Lady holding a piggy bank
with dollar bills falling from the sky.
[image © copyright Photos.com

The stock market, for example, can, as we have seen, fall 40 to 50% in a single year, although that is a rare occurrence. So, decide up front, how much you can afford to lose. It’s likely that if you are in your fifities, you will have a higher minimum value on your nest egg than a thirty-something with years to go before retirement.

You also have to decide your time horizon. If you are investing for 10 or 20 years, and can afford to hang on to your investments, you shouldn’t worry about short term falls as, at some point in the future, prices will recover. That is true of property too, but the problem with property is that it tends to be a ‘leveraged’ investment. People tend to borrow to invest in property, so that a fall in the value of the property or in rents can mean that the loan is called in and substantial losses incurred. People tend not to borrow to buy shares so investing in shares is less risky than borrowing to invest in buy to let.

But the simplest way to make sure you maximise your expected return for a particular level of risk is to diversify across different kinds of assets. Put simply, don’t put all your eggs in one basket. Put some in cash, some in bonds, some in shares and possibly some in property or another ‘alternative asset class’ such as gold or even classic cars. By so doing, you will be making sure that at least part of your savings doesn’t fall. For example, when the stock markets were crashing in 2008, investments in government bonds were racking up capital gains of 30% or more. And if your pot is not big enough, there are plenty of investment trusts or unit trusts who will diversify on your behalf.

And, finally, if you are investing in the stock market, don’t invest it all at once. Regular saving, so called ‘dollar averaging’ means that you don’t put all your money in at the top of the stock market cycle and also that you do put some money in when shares are cheap. Regular saving avoids the classic small investor’s temptation – to buy at the high in the heat of a stock market boom and to sell when prices have gone down.

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Share prices of all companies have certainly been volatile in the past couple of years. Indeed, individual shares have risen or fallen as much as 25% in a single day. As well as that, most shares have fallen in value by around a half in the past two years and are back at levels seen five or more years ago.

Executive directors had bonuses in share options, so boosting share price made them personally richer

In the twenty first century, shareholder value became the new corporate mantra. CEOs and directors of companies had as main objective the maximisation of shareholder value and that meant boosting the share price. A couple of simple techniques were developed to do this: share buybacks and takeovers. Borrowing money to carry out share buybacks meant more leverage on the balance sheet which meant greater percentage profits growth in the boom years.

Buying companies using debt also increased leverage and allowed the stripping out of surplus cash as dividends. Since executive directors all had bonuses in the form of share options, the more they could boost the share price, they richer they personally became. Directors certainly paid a lot of attention to the share price as the inexorable rise in the early twenty first century could be used to keep investors happy and provide a measure of bonuses to come.

In the bear market since 2007, share prices have fallen faster than ever before - partly due to the embedded leverage of many companies. The worst to suffer have been property companies, financial services companies, and private equity firms whose investments in companies were themselves highly geared. Indeed, for many firms, the options included in bonus packages are 'under water' and new ones at lower prices have been issued.

But falling share prices have other consequences for management. One problem now for many companies is whether they are going to be forced into liquidation as they breach debt covenants. The share price is a reflection of investors' perception of that probability. The lower it is, the less likely that investors will be willing to refinance the firm. Recently, some rights issues have had to be done at 50% or more discount to the current, low, share price to be successful. And, by law, firms cannot issue shares for less than their nominal values of say £1 per share or 25p per share.

Another problem is the lack of loyalty of today's shareholders. In the old days, retail shareholders and institutional investors could be relied upon to invest for the relatively long term. No more. Today’s investors include hedge funds which are just as willing to sell as to buy shares. Some of the major UK banks have ended up part nationalised after sudden collapses in their share price after short selling by hedge funds. Although some people argued that short selling was not the cause, it was banned for a time in the UK on certain shares and even now has to be disclosed.

A low share price makes firms vulnerable, either to bankruptcy or to takeover. And the last thing a CEO wants is to lose control. Just look what happened to John Thain of Merrill Lynch after the takeover in extremis by Bank of America!

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The present value of all these future cash flows tended to be a very big number. This attitude is exacerbated by the use of spreadsheets such as Excel. It is very easy to start with a number, then grow it by a constant percentage, say 2%, which looks conservative. It is far harder to produce a cash flow forecast which has negative as well as positive growth.

In a recession, the opposite approach takes hold. Horizons shrink, with companies reluctant to look beyond five years, or even less. Those with cash flow problems think more in terms of months or weeks than years.

