Soaring gas prices remind us that there is a trade-off between efficiency and resilience – and we often neglect the latter.
I say so because one contributing factor (of several) to the surge in UK gas prices is our lack of storage. This absence is efficient in normal times, as it saves on the cost of maintaining such facilities. But this efficiency comes at the expense of resilience: it makes prices more volatile, ruinously so for some users.
This is however only one example of a trade-off between efficiency or optimisation on the one hand and resilience on the other. In the 1980s and 1990s Equitable Life paid out big profits to its policy-holders and offered high guaranteed annuity rates. That was an efficient way to win business (and, remember, a good reputation) until its reserves proved inadequate to meet the higher costs of those annuities and so it went bust. It was efficient, but not resilient. Similarly, under John Browne, BP increased profits by holding down maintenance spending. Which was efficient, until the Texas City refinery exploding, costing the company tens of millions. And in the run-up to the financial crisis banks had optimised portfolios of mortgage securities and many used low-cost wholesale funding. Which was efficient but not, we now know, resilient.
What looks like efficiency can therefore be in fact fragility and vulnerability to disaster. There’s little point making a nice profit 99 days out of a hundred if the hundredth day wipes you out. It’s better to survive to see the next period than to maximise profits in this one.
This, of course, applies to retail investors as much as it does to company bosses or politicians. We too need resilience. And luckily, it’s easy to achieve this.
Obviously, a resilient portfolio is a diversified one. What’s not so obvious is that we don’t need fancy maths or complicated strategies to do this. I’ve shown that simple portfolios of equities, gilts, gold cash and foreign currency with reasonable but arbitrary weights can do as well as clever professional managers of balanced funds. Which isn’t an isolated example. The London Business School’s Victor DeMiguel and colleagues have shown that the naïve strategy of spreading your money evenly across assets does as well as sophisticated optimisation.
There’s a reason for this. If we are to optimise our portfolio we must know assets’ volatilities and correlations with each other. Past data on these can however be a bad guide to the future. What looks like an optimised portfolio can therefore make big losses when volatilities and correlations change. Which is why so many banks failed in 2008 and why Long-Term Capital Management collapsed in 1998. Rough-and-ready diversification needn’t be so sensitive to unrepresentative data and so can be more robust.
A big part of any such strategy must be cash. Its worst-case loss is simply the real interest rate which is unlikely to be much more than 5 per cent over the next 12 months. Worst-case losses on gold, gilts or equities could however be far more than this. What’s more, cash protects us from the risk that bonds and equities will become correlated and lose money at the same time.
You’ll object here that holding cash is dead money because returns on it will remain paltry even when the Bank of England does eventually raise rates.
You’d be bang right. But that just shows that there’s a trade-off between efficiency and resilience. Efficiency says we must put our money to work. Resilience says we should hold onto it.
Another way to be resilient is to be on guard against the most expensive mistakes. Buying small speculative stocks is one such error. So is holding onto losing stocks in the hope they’ll come good. It’s in this context that the rule to sell when prices are below their 10-month average is so useful. This rule never gets you out at the top of the market and it can lose you money in flattish markets when buying on dips works. What it does do is save us from really horrible losses of the sort we saw during the financial crisis and bursting of the tech bubble. It might not optimise your portfolio, but it will make it more resilient.
You might add to this that we can increase resilience by holding companies with what Warren Buffett calls economic moats – barriers to entry that protect them from competition.
Only up to a point. Kodak had an economic moat until the emergence of digital photography. Nokia had a moat until Apple launched the smart phone. Which tells us that monopoly power doesn’t always protect companies from the long-run forces of technical change and creative destruction. In fact, most companies lack strong moats. Hendrik Bessembinder at Arizona State University has shown that, over the course of their lifetimes, most stocks actually underperform cash, and that a mere 1 per cent of shares account for all the net wealth created by global stock markets since 1990. If it’s long-term resilience you want, you need a tracker fund rather than to pick stocks.
Resilience requires that we do what the Nobel laureate Herbert Simon advised – that we “satisfice”. Rather than chase every penny we should make do with a strategy that won’t fail horribly.
In this sense, we retail investors are lucky. The fund manager who holds a resilient portfolio will lose business in good times to the lucky one who chases risk. The company boss who avoids debt and is careful to maintain his plant well will be criticized by investors and analysts for not cutting costs. And the government that ensures there’s spare capacity in the NHS will be accused of wasting tax-payers’ money. We don’t face these pressures, and so can more easily focus on resilience – on return of capital rather than return of capital.
And we need to, not least because we need to protect ourselves from the consequences of other people chasing a fragile and illusory efficiency.
