Changes since 28/10/00 1. Burkard’s 2 slides added to the end.

1. Changes since 28/10/00 1. Burkard’s 2 slides added to the end. Investing -What you need to know-about investment risks & how to deal with them- about the current investment climate.

2. Why invest? • To help us create financial security • over the long-term (for the rest of our lives) • for ourselves and our families

3. Therefore, what is investing not about • Picking every winning investment • which gets a good return • Knowing everything about investing • that is impossible • Predicting every next market movement • market timing is a very imprecise game • particularly over the very short-term • “The future is ultimately unknowable” Alan Greenspan • Making big win-or-lose bets • this creates too big a chance of a bad result

4. What investing is about • Investing is about getting a higher return than cash • over the long term • Taking acceptable, well-considered risks • Seeking to have a higher standard of living in retirement • while living within our means • Maintaining or achieving Financial Security • we should avoid strategies that threaten your financial security • Avoiding losing a lot of money • We need position portfolio to minimise chance of big loss. • Kerr Neilson would argue that • avoiding big losers is more important than finding winners • this is why we need to avoid speculative bubbles - discussion later • Not being too dogmatic about your beliefs • dogmatism can blind you to important market developments • eg a developing speculative bubble • Most investment philosophies fail • at least in certain circumstances. • We need to try to understand when our philosophies might fail.

5. Investing - what do we need to know about? • Volatility • of capital values over the short-term • Variability • of returns over long term • (eg 30 years) / rest of your life • Modern Portfolio Theory • Risk/return • Efficient Market Theory • Danger periods for investors • Recession/depression, inflation, speculative bubbles

6. What do we mean by volatility? Possibility of losing money by buying & selling over short-term.

7. Aside: One implication of volatility. • Has anyone ever heard an investor ask? • How has this investment performed? • On hearing the answer “Very well!” • They said “Then I will have some of that.” • Hands up please.

8. Why is this line of “logic” dangerous? • Example:- • Consider this situation. On the 19th October 1987, if we used this sort of logic we would say • “Australian shares have done really well” • “I better have some of that”. • What happened to this investor? • Or to the investor who bought into .Coms in Feb for same reason. • This is “Momentum investing” • it fails when there are market discontinuities eg crashes • When things have been good for long-time • you get more momentum investors - like now • recent experience reinforces behaviours that have been working • Not a great strategy when things are volatile • like things are likely to be. • Can get you into fundamentally unsound investments.

9. Implications of Volatility • If you buy and sell over the short-term • The more volatile your investment • The higher the likelihood • That you will make a loss

10. Is volatility a problem for long-term investors?Long-term =10-30 years. • For long-term investors,returns over the long-term are what matters • Does that mean, as long-term investors, we can ignore volatility?

11. Unfortunately, not entirely. As long-term investors, can we ignore volatility? Unfortunately, as soon as we take this view point, the “problem” gets a LOT tougher. Unfortunately, history indicates that it is dangerous to ignore the warning signs.

12. What do we mean by variability? • Returns over the long-term eg the rest of your life • Are far more variable than most realise. • If you ask most people • what returns from shares over a 5 year period • answer is usually something like 10%pa-15%pa • based on some sort of historical averaging • Unfortunately, averages hide a host of sins. • Tell me, what do you expect the return from shares • is likely to be over 5 years? • Comments please

13. Return from shares over 5 years? • US experience in 20th century • over 5 years • returns will be in the range between • -16%pa & 33%pa compound (in real terms) • Lets deal in real terms • because that is the thing which matters • real terms = adjusted for inflation • real terms = impact on your purchasing capacity • real terms = what is important for financial security

14. How variable can it get? • US experience in 20th century is • over 10 years (-5%pa to 18%pa real) • over 20 years (0%pa to 13%pa real) • over 30 years (1%pa to 11%pa real) • Much longer term UK data • shows you can even get a negative real return over 30 years • that would be terrible to live through • you cannot be sure that this is what is ahead • History does not tell us what will happen • History tells is what CAN happen • People (including advisors) have told me • “it could not happen again.” Brave statement. Prove it. • It is not possible to prove that it cannot happen again. • However, it is reasonable to believe, if it has happened in the past • it can happen again.

15. How variable can returns be? If the period ahead is really good, we can be reckless & get away with it. But our strategy has to be able to cope, if the period ahead is bad. “The future is ultimately unknowable” Alan Greenspan.

