You’ve probably heard the phrase ‘the value of your investments can go down as well as up.’ Well, they do. Regularly. By the minute.
The extent to which you’re comfortable with fluctuations depends on the returns you want to achieve and over what time. The key consideration to remember is the correlation between risk and return. In general: the greater return you hope to achieve, the greater the risk of losing money.
The starting point for an investment manager in constructing a portfolio is understanding the ebbs and flows of our economy and their impact on investment portfolios.
Why are economic cycles important for investors?
Over time, economies fluctuate. They expand and contract. During expansion, indicators such as GDP, employment and consumer spending rise. Once you’ve passed the ‘peak’ when some – or all – of these measures start to fall, you’re entering the contractionary phase. That continues until you’re past the ‘trough’ when economic indicators start improving again.
Economic cycles are difficult to time but perpetuate approximately every five years.
Interest rate cycles also matter to investors
As countries’ economies expand and contract, the central banks of those countries try to keep things within acceptable boundaries.
A powerful tool they use is the setting of interest rates. When economies expand, they increase rates to have a ‘cooling’ effect. During downturns, they decrease rates, lowering the cost of borrowing, incentivising spending, and giving businesses and governments more capability to invest.
It’s a rather blunt instrument with far-reaching impacts on consumer spending power but it has proven to be effective. This is important for an investor because separate phases of economic cycles and interest rate cycles benefit different types of assets.
What equity balance is right for a portfolio?
Before you can answer this question, you need to understand what returns you hope to achieve over a specific time. You also need a clear sense of how much risk you are prepared to take on.
For example, if you’re in it for the medium term, you’re likely to have a limited appetite for risk because the shorter-term volatility of equities might not be for you.
Equities (shares in companies) perform well when the economy is growing, but poorly in contraction. In the 2008 global financial crisis, the FTSE All World Index declined by 58%.
Assets such as bonds, alternatives, and cash tend to perform more steadily, so adding them to your portfolio can insulate you somewhat from fluctuations in equities.
So, in the shorter term, a conservative approach with a higher allocation to bonds, alternatives and cash is appropriate. For a longer-term horizon, a more aggressive approach with a higher allocation to equities is suitable. Short-term volatility is not such a problem if you have an eye on longer-term returns.
There are only a few instances in the past century where rolling 10-year equity returns are negative, while for shorter rolling periods equity markets are often in negative territory.
In the past century for the US equity market there are only three periods where 10-year returns were negative, the second world war, 1970’s inflation and the global financial crisis.
Eliminating human bias in investing
Each economic cycle is different. And it's important to understand those differences and alter the make-up of portfolios to reflect the challenges and opportunities posed by a specific cycle.
When constructing a portfolio, the aim is to try to limit the impact of human bias by adopting a strict risk profiling framework, i.e. you shouldn't pick an asset or a sector simply because you like it.
Reducing bias as much as possible and the danger of over- or under-committing to risk aligns your asset allocation to match your goals over a typical economic cycle. The only problem is no economic cycle is typical, further adjustments are required.
Equities
Some equities are considered less risky than others. High-quality companies with strong fundamentals, such as consistent earnings growth, robust balance sheets and deep economic moats, are often more resilient during economic downturns. Valuation is crucial to avoid overpaying, and diversification helps mitigate risk.
Fixed Income
Bonds are a key component of a diversified portfolio. Including bonds in a portfolio should give you solid returns over the economic cycle and serve as a counterweight to the negative performance of equities during contraction or recession.
Understanding the interest rate cycle is central for fixed income investing. When interest rates rise (typically during an economic expansion) bond prices fall, during these periods interest rate risk should be reduced, and credit risk is favoured to enhance returns.
When the cycle turns and economies slow down or contract, central banks cut interest rates to stimulate growth. This stage in the cycle is best for traditional fixed income.
More interest rate risk is favourable and provides a ballast to equity market volatility. Here, government bonds and high-quality investment grade credit are favourable.
What is the benefit of alternative investments?
You can very crudely think of equities and bonds as two sides of a seesaw; there is often an inverse correlation in how they behave, particularly during recessions. Alternatives can do something different. Examples of alternative investments include hedge funds, commodities, and private equity.
We prefer liquid alternatives with a low correlation to equities and bonds and target returns in excess of cash.
Equity and bond prices often fall further and more quickly than when they rise. With this asymmetry in mind, protection against the worst periods is valuable.
‘Tail protection’ enhances overall portfolio resilience and provides a ‘smooth ride’ over a market cycle. This is particularly the case for lower-risk profiles with less tolerance for drawdowns.
Tom Hibbert is a multi-asset strategist at Canaccord Genuity Wealth Management. The views expressed above should not be taken as investment advice.