However, in a rapidly changing world, the vagaries of an unknown future can obviate even the best-laid schemes.The long-term lies beyond the foreseeable future, a strange and uncomfortable world. The regularities we know and have experienced may recur, but their magnitude, timing and frequency are highly uncertain or completely unknown.
Even more problematic are new discoveries and inventions, and other developments for which we are completely unprepared. But a lack of financial literacy prevents many from understanding what their pension is all about, write professors Annamaria Lusardi and Olivia S. Mitchell in
. Financial literacy and retirement preparedness: evidence and implications for financial education programs
Financial illiteracy can stunt peoples’ ability to save and invest for retirement. “The crucial challenge is to better equip a wide range of households with the financial literacy toolbox they require, so they can better build retirement plans and execute them,”believe
Lusardi and Mitchell.
The Precautionary Principle appears in many official statements after being translated into English from the German term Vorsorgeprinzip in the 1980s. In some of the stronger forms, it could lead to paralysis and an absence of economic advancement. Con Keating suggest that the appropriate criterion is that it should be invoked when there is a possibility of ruin, however small. But, he notes, summing even small likelihoods of ruin over time will lead to ruin with certainty
Given these challenges, it may be best to go straight to the source: the design of financial products which an increasing number of asset managers such as
Amundi or Prudential Financial adapt to low levels of financial understanding. Allianz Global Investors is another manager that decided to put the cart before the horse. With a steady stream of retirement income in mind, its annuity focus strategy aims to reduce the risk of an unfavourable exchange of accumulated wealth for a lifelong annuity stream (transition risk) by minimising interest rate sensitivities.
Markets are mixed games; partly exogenous, against nature, but predominantly endogenous, Against others Con Keating CONVERGENCE TO ECONOMIC REALITY
Markets are mixed games; partly exogenous, against nature, but predominantly endogenous, against others. In the long-term, volatility is broadly – though some care is needed with saying this – in line with the volatility of national output. Rather than being some unexplained property of mean reversion, this is convergence to economic reality. While this is not always immediately apparent in the patterns of seemingly chaotic securities prices over time, it is demonstrated in foreign exchange markets, where a relatively small stock is turned over manically.
The most elementary measure of the stock of foreign exchange for a currency is the total external liabilities of the banking system. In the most actively traded currency, the US dollar, the daily turnover is approximately equal to the stock. The result is a short-term series totally dominated by noise, but where, in the much longer term, basic macroeconomic pressures prevail. In the long term, diversification is concerned with the number of effectively independent sources of income, while in the short term it is about the diversity of periodic returns, and relative price performance.
The nature of the instrument also affects the risk profile of an investment portfolio. This was illustrated by Campbell and Viceira in Strategic Asset Allocation (2001), who showed that over their term, long-dated bonds essentially return their coupon with minor variation due to the convexities of coupon re-investment. A sequence of short- dated bonds re-invested at intervening maturities, but of equivalent overall term, has a much more variable set of outcomes, which is increasing in term.
METEOROLOGY OR CLIMATOLOGY
Equities, by contrast, exhibit declining volatility relative to their geometric average return with increasing holding period. A characteristic of what happens as horizons lengthen from short term through to very long term is to be found in the flattening of the efficient frontier: when optimal portfolios’ risk return characteristics are mapped over a long horizon, the curvature of the frontier disappears entirely and one is left with a gently upward-sloping but essentially straight line.
There is a seeming paradox: in the short term, investment performance is unpredictable, but in the long term, it is not. An analogy may help: this is equivalent to the difference between meteorology and climatology. The OECD associates long-term investment with “patient”, “productive” and “engaged” profitable capital and notes there are cyclical and structural impediments to such investment. These attributes can each be criticized, but the more important issue raised by the OECD is that of cycles in economic activity.
The Kuznets infrastructure cycle, with a term of around 25 years, and the Kondratieff long technological cycle, of around 50 years, have been relevant in the post-crisis period. Schumpeter’s “creative destruction” and its role in productivity growth and employment have also been widely discussed.
As individuals, our long term may be our lifetime, or that of our children, but with institutions the long term may amount to hundreds of years. Consider Balliol College which has existed for 750 years, or the Catholic Church, whose vision is literally apocalyptic. in the UK, the legal form used for the long term is often “the reign of her majesty, Queen elizabeth, her heirs and successors”
THE WIND FARM EXAMPLE
What matters most for investment in this process is the question of capital scrappage: the loss of business asset values associated to their second rather than first best use. This is capital lost irretrievably. In recent times, we have become familiar with the dramatic disruptive change of information technology, but there is a more subtle ongoing variant associated with the effects of productivity growth on sunk costs of investment.
Take the example of wind farms: the steady increases in productivity of new installations also serve to lower the residual value of the older, less efficient plant. This can be a challenge for valuation as these older plants will continue, under fixed feed-in tariffs, to generate the same cash flows as previously forecast, and upon which amortization schedules were originally constructed.
One way of distinguishing analytically between the long and the short term is by the source of cash flow or liquidity. Where dividends, coupons and repayments of principal are the source of the investment return to be realized, this is long-term investment. Where sale in markets is the source of the return, this is short-term or speculative in nature.
Sequential reinvestment strategies, involving balance sheet maturity mismatches, rely upon the existence of markets for their implementation. It is important to understand that liquidity has a cost – if it did not, all assets would be perfectly liquid. In other words, the natural state of the world is that, where all else being equal, illiquid investments have higher returns than “liquid” marketable securities, which will also bear the frictional costs associated with trading.
It is possible to question the current vogue for institutional purchases of illiquid securities when the cost of market liquidity is at an all-time low. The profound differences between the long term and the short require a far richer set of risk management techniques and practices, such as are captured by the precautionary principle.
This is a topic I wish to address in a forthcoming article. Planting acorns is one of the many metaphors used to highlight the difference between short-term and long-term approaches. The metaphor well illustrates both the importance of long-term planning and how the vagaries of an unknown future can obviate the best-laid schemes. Nelson’s second-in-command at Trafalgar, Admiral Cuthbert Collingwood, planted acorns wherever he found a suitable spot. His intention was to ensure the Royal Navy would never want for oaks to build fighting ships, but while some of his trees are undoubtedly still growing, his foresight is redundant in an era when nuclear powered submarines patrol the seas.