Dangers of trying to catch a falling knife

LONG term investors are understandably nervous about the weeks and months ahead in the financial markets and for the safety of their hard earned savings. At some point, the music is going to stop – Greece is facing an imminent default, and many will have seen Dexia’s trials earlier this week as the first of many.

Risk asset classes are falling into close correlation and government engineered inflation is picking savers’ pockets – so how should investors react to a black swan event that finally tips the markets over the edge?

We turn to two investment management veterans for their advice.

THE CASE FOR DIVERSIFICATION
Simon Lough is chief executive of Heartwood – after 12 years in investment banking, he joined Cripps Harries Hall in 1996 to open the London office, becoming a director of Cripps Portfolio (now Heartwood) on its establishment in 2001.

Having successfully steered clients’ funds through previous downturns, he warns of the difficulty of trying to catch the proverbial falling knife: “We are very cautious about trying to market time as the academic and empirical evidence shows that this is very hard to do for professionals, let alone private individuals, even in relatively stable markets.” Market timing is particularly difficult in the current market climate – just take a look at Tuesday’s market reaction to Federal Reserve chairman Ben Bernanke’s speech or the mass market sell-off that ensued during the US debt ceiling wranglings. When stocks are being dumped indiscriminately – driven by sentiment and political considerations rather than by the fundamentals of company performance – timing becomes particularly difficult. As a result, Lough believes that it is important to to average fund performance from new investors over a couple of months.

“We believe the key role is to systematically calibrate the amount of risk you can and are prepared to take, develop a strategy and then stick in a disciplined way to that strategy.” Lough views this as being crucial to avoiding what he describes as one of the key traditional weaknesses of private clients – that of getting out of markets at the bottom and then re-entering at the top: “In our case, that will involve a muli-asset approach, as we believe that asset class diversification gives the best long-term risk-adjusted returns.”

THE CASE FOR CASH
Yogesh Dewan is the chief executive and founding partner of Hassium Asset Management and has fifteen years of professional investment management experience. Though he takes a similar stance to Lough, he differs on the issue of maintaining a multi-asset approach in a market down-turn: “In a black swan environment, cash is the only reliable diversifier. The correlations of all other major asset classes – bonds, equities and commodities – would all be at unprecedented levels and the diversification benefits of holding them would be limited.” Despite the current negative real interest rates, Dewan feels that the pay-off (or lack of it) is worth it in order to avoid significant draw-downs in portfolios.

Should investors try to eke out risk premia and chase yield in a downturn? “Our view is no,” says Dewan. “Investors who try and get some extra yield for their cash investments by taking additional risks, such as credit risk, liquidity risk or interest-rate risks, would in our view be doing the worst thing possible.”

Such is the scale of the potential crisis on the horizon, that Dewan advises that investors invest their cash with more than one counterparty and to only choose banks of the highest credit quality – the list of which is slowly contracting. The government-backed Financial Services Compensation Scheme (FSCS) only guarantees savings up to £85,000.

Above all, Dewan advocates that investors do not get caught up in the short-term noise: “Do not trade. Do not speculate. Wait for the dust to settle and only then look to allocate riskier assets.”