personal investment blog

Contagion

Contagion

16 Oct 2018

 

“The least thing upset him on the links. He missed short putts because of the uproar of the butterflies in the adjoining meadows. ”

PG Wodehouse

Financial contagion is a phrase employed by those who try to explain a fall in an asset price that they didn’t see coming.  If it means anything, which is not certain, it describes the fallout from the volatility that results when any market falls because people are forced sellers. This is prone to cause panic which in turn means that the attraction of holding cash rises. Given that no one likes to sell a falling asset (a psychologically taxing experience) people prefer to raise money by selling things that haven’t fallen in price but look potentially vulnerable (especially if viewed with a newly sceptical eye).

As the quote from PG Wodehouse shows, when things go wrong we tend to cast around for something to blame. Bad things happen to relatively overpriced assets and the nature of the event that triggers their decline is really of no consequence. The need to explain what happened is driven by a reluctance to take responsibility for a poor investment decision. Hence we are allegedly the victim of the devaluation of a currency, the collapse of an obscure foreign bank, the failure of a harvest or the uproar of beating butterflies’ wings.

In reality, contagion is not a hidden threat but a constant reality that we should never forget. All assets are in competition all the time, subject to perceived risk and liquidity. All asset values are relative to each other. The most crass mistake that financial analysts make (and I certainly write from experience) is to compare the price of an asset with its own history and to declare that this proves it to be cheap or expensive.

Here are ten assets in which you, if your assets and liabilities are UK based, might conceivably invest, ranging from cash (the most liquid) to commercial property arguably the least liquid). Note that all savings are investments, even cash.

 

Gross yield

Cost of ownership

Net yield

Capital gain/loss?

Building society

2.0%

0.00%

2.0%

No

Government Gilt

1.7%

0.25%

1.5%

No

Cash

0.0%

0.00%

0.0%

No

UK equities

4.0%

0.25%

3.8%

Yes

Property yield (commercial)

4.6%

2.50%

2.1%

Yes

Property yield (residential)

5.0%

5.00%

0.0%

Yes

Gold

0.0%

0.70%

-0.7%

Yes

Crypto currency

0.0%

1.00%

-1.0%

Yes

Wine

0.0%

2.00%

-2.0%

Yes

Art

0.0%

3.00%

-3.0%

Yes

Some assets, like cash and building society accounts, have no cost of acquisition or ownership. The costs of holding them are opportunity costs i.e. doing something more rewarding with the money but something more rewarding generally involves more risk and less liquidity meaning that you may not be able to sell at the price or the time of your choosing. Many of the investments are straightforward bets on the price of the asset rising. The fact that so many people are comfortable with this is testimony to their natural optimism.

The assumptions I have made about yield and cost of ownership are best guesses based on incomplete information but they give an idea of what potential investors should be thinking about.

Building society accounts are basically safe as long as you are protected by the FSCS protection scheme, a government guarantee of up to £85,000 per person per institution. As we remember from 2007 and 2008, high street financial institutions are not completely safe and the run on Northern Rock will live me for as long as I have a memory. The queues revealed that many people had much more than £85,000 invested with Northern Rock.

Gilts are as safe as the Bank of England, an expression that should be taken literally. The Bank is the agent of the government and governments do default from time to time. If J Corbyn becomes Prime Minister some right of centre commentators will bring this up. I have said that there is no capital gain or loss from gilts. This is not strictly true because they will go up and down as interest rates move but you should certainly get back the nominal value when they mature.

Cash is a high risk investment in an inflationary environment. I think most people understand that. In Japan, where inflation has been negative for many of the last thirty years, cash is a very popular investment.

UK equities are usually referred to collectively as “the stock market”. This is not very helpful because it causes people to anthromorphise the market as if it were a crotchety relative who offers to help with the washing up after it has noticed that someone else has started to stack the dishwasher. A stock market is a place where people meet to buy and sell shares. Picking shares is not easy and involves some work but it is worth the effort because you can get a 4% annual yield and a considerable capital gain, if your investment is timely. Shares can, of course, go down as well as up and this seems to make people overestimate the risks and de facto overlook the risks of things that are easier to understand. Such as….property.

Commercial property and residential property share the characteristic that their rental yields often just cover the costs of ownership, especially if those include mortgage payments. As investments they have for a long time relied on the price of the property appreciating. This worked so well for so long that I suggest that many investors, particularly individual buy-to-letters, have nearly forgotten the risks. If interest rates rise and mortgages become more expensive (and I suspect that the Treasury and the Bank of England will do or say almost anything to stop that happening) there will be “contagion” in the property market as the dominoes begin to fall. But the truth is that bad things happen to relatively overpriced assets.

Gold is ridiculous, the fantasy investment of doomsday prophets. Read here for an explanation if you need one.

Crypto currencies (e.g. Bitcoin) are even more ridiculous and rely on the Ponzi principle that an even more delusional investor will come along to take you out of your position. The two basic requirements of a successful currency are 1) that it is widely accepted and 2) that it maintains its value over time. That’s a Lose-Lose for crypto currencies.

Wine is an investment that is expensive to maintain (expert storage) and carries the opportunity cost of not being able to drink the stuff.

Art has many of the same characteristics as wine though the transaction costs are surpassed by nothing, not even the most expensive properties. If you invest in art you need to be rich enough never to have to sell it. But you might make a lovely paper profit.

Contagion is a fact of life, not an explanation.

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