The key questions: when will it start, and how fast will it be?

But planning for the upturn requires companies to think beyond the falls in sales and profits of now. The key questions now are when is the upturn going to start, and how fast will the rise in sales and profits be?

Factors influencing the timing of the upturn include government policy: the more ‘quantitative easing’ - otherwise called ‘printing of money’- the quicker the upturn is likely to come. Leverage is also a factor – just as lots of debt helped boost profits in the boom years, so the current deleveraging of business will slow the recovery down. And how much companies have cut operations to save costs now will influence how quickly they can take advantage of the upturn. That’s why firms are mothballing plants – and employees – as much as they can.

Even if one can forecast the timing of the upturn, forecasting by how much sales and profits will rise is almost impossible. I certainly wouldn’t like to be asked to produce sales and profits forecasts going out ten years – or even five - for say an estate agency or a car company now. A crystal ball might be a better option than a spreadsheet!

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Hedge funds were promoted as the new asset class for institutional and large private investors. Yale University’s endowment funds invested in hedge funds which earned annual returns of over 20 per cent for more than a decade. Why buy equities when they earned less, were more volatile and could crash as in the dot com boom?

So investors piled in. And since institutional investors, in particular, tend to follow the herd, it became difficult not to invest in hedge funds. Such was the demand that traditional fund managers left the sinking ship of conventional equity fund management and started their own hedge funds. The rewards for them were much higher, not only a higher management fee – two per cent a year instead of, say, half a per cent – but also 20 per cent of the upside against a not very challenging benchmark such as the cash interest rate. And investors had to ask permission to get their money back again.

What happens to a hedge when there's a crash?
[image by The_repairman, some rights reserved]

Instead of sticking to borrowing a little and buying equities, many hedge funds chose to borrow a lot (interest rates were very low) and invest in bonds – often linked to the US subprime market. When this market collapsed, hedge funds were asked for more security to back their loans and had to sell equities to cover their commitments. Many have either folded or have refused to return money to shareholders, saying they will just have to wait until – or if – times get better.

It now seems so obvious it was madness to give large sums of money to a few people who said they could reinvent investment returns with no regulatory framework, no published accounts, and no transparency on fees and commissions paid. How could sophisticated banks invest their clients’ money in hedge funds such as that run by Madoff, which had improbably consistent performance figures? It helped that they earned good fees for so doing.

Hedge funds are now one of the main scapegoats for our credit crunch woes. European governments are planning to introduce regulation to stop fraud if not incompetence. But this is closing the stable door after the horse has bolted. When the markets turn up again, these fund managers will reinvent themselves – just watch for the next fashion in fund management!

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Janette Rutterford is Professor of Financial Management at the OU Business School, having previously worked in corporate finance and investment. Jannette's research includes pension funds, equity valuation and investment history, in particular the history of women and wealth.

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How can this be? The answer is easy. Traders borrow using the security of the securities they are going to buy! How does it work? Well suppose you think Marks & Spencer shares are going to rise in value. You buy them, then immediately pass them to a bank which in return provides cash. You then use this cash to pay for the securities you have just bought! This is called repo (short for ‘sale and repurchase’) and is exactly like secured lending. Everyone is happy. The lender has security in shares to cover the loan, and you have been able to borrow to speculate on shares rising.

But traders are not always bullish. Sometimes they want to bet on shares going down, In this case, the reverse transaction takes place. You sell shares you don’t own – called selling short. You immediately borrow the shares from another institution and hand them the money you’ve received from the share sale. When the price has – you hope – fallen, you buy back the shares at a lower price and close out your position.

Another way of speculating when you don’t have much capital is to use derivatives. These are synthetic securities which can be traded in the same way as shares, but where you only have to pay an initial deposit (margin) which is as little as 1% of the underlying value. If the price goes the way you have bet, then you need put no more money in, just take the profit when you sell the shares. But if the price goes against you, you have to top up the account to cover the losses on a day to day basis. But in general, derivatives allow you to leverage up by factors of 50 or more.

In recent years, hedge funds, who are investors in that they manage a pool of money, saw the profits that could be made through leverage and began to behave like traders. All went well until the credit crunch. But when things go wrong, leveraged traders can be wiped out very easily. The hedge funds run by Madoff used derivatives to enhance return supposedly without taking on too much risk. Yet anyone in the business knew that there is no holy grail. You can make fat profits in the good times only if you take on risk – and that means there is always the chance of going bust.

