The financial crisis has raised a number of questions on the relevance and reliability of modern financial theory. Modern finance is built around the concept of market efficiency where markets tend to move towards an equilibrium as participants have access to the same information, and behave quite rationally. This theory is still being taught in all major business universities as the backbone of efficient portfolio management.
As a result, the majority of finance graduates build their investment and financial decisions based on this theory; resulting in unexpected surprises.
To confirm this statement, one just needs to read any financial recommendations by major financial institutions. Their recommendations are based on the variables derived from this theory.
Two influential investors have long argued against this theory and the negative implications the finance industry may have if it continues to base its decisions on this theory. Warren Buffett and George Soros stress that they base their successful investment decisions on the concept of long term capital value and the theory of reflexivity respectively.
Both agree that market psychology is more influential than market theory. By market psychology we mean the timing, reaction to news, and herding behavior.
In 2009 we have witnessed two different scenarios. From September 2008 until March 2009, the financial markets were in a bear territory (with losses of circa 50 per cent), while since March, the markets gained back nearly all these losses.
This was a clear herding effect on the international markets. While investors dumped their assets in the initial six months as they considered their investments worthless, they rushed to buy them back few weeks later even if we are still in a cloudy economic climate.
This surely highlights the importance of active portfolio management. Unfortunately some investors tend to buy an investment (a share or a bond) and hold it till maturity or for a long period of time without benefiting from the price volatility of that particular investment.
A typical example was the volatility in the price of bonds during this period. As prices of certain bonds decreased by 50 or 60 per cent, particularly perpetual bonds, some investors grasped the opportunity to average the cost of their investment by increasing their capital injection.
Now that prices are returning from their lows, these investors are witnessing astronomical gains on their investment thanks to active financial management. Passive investors did not benefit at all from this volatility. During a financial crisis, it may be optimal for investors to reassess their level of risk. What was deemed as low risk a year ago may not be the same today. As bonds still offer interesting positive returns, one may seize the opportunity of switching his holdings to other undervalued investments with the aim of maximizing his returns while minimizing his risk exposure. Investors should get used to market volatility. The best way to profit from this volatility is by being active.
Another consideration an investor should look at is the currency exposure. When investing in the international markets, there are only two risks: the company (or country) risk and the currency risk.
Unfortunately a lot of importance is given to the former, while in reality the latter is much more detrimental to total investment return. You may have had a risk-free investment in US dollars or in British pounds, but you may still be in a loss due to currency movements.
The best way to hedge your currency risk, is to invest in your home currency. With the Euro in our pockets, there is no need to experiment in exotic or other major currencies to boost your returns. Nowadays a number of companies have dual listing in both the European and the American markets, thus trading in both euro and US dollars. If you can minimize your risks for the same return, why risk it?
This article was written by Mr. Alex Mangion, Managing Director of MPM Capital Investments Ltd. MPM Capital Investments Ltd is licensed to conduct Investment Services Business by the Malta Financial Services Authority
