also time that investors shouldered some of the blame. They need to learn to be more realistic about returns. How many more times will naïve investors be caught by an offer that seems too good to be true (and still believe that it is)? Asset class returns revert to the mean and anyone investing because of the promise of exceptional or abnormal returns is going to get burnt.

Consider the table below from Prudential Asset Management which shows the 30 year returns from the 4 major asset classes to December 2012.

Take a good look at the real returns (i.e. the return after inflation has been taken into account). These returns are close to the long term average returns that we expect from the asset classes. Now compare them with the 1 year returns for each asset class.

2012 was an excellent year for the markets, but these are not “normal” returns. I am not predicting a market crash, although I guess if you do it often enough you will eventually be right, but we do know this: the returns for 2012 have been “too good”. In fact, the returns on some of the asset classes have been too good for a while now and at some stage in the future we will have to give back as asset class returns revert to the long term mean.

Investors need to be realistic about returns and would do well to remember this:

• Markets move in cycles: they go up and down over time (not necessarily in that order) and nobody knows exactly when this will happen – no one can consistently time the markets.
• Equity markets should provide out-performance over the longer term (>10 years) but they are also more volatile over shorter periods.
• High risk does not necessarily imply a high return (take gambling for instance).
• Diversification is the prudent way to manage risk. This includes diversification among various asset classes, regions and investment styles.

• Investing is about probability and not prophecy. We don’t know which sector will perform best next nor do we know when the rand will weaken further or even if the market has hit its top (or bottom). We do know, however, on balance of probability (built up over a very long time) that as an asset class, equities will outperform property which will in turn outperform bonds which will outperform cash (after tax). This is a fundamental consequence of the risk/return relationship. The long term real returns from SA asset classes are shown in the table below.

Source: Fortune Strategy, Bradley et al (the international experience is similar)

Any investor who goes into the market, expecting a repeat of 2012 in 2013 is likely to be disappointed. The long term returns from the asset classes are less than what we have come to “expect”. If only investors remembered this, then no matter how good the commission, they would not buy into schemes such as Sharemax. But as the old market saying goes, “bulls make money, bears make money, but pigs get slaughtered” Don’t be a pig!