16. Modern Portfolio Theory • Risk/return relationship • Efficient frontier concept • Efficient market theory

17. Risk / Return relationshipMore risk = more return over long-term.

18. Risk/Return Trade-off Summary • If • You have a good spread • of quality investments • then over the long term • you should gain a higher return • if you • take higher risk.

19. Efficient Frontier Concept • Does taking a higher risk guarantee a higher return? • No. Clearly there are ways of taking more risk and losing everything. • How do we reduce our risk of a bad return, • when we take a higher risk? • This is the problem that efficient frontier concept tackles. • Efficient Frontier is where • for given level of risk • maximum level of return is defined • Conversely the efficient frontier is where • for a target level of return • minimum level of risk is defined

20. Risk For this level of risk maximum return possible is Efficient Frontier Minimum risk required to achieve target return Return Efficient Frontier Concept

21. Efficient Frontier Concept -Eg

22. Risk In such a period, the more risk you took, the bigger the loss. Efficient Frontier Return Efficient Frontier Issues • It is easy to identify the efficient frontier • for a given period, in hindsight • not as easy to identify it, looking forward. • But it can help us identify investments worth looking at. • No guarantee that for the next period • the efficient frontier might look like this (eg in a depression)

23. Efficient market theory • An efficient investment market • is defined as a market • where the price of an asset • instantly reflects any new information • which becomes available.

24. Efficient market theory implications • Hot tips have no value • Any value the “hot tip” might have had • is priced in to the market • Market forecasts have no value • traders have taken into account • likely future profit growth already • Charting has no value • because any useful information visible in charts • already priced into the market

25. Evidence for efficient market theory. Efficient market theory therefore suggests that it shouldn’t matter whether you buy Westpac shares or NAB shares, the total likely (in the probabilistic sense) medium-term return should be expected to be the same. History broadly supports this view.

26. Evidence for efficient market theory. Likewise efficient market theory therefore suggests that it shouldn’t matter which of less similar shares you buy eg News Corp, Coles, NAB, BHP or Brambles.

27. Evidence for efficient market theory. Likewise efficient market theory therefore suggests that it shouldn’t matter whether you buy US or Australian shares.

28. Efficient market theory - summary • There is a lot of evidence for efficient market theory • many markets display at least • a fair degree of efficiency • Some markets are more efficient than others • eg US is more efficient that Australian market • market in large caps is more efficient than small caps • more efficient in developed countries than less developed • For new investors it is very dangerous to assume • that the market is not efficient • because there are many highly resourced institutions • who are focusing their energies on finding and arbitraging • any market inefficiency • Unfortunately, many new investors assume that • markets are not efficient -without realising they are making this assumption • Anybody own any shares recently? Which? Why? Why not Index Fund? • Because you feel you can do better than the market? How sure are you that the market has priced that stock incorrectly?

29. However, efficient market theory does not explain this- market crashes

30. And efficient market theory does not explain this- speculative bubbles

31. Efficient markets - extension • My view - I believe in comparative efficiency • Similar stocks are priced relative to other similar stocks • one tech stock is priced relative to other tech stocks • but the whole tech sector might be mispriced • this helps us to understand speculative bubbles. • And it helps us to understand crashes. • This extension • helps us build rational strategies covering these situations

32. Risks & strategies for investors. • Failure of individual investment • diversify • Volatility • invest for the long-term • Variability • manage your outgoings in line with incomings • eg in retirement budget to spend 4% of investment assets each year • automatic belt tightener • enables you to survive the bad periods • so you can enjoy the good periods which often follow • Speculative bubbles • be on your alert - and avoid • it never makes sense to “invest for the long-term” in a speculative bubble • Inflation taking off • lower weighting to shares • higher weighting to short-duration fixed interest or cash • Recession/depression • lower weighting to shares/property • also see variability

33. What else does an investor need to know? • Relationship between prices of shares & bonds. • Relationship between cash yield & bond yield? • Geared share investors need to be market timers • How do you value a stock? • Using Net Present Value of future profit stream • Why does this mean “tech stocks” will • continue to be volatile?

