The Devil wears nada


The global fashion industry is fickle by nature, pushing and then pulling trends to keep hapless consumers forever turning over their wardrobes. Some people in the financial services industry work the same way.

Fashion designers, manufacturers and media operate by telling consumers what's in vogue this year, thus artificially creating demand where none previously existed. What turns up in the boutiques is hyped as hip by the glossy magazines. So, you "have" to buy it.

Likewise, parts of the media and financial services industries depend on fleeting trends and built-in obsolescence to keep investors buying new "stuff". Driving this industry aren't so much the real needs of individuals but manufactured wants with short shelf lives.

Just as in the fashion industry, investors can jump on to a trend just as it's peaking and when the maker has moved on to something else. So their portfolios are full of mismatched, costly and idiosyncratic investments where the real risks are obscured.

These products tend to be created because they can be sold. In early 2005, Reuters wrote of how banks were manufacturing exotic credit derivatives for investors looking for ways to boost yield at a time of narrowing premiums over risk-free assets.

Four years later, in the midst of the crisis caused by those same derivatives, the shiny new things were "guaranteed" or "capital protected" products, as financial institutions rolled out a new line of merchandise they thought they could sell to a ready market.

Some investors made the mistake of swinging from one trend to the other, ending up with overly concentrated portfolios – like a fashion buyer with a wardrobe full of puffy blue shirts.

Now while some of these investments may well have found a viable market, it's worth asking whether the specific and long-term needs of an individual are best served by the design and mass marketing of products built around short-term trends.

Luckily, there is an alternative.

Rather than investing according to what's trendy at any one moment, some people might prefer an approach based on long-term evidence and built upon principles that have been tried and tested in many market environments.

Instead of second-guessing the market, this alternative approach involves working with the market, taking only those risks worth taking, holding a broad mix of assets, keeping costs low and managing one's own emotions.

Instead of chasing returns like an anxious fashion victim, this approach involves trusting the market to offer the compensation owned to you for taking "systematic" risk to those risks that can't be diversified away.

Instead of choosing investments styles by what's fashionable, this approach is based on long-term dimensions of expected returns, or premiums that have been shown as sensible, persistent and pervasive.

Those premiums relate to the sharemarket itself over cash, from small over large companies, from low relative-price over high relative-price companies and form more profitable firms over less profitable ones.

There is no reliable way to predict these premiums, therefore the only way of capturing them is to target them continuously.

Instead of focusing on specific securities and fleeting fashions, this approach spreads risk across and within many different asset classes, sectors and countries. That's a tried and true technique called diversification.

And instead of chasing individual securities based on the perception of mispricing, this approach starts with the assumption the market prices are fair and then focuses on implementing at low cost.

Most of all, instead of focusing on investment created by the industry based on what it thinks will sell, this approach can be used to build diversified portfolios based on each individual's own needs, risks appetite, goals and life circumstances.

To paraphrase the legendary designer Coco Chanel, investment fashion changes but style never goes out of fashion.


• The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed or relied on as a recommendation to invest in a financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any financial decisions. A disclosure statement can be obtained free of charge by calling 0800 878 961.