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INTERVIEWS
WITH ECONOMISTS
PROFESSOR
ROBERT FAFF
Professor of Finance at RMIT University since 1996, Professor
Faff has published widely in refereed journals including:
Journal of Banking and Finance, Pacific-Basin Finance
Journal, Asia–Pacific Journal of Management, Asia–Pacific
Journal of Finance, European Journal of Finance, Global
Finance Journal, Australian Journal of Management and
Accounting and Finance. Professor Faff is the co-author
of an undergraduate text in finance, Corporate Finance,
published by Harcourt, Brace and Company, and is also the Editor
of the McGraw-Hill series in Advanced Finance.
He is the past Treasurer of the Accounting Association of Australia
and New Zealand, the current Treasurer of the Asia–Pacific
Finance Association and the Editor of the Accounting Research
Journal. He has a BEc (Hons) and MEc from ANU and a PhD from
Monash.
Capital markets around the world have undergone significant
changes in recent years. What do you think has been the driving
force for these changes?
One of the major changes taking place in capital markets in recent
years has been the removal of economic and legal barriers which
have served to inhibit the free flow of investment capital between
national markets for many years. This has led to markets becoming
more competitive than ever before and it has greatly enhanced
the diversification opportunities available to investors all around
the globe. Probably one of the driving forces behind this trend
has been the rapid advancement of technology – primarily
computer driven — that has helped to make transacting around
the globe a cheap and speedy activity. The next wave is well and
truly underway via the medium of the Internet. In effect, the
boundaries for profitable trading in financial assets have been
massively expanded in a relatively short time. Further, governments
have seen the need to adapt to ever-increasing international opportunities
— to replace areas of comparative economic advantage that
no longer exist. In this dynamic environment, with an ever-increasing
need to explore new markets, intense competition for the most
attractive opportunities has been and continues to be a major
factor shaping the way capital markets will enter the next millennium.
What do you think were the causes of the Asian crisis that occurred
in the mid- to late 1990s? What lessons can be drawn from this
experience?
The task of identifying the causes of the Asian crisis is one
that has created a mini-industry for financial economists. Hence,
the thinking on this most interesting (but at the same time very
difficult) issue is still evolving. My thinking on this accords
with the views of Nobel laureate Merton Miller who argues that
the ‘real culprit’ was ‘the low and falling value
of Japanese interest rates and the reduction that induced in the
value of the Japanese yen’. Further, it seems that it is
really a case of three separate crises – each relating to
three types of financial risk. The risks are: (a) interest rate
risk (b) foreign exchange risk and (c) credit risk. With regard
to the first risk, it came home in the form of unexpected rises
in interest rates that hit borrowers very hard. With regard to
exchange rate risk the trouble seemed to begin with the attack
on Thai currency in 1996, and the fact that its exchange rate
was linked to a basket of currencies until the Bank of Thailand
ran out of foreign currency reserves. Finally, the credit risk
crisis relates to the refusal of banks (primarily Japanese) to
write off bad loans and the negative consequences this reflects
and induces.
Perhaps one of the most important lessons to be learned from the
crises is that the banking systems in some of the major Asian
countries (most notably Japan and Korea) are in need of urgent
reform. Countries that have traditionally relied on bank-driven
economic development, in the ‘new world’ of globalised
and integrated markets, will have to: (a) downsize their banking
sectors (b) encourage the growth in alternatives to bank lending
as finance sources and (c) be more open to the requirements of
foreign investors.
What impact do you think the globalisation of world economies
will have on capital markets?
In truth the globalisation of world economies and of financial
markets that has gained considerable momentum in recent years
has occurred simultaneously. While the growth of globalisation
cannot be put down to a single factor, it no doubt has been strongly
influenced by the reduction and ultimate removal of investment
barriers and regulation between countries. Hence, momentum has
gathered towards achieving freer international markets, with a
major consequence of a more level ‘applying field’ for
international investors. One view of the dynamics of change suggests
that once it was clear that the world’s financial markets
were moving towards a globalised setting, all other markets (not
just financial) would be forced to follow — albeit with some
time lag. Thus, it is not at all clear which markets are leading
and which follow. Realistically, it will be a case of ongoing
feedback from one market to another which will have a reinforcing
effect. The important bottom line of this, however, is that, in
the absence of any government re-regulation, all markets will
tend to move away from segmentation and towards integration over
time. Integrated capital markets have one major implication —
where previously we would interpret and analyse capital market
phenomena from an (insulated) domestic market setting, we now
need to consider the same phenomena in a global market perspective.
That is, in integrated capital markets financial assets are priced
relative to world-wide investment opportunities. Finally, an additional
concern in such an environment is the extra dimension of risk
created by foreign exchange exposure.
If you were to pick your own investment portfolio what principles
would you apply?
Working from the realistic basis that I, as an investor, have
no special skill or advantage over the many thousands of investors
against whom I am competing, the general answer to this question
is relatively straightforward. Either, directly or indirectly
(through a managed investment fund), the best long-term strategy
is to choose a well-diversified portfolio. The portfolio should
contain a large number of different assets that may be largely
biased toward stocks — but not necessarily so. The important
thing is that the constituents of the portfolio provide a good
spread across all major sectors of economic activity. In this
way you can spread your risks such that if one sector of the economy
does poorly it is likely another will be doing pretty well, thus
delivering you a reasonable return on average and with minimal
unnecessary return variation (or risk). Given that transacting
is relatively costly, you would not bother re-adjusting your portfolio
very often — only when you perceived it to have changed its
nature such that it no longer satisfied your desired risk/expected
return goals. Further, as discussed above, given the move towards
integrated capital markets and the potential increase in diversification
benefits that international investment makes possible, it would
be very prudent to have a good portion of the portfolio devoted
to foreign stocks — particularly the major markets of the
US and Europe. Depending on your tolerance for risk, this international
component may even extend to some of the developed markets in
the Asian region and even perhaps some of the emerging markets
in this region, South America and Eastern Europe. At the end of
the day, for any portfolio formed, no matter how well diversified,
it will contain risk! There are no free lunches. One final thing
to remember, however, is that for the average investor, investing
in the stock market and holding a portfolio is not a substitute
for gambling at the casino — it is best viewed as a long-term
investment medium.
When investing in the stock market why is it important to consider
the time frame for your investments?
For the average investor, the stock market should be viewed as
a long-term investment medium. Often the greatest cause of investment
losses is the belief that short-term profits are easy to make.
Of course, there is much folly in this view. Remember at the end
of the day it’s a ‘zero sum game’ – if you
win then someone else loses. If you are the one that has no special
skill, then who is likely to win? While there are no guarantees,
taking a ‘buy and hold’ strategy in the longer term
is the best policy for most investors.
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