34. Relative valuation of asset classes • Shares and property are priced relative to bonds • Government bonds are the “risk free” asset class • Investors in other assets require:- • government bond return + risk premium • share investors have historically required • approximately government bond return + about 4%pa • Implications • if (everything else being equal) • bonds fall in value by 10% (I.e. yield rise by 10%) • shares fall in value by 10% (I.e. yield rise by 10%) • (similarly for property)

35. 3,000 10000 9000 2,500 8000 7000 2,000 6000 The fixed Interest crash of 1994 - caused a similar slump in share prices 1,500 5000 Impact of bond prices on shares prices 4000 1,000 3000 Australian Bond Accumulation Index - LHS All Ordinaries Accumulation Index - RHS 2000 500 This relationship was probably even more evident in the 1970s 1000 0 0 1993 1994 1994 1995 1995 1996 1996 1997 If bonds fall in value, shares fallIf we have a fixed interest crash, all asset classes experience a downturn

36. Evidence for risk premium for shares

37. .

38. .

39. Relationship between cash yield & bond yield?

40. Geared share investors need to be market timers Margin loans are currently about 9.35% (90day bills+ ~3%)

41. 100% geared share investors starting at different times.

42. Other issues • What is a speculative bubble? • Why are speculative bubbles so dangerous? • Are we seeing a speculative bubble now? • One of characteristics of a spec bubble is that there is not general agreement that one exists. • If general agreement existed, then rational investors would bail out and the bubble would burst. • So there can only be consensus in hindsight. • Why at the very least, “tech stocks” will continue to be very volatile. • What other risks do we face? • Do we risk Inflation? Or Recession?

43. What is a speculative bubble? • Where investors are prepared to pay • more than the “fundamental” or intrinsic value of a stock • They are buying because they can sell it on • at a higher price to • the next investor • I.e. speculating (not investing) • By definition, during a speculative bubble • the market is not behaving efficiently • because a rational objective observer • can identify irrational behaviour & speculative frenzy • and can achieve advantage by picking stocks

44. Characteristics of a speculative bubble • Belief that “it is different this time” • “Frenzy” to buy. Must buy now or miss out. • “Supply & demand” argument • supply is short, so I must buy at whatever price I can get it - or I will miss out. • Many “new inexperienced investors” • Investors tend to focus on “how much money can be made” • and none on “how much can be lost” • investors stop managing risk • … because they either do not see it … or do not believe it exists • Typically “Warnings” are available from “old timers” • but often these warnings are ignored. Why? • What draws otherwise sensible people into the later stages of a bubble? • And causes them to ignore the risks? • “There is nothing so disturbing to one’s well-being and judgement as to see a friend get rich.”Charles Kindleberger in “Mania’s, Panics and Crashes” • Its takes strong, clear-minded individuals to resist this urge. • Key characteristic of a bubble: • Only agreement a bubble existed in hindsight. Is this a bubble?

45. But is this a bubble? It smells like a bubble. • Would you regard the 1999 listing of .Coms as a frenzy? • YES clearly • Are people buying because of something other than “valuation” • Yes, many were seeking “opportunity” for killing on floats • “Momentum investing” has taken over from valuation approaches for many • Is the “Its different this time argument alive?” • Yes, “Internet changes everything”. “Completion of human genome project” • Is the “supply & demand” argument for high prices alive? • Yes, “inflows from super funds must drive share prices higher”. • Are the old-timers warning it is a bubble? • Kerr Neilson,Galbraith,Buffett,ASX chairman,Levitt (US SEC),Professor Robert Schiller • Has there been an increase in leveraged share investing? • Yes, margin lending & via hedge funds - over recent years • Are there a lot of new inexperienced investors in the market? • Yes, a 20-year bull market has drawn many inexperienced players into the market • Yes, spectacular rises (eg Nasdaq) have sucked many into speculation • Do many share investors think they can’t lose money? • Yes, bull market for 20 years, little experience of bad times • 20 years of good times creates over-confidence - see Buffett article • overconfidence -> gravitation to the speculative end of the market - tech stocks • Galbraith warns “Never confuse genius with a rising stock market” • Collective self-delusion with “techs”? • “escape from reality” as Galbraith describes it • US manager says “His performance has been better since he stopped thinking”.

46. Why is a speculative bubble so dangerous? Gold shares in 1980s Prices can plummet without notice - often around 90% It never makes sense to “invest for the long-term in a bubble”.

47. Nickel - Poseidon bubble

48. Gold Price Bubble

49. How long are your prepared to wait?To get your money back let alone get a return.

50. Now is this a bubble?Or really, is it “different this time”?Your answer is crucial. It changes your investment strategy totally.Even if your answer is “Reasonable possibility of bubble”, this should have a major impact on your strategy.