We have spent the most part of the last few weeks reviewing our clients' portfolios against the back drop of the recent market pull back caused by the recent credit crisis. The conclusions that can be drawn is that a structured and sound investment methodology backed by academic research that captures the asset class return has a far more reliable outcome than that deployed by investors who try to time the market and pick stocks on either a random or under researched basis.

At the same time it's worth explaining the cause of the crisis and what this means for your portfolio.

What caused the crisis?

The crisis was caused by hedge funds and other leveraged investors chasing equity-like returns through opaque fixed income vehicles. In this case, the vehicles were asset-backed securities that used high-risk US sub-prime mortgages as collateral.

Sub-prime mortgages are housing loans granted to the least credit-worthy borrowers. These were bundled with other less risky investments into complex securitised vehicles called collateralised debt obligations (CDOs).

While this bundling qualified the CDOs for a higher overall credit rating, it also masked their underlying exposure to the riskier and less frequently traded (or "less liquid") assets.

Many managers also sought to increase their returns on these CDOs through borrowing. But as defaults rose in the sub-prime market, they were asked to post further funds to support their borrowings, just as geared individual investors receive margin calls when their stocks fall in value.

This in turn forced the funds to sell equities and other profitable trades to cover their sub-prime losses- which partly explains why the credit crisis spilled over to equity, commodity and currency markets.

Why did central banks become involved?
 
Central banks became involved when what began as an upsurge in default risk started to broaden into liquidity risk.

Liquidity is the ease with which an investment can be sold and turned into money or with which money can be raised in debt markets. So in a liquidity crisis, even creditworthy borrowers like banks find it hard to source funding.

So the central banks have performed their role as lenders of last resort, providing emergency funds to the financial system at low cost to ensure the system keeps operating smoothly. This appears to have done its job for now.

What does the crisis mean for my portfolio?

The good news is that if you maintain a long-term view and stay properly diversified in a portfolio structured around compensated risk factors, you already have done what you need to do to ride through this turmoil.

If anything, the events of recent weeks in global markets reinforce the benefits of this long-term, patient approach.

It is the nature of markets to go both up and down. But if you have realistic expectations, remain diversified and disciplined and focus on capturing long-term asset class returns, you maximise your chances of having a successful investment experience.