Market crashes are the largest wealth destroyers for investors and Australia's largest superannuation funds and fund managers took the opportunity at last week's Conference of Major Superannuation Funds to exchange ideas about the lessons learned from market downturns since 1987.
While these funds manage billions of dollars of retirement savings on behalf of many people, there are some salient lessons for all investors.
Bridgewater Associates senior portfolio strategist Jim Haskel said it was important to understand the nature of market crashes.
"Crashes will always occur because of fear and greed. What is crucially important is to understand whether market crashes are temporary or debilitating," Haskel said.
Haskel drew on experiences learned from the 1987 stock market crash and the more recent global financial crisis (GFC).
He found it was debt, and in particular the level of debt, which played a crucial part in whether the recovery was quick and sustained.
"The difference between 1987 and today is that in 1987, while countries had a significant amount of debt, interest rates were high. When the crash came, the US Federal Reserve was able to cut interest rates, liquidise the economy and create a recovery that was sustainable," he said.
"In 2008, interest rates were very low. That made it difficult for central banks in the US and Europe to inject liquidity into the system and create a recovery that was sustainable."
Russell co-chair of global consulting Don Ezra said the GFC had re-taught investors the importance of risk management.
"Risk has a friend called pain. The recent crisis has showed us that we tolerate pain a lot less than we thought we could. Risk management has become more important than just seeking return," Ezra said.
However, he said investors could still rely on their intuition when balancing return with risk, particularly during extreme times in the market.
"Opportunities often emerge when markets are at their extreme points. Here, investors could rely on a number of market models to determine where the opportunities are," he said.
He said rather than looking at risk in the overall portfolio, investors should analyse their exposure to each specific asset class.
"Investors should check their exposure to equity versus bonds, or domestic equities versus international equities. This will give you greater clarity," he said.
Marry a model instead
Haskel said he believed the extreme market cycles, such as the GFC, had made modern portfolio theory redundant. In fact, he said he believed modern portfolio theory was dead.
However, he said the age-old lesson of diversification remained crucial for investors, but active management must be adopted as well.
During his presentation, Haskel took a poll of the conference audience and found over 60 per cent believed avoiding concentration in a single asset class was the most important factor in protecting an investment portfolio.
Yet, he said the typical Australian investment fund portfolio was largely exposed to equity risk.
"Australian portfolios are similar to US portfolios - they are both heavily concentrated in equities, which leaves them exposed to stock risk. If stocks are not in favour, then there will be a problem with the portfolio," he said.
"Combining good active management with more balanced asset allocation represents the best chance for investment success."
Ezra agreed that caution should be taken when relying on models. He quipped that a colleague of his, an actuary, advised the best use for a model was to marry one who drew their earnings from walking the runway.
He took a practical approach to financial modelling and said investors could use a multitude of models to ascertain risk and return, as opposed to adopting a single model.
"All models are wrong, but some are useful," he said.
