What we can learn from the cockroach

Today I want to talk about cockroaches. Cockroaches are truly amazing creatures. They can go without air for 45 minutes, survive underwater for half an hour, and endure freezing temperatures. They are between six and 15 times as resistant to radiation as humans. If we ever have a nuclear war, cockroaches will rule the planet.

So, cockroaches are resilient. That’s why they’re awesomely long-lived as a species. The oldest cockroach fossil is 350 million years old – humans have been around for only 200,000 years or so. Cockroaches first appeared, according to the fossil record, after the second of the earth’s five mass extinctions to date.

They survived, in other words, the third, fourth and fifth mass extinctions (defined as an event that wipes out 75% of all species on our planet). That last, fifth extinction is the one that did for the dinosaurs. Their ‘system’ seems to be able to survive anything this planet can throw at it.

And that system is wonderfully unsophisticated. Richard Bookstaber points out that the cockroach behaves according to a crude but elegant algorithm: “Singularly simple and seemingly sub-optimal: it moves in the opposite direction of gusts of wind that might signal an approaching predator.”

But according to a recent report by Dylan Grice, one of the best financial commentators I know, there is a lot we can learn from this ultimate survivor. Let me explain exactly what I mean…

20 years of boom and bust

I began my career in the financial markets in 1991. At that time the economy was in recession, so the bond markets were booming. And then when the Fed started raising rates in 1994, the bond markets collapsed. Later that decade, equity markets surged higher as investors discovered the internet. And then the Asian crisis hit.

Russia defaulted and long-term capital management imploded, triggering a freeze in the capital markets that turned out to be an eerie premonition of 2008. Then we had the attacks on the twin towers in 2001, causing US stock markets to close for a week. In the week that they reopened, US stock markets lost $1.4trn in value.

Subsequently we had more recessions, a boom in property prices worldwide, the subprime mortgage bust, and a gigantic corporate and then sovereign bond crisis that lives with us to this day…

The two major asset classes – stocks and bonds – have enjoyed a wild ride over the course of the last two decades. Backing one or the other, depending on timing, will have jeopardised or destroyed huge amounts of capital.

Investors in stocks in the late 1990s thought themselves heroes – until the dotcom bust. Investors in bonds will have made small fortunes – unless they backed the wrong markets, like Iceland, or Lehman Brothers, or RBS, or Greece.

And now I believe the risks for most bond markets (and not least UK gilts) are all on the downside, both for government and corporate debt.

The yields on offer are simply too low, and the risks of rising defaults and inflation are simply too high. So unless you were very, very good at market timing and switching from bonds to stocks to cash and back again, the last 20 years will have given you almost nothing but grief.

The cockroach portfolio

But it wouldn’t have worried our friend the cockroach, says Dylan Grice.

The cockroach doesn’t know where we are in the interest-rate cycle. It doesn’t know (or care) if capitalism is in rude health or about to collapse. The cockroach doesn’t have a view on currencies, asset allocation, stock selection, or the fiscal cliff, or of the survival of the eurozone.

The cockroach, therefore, not having any fundamental view, would simply divide its assets across nominal and real assets. It would only be concerned with recoiling from those troublesome gusts of wind that might spell danger.

Dylan’s cockroach would have 25% of its portfolio in cash; 25% of its portfolio in government bonds; 25% of its portfolio in equities; and 25% of its portfolio in gold.

Each of those asset buckets protects against a different type of risk. And that is a very sensible approach to investing in the year ahead. Cash will protect you against a market collapse in anything (provided it’s cash held with a solid institution).

Government bonds protect against deflation (provided your money’s invested in solid government bonds and not trash). Equities offer capital growth and income. And gold, as we know, protects against currency depreciation, inflation, and financial collapse. It’s vitally important to maintain holdings in each, in my opinion.

The beauty of a ‘static’ allocation across these four asset classes is that it removes emotion from the investment process. We all know how we should behave when the market throws opportunities at us. But human nature being what it is, we are more likely to flee the market in terror precisely when we should be wading in and scooping up bargains. With a more or less constant allocation to each asset class, emotion is less liable to get in the way.

For example… as a fund manager, I live in fear of a stock market collapse. But having given the topic much considered thought throughout my career, I’ve decided that the best way to protect against the eventuality is, like the cockroach, to be well hedged.

Because the market today is facing a number of critical issues that have yet to be resolved. Is the UK in a recession? I think we are, and I think the UK is fated to low nominal GDP growth. Austerity isn’t working, either here or elsewhere, and rising political and social tension looks to be the order of the day throughout Europe. Speaking of which, is the eurozone debt crisis any closer to resolution?

I don’t think so, which is why I haven’t yet committed to otherwise cheap-looking European stocks. I don’t dispute the valuation argument, but I’m just as concerned that the currency could buckle suddenly without warning.

The US has around $17trn of debt to deal with. So, by a process of elimination, and not least superior demographics and growth prospects, makes Asia (admittedly a massive region) look like the ‘growth’ candidate for our portfolios.

Whatever your financial worries, just emulate the cockroach. And relax.

Category: Market updates