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Janette Rutterford is Professor of Financial Management at the OU Business School, having previously worked in corporate finance and investment. Jannette's research includes pension funds, equity valuation and investment history, in particular the history of women and wealth.

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Home ownership statistics should be treated with caution – different countries measure them in different ways. For example, it depends what you mean by a “house”: using the US definition, four out of 10 homes in India would fail to qualify. Also, in a growing population, for the percentage of home owners to stay still, the number of house owners would have to radically increase. For example, in the US, the number of households increased by 10 million in the 1990s and yet the home ownership rate increased from 64% to 67% during that decade. In the UK, the big increase was between 1951 and 1981 – 28 percentage points – largely due to the sale of council houses at below market rates.

Buying a house at a discount to the market price is a ‘no brainer’. Similarly, in the US, mortgage interest payments are tax deductible, while rental payments are not, making buying relatively attractive compared to renting. Tax deductible interest on mortgages also encourages borrowing up the hilt – the more you borrow, the lower your tax bill.

Toy house on a calendar.
[Image © copyright Photos.com]

In the UK, mortgage interest tax relief was abolished in 2000. But buying is still attractive for tax reasons – there is no capital gains tax on your main residence, however much you have made. When the capital gains tax rate was 40% on everything else, that looked attractive. And , in any case, you could take advantage of low taxation by setting yourself up as a ‘buy to let’ investor, with tax-deductible mortgage interest payments and a reduced capital gains tax rate of 24%. And all this was happening at a time when the mortgage market was deregulated, with traditional banks competing with building societies to offer attractive loan packages. They were able to offer so-called “fixed rate” mortgages – in practice for only 2 or 3 years, with borrowers expecting to be able to refinance at the end of this lock-in period with another attractive offer.

The rent versus buy decision is clearly partly a financial one. In a rising property market, it is easy to persuade yourself that if the mortgage costs the same as the rent, it is worth buying for the potential tax-free capital gain. And we all get sucked in. If we don’t buy, so the argument goes, we will lose our toehold on the property ladder. And that means only being able to afford a smaller house or flat in a less desirable area when we do – as we all expect to- eventually buy a property.

But we tend to forget that the property market is just that – a market in which prices go up and down and – worse – where liquidity can dry up much more easily than in a stock market. In a falling market, you may not be able to sell at all. My sister is trying to sell her house and has had the sum total of three visits from potential buyers in the past nine months.

The property market is a market in which prices go up and down...liquidity can dry up much more easily than in a stock market

In a rising market, we also tend to forget about the high costs of buying and selling. For example, renting a flat for £300 a week will cost around £15,000 a year on a flat worth say £350,000. But buying a flat for £300,000 will involve £10,500 of stamp duty, that is, the equivalent of 8 months’ rent. And that is before taking into account the legal fees, the estate agents’ fee on sale, the cost of the HIP, and the fees attached to any mortgage.

But there is a key non-financial reason why we don’t rent as much as say in Germany or France - security of tenure. In the UK, rental agreements are typically for 1 year with a possible break at 6 months, for both furnished or unfurnished homes. You’ve hardly had time to get settled in and you may be on the move again.

In France, furnished lets are similarly short term. But, the most common form of let, unfurnished, is for three years. The person who rents can give one month’s notice at any time; the landlord has to give six months’ notice at the end of the three years and only if there is a very good reason, such as they want to sell, or a close family member wants to move in. And, whatever the rental agreement you have, and whether or not you have paid your rent, you cannot be thrown out during the winter, between November and March.

I once asked a successful entrepreneur what was the best financial decision he had ever made. “Buying my house in Hampstead”, he replied. He had made more money in the property market than from his successful business. I think it is sad that we should in a sense be forced to buy houses and become experts in plumbing, electrics, and painting and decorating. I would far rather delegate that to the landlord, and get on with my work at which I am much more competent! The only problem with renting is the lack of a long-term rental contract to give me peace of mind. Maybe, instead of trying even harder than ever to encourage home ownership, the government could try to sort out the rental market instead.

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Janette Rutterford is Professor of Financial Management at the OU Business School, having previously worked in corporate finance and investment. Jannette's research includes pension funds, equity valuation and investment history, in particular the history of women and wealth.

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A more straightforward way, though, is to make money indirectly through the stock market. In the old days, it was quite hard to do. If you held shares and the market went down, you lost money. Now, you can easily take a position which makes money when a share falls in price. You don’t even have to be a stock market professional.

Stock market figures.
[image © copyright Photos.com]

You can use futures or options – so called ‘derivative products’ which are linked to the underlying asset you want to trade. If you think, for example, that the FTSE 100 stock market index is going to go down, you can sell futures contracts on the index. Your brokers will require cash from you, to protect themselves if you are wrong, but essentially, you hope the index will go from say 6000 to 5500 and that what you sold at 6000, you can buy back at 5500, pocketing a profit of 500. The more futures contracts you sell, the bigger your profit.

"whether we are living in good times or bad, we can make money from the stock market"

Sounds too good to be true? The problem is – what happens if you are wrong, the FTSE 100 rises to 6500 and you have to buy back at a higher price than you sold? A lower risk way is to buy a put option. For a small premium, you have the option to sell the FTSE 100 say at 5750 when it is currently trading at 6000. If you are right and the index falls to 5500, you can effectively close out your position for a 250 point gain, less the cost of the put option. This way, if you are wrong, you can simply walk away, worse off only by the put option premium.

Investment professionals use futures and options to bet that prices will fall all the time. George Soros is famous for having made a fortune from selling the pound sterling just before it left the European Exchange rate mechanism. More recently, two traders at Goldman Sachs – Josh Birnbaum and Michael Swenson made money out of the ‘credit crunch’ – they sold products linked to the sub-prime market and bought back when prices had fallen. As a result, Goldman made around $4 bn from this strategy and Josh Birnbaum has set up his own $1bn fund trading sub-prime mortgages.

What can you do when markets have already fallen? The answer is invest in a so-called vulture fund which buys securities which have fallen dramatically in price, in the hope that they will recover. So, whether we are living in good times or bad, we can make money from the stock market. The only problem is getting your timing right!

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The opinions expressed are those of the author and are not held by the Open University or BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.

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Janette Rutterford is Professor of Financial Management at the OU Business School, having previously worked in corporate finance and investment. Jannette's research includes pension funds, equity valuation and investment history, in particular the history of women and wealth.

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The lowering of the top rate of UK income tax from 98% to 40% in that time, with businessmen and women now able to turn income into capital gains paying a special low rate of 10%, has also widened the gap between after tax pay of high and low earners. Governments now compete to attract entrepreneurs to their shores. For many foreign-born super stars, London is a tax haven, with non-domicile status meaning that they don’t have to pay UK tax at all – apart from council tax.

There are problems with being super-rich

But there are problems with being super-rich. You need the trappings to go with it – and they don’t come cheap. Forbes’ so-called CLEWI index (Cost of Living Extremely Well) keeps on going up by more than the standard rate of inflation. The index includes such essential items as designer handbags, opera season tickets, a Harvard education, as well as a Rolls Royce, Lear jet and a race horse. This dollar-based cost of luxury goods index went up 7% last year compared with 4% for the US Consumer Price Index. But this may be understating the problem for the super-rich in Britain: London rents have increased by 25% since 2002 and, since last year; Range Rovers cost 20% more; a season ticket at Chelsea 8% more; and a case of Château-Lafite 117% more!

The increasing disparity between the rich and the poor and between high earners and low earners is a global phenomenon. In the US, for example, 1% of the population control almost 40% of wealth and 20% of income. However, in emerging markets, High Net Worth Individuals (HNWIs) – defined as those with over $1 million in financial assets alone - are rapidly acquiring large shares of their national cakes. And their numbers are growing at a faster rate. In a single year – 2006 – the percentage increase in HNWI wealth in Africa was 14.0% and in Latin America 23.2% compared with a measly 7.8% for Europe.

This also has implications for the super-rich. An ever increasing number (currently 10 million HNWIs globally) are chasing the same status symbols. There is increasing similarity as to which types of property, cars, boats and planes, and which “investments of passion” – jewellery, art and football clubs – HNWIs want to buy. So it is likely that the CLEWI index will continue to rise by much more than the average rate of inflation!

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• Superstar, Super-Rich - technology is helping Britain's super-rich grow their fortunes.
• Is tax avoidance only for the rich?
• Tax shelters - nobody likes paying tax, but how far would you go to avoid it? Liberia? Monaco?
• Where do the millions go? - it costs more to keep up the lifestyle
• Gaps in income and wealth remain large
• 1% of population owns 21% of wealth
• Take it further - the Open University's finance courses explain more about the distribution of income and wealth

About the author

Janette Rutterford is Professor of Financial Management at the OU Business School, having previously worked in corporate finance and investment. Jannette's research includes pension funds, equity valuation and investment history, in particular the history of women and wealth.

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