By Scott Haslem
The years since the global financial crisis have been good for markets. A wave of stimulus from the world’s central banks has underpinned a significant period of expansion for global economies and markets have performed handsomely, particularly over the past few years.
But as we reach record territory for the length of the cycle the photocopiers are being turned off and central-bank money printing – and ultra-low global interest rates – appears to be coming to an end.
As the cycle matures, investors’ attention turns to when the cycle might end or, more importantly, if a bear market will begin. As each day passes, we move closer to the end of this cycle. A maturing cycle can make investors nervous about deploying fresh capital and being exposed to loss if the markets swing one way, or indeed, another.
Yet “timing the market” is not easy and it’s unwise to let emotions rule an investment decision. The degree of precision required to beat a buy-and-hold strategy is extreme – it’s just as difficult to decide when to buy in a falling market as it is to sell in a rising one. As Crestone’s head of asset allocation, Rob Holder, recently noted, “Numerous behavioural finance books and studies on market timing tell us that the practice is likely to lead to a sub-optimal result.”
The key factors in constructing a long-term portfolio today
Attempting to time markets (not to be confused with tactically tilting allocations) is at odds with one of the most important tools for long-term investors, namely the discipline provided by a strategically asset-allocated portfolio. So, what are some of the key considerations when constructing your portfolio? The three main factors should be:
- your return objective;
- your risk tolerance and investment time horizon; and
- the level of portfolio liquidity you require.
These key factors will help determine the appropriate (long-term) strategic asset allocation; current (short-term) tactical views, then dictate the final portfolio weights. By understanding the likely future risk, return and correlations of different asset classes, a portfolio can be designed to deliver an expected return maximised for an investor’s level of risk tolerance.
The higher the return objective, the greater the required allocation to riskier assets in order to achieve that result. Of course, the higher the return objective, the higher the volatility (and possibly lower liquidity) that will likely be needed to deliver that return. By thinking in this way when constructing a portfolio we can help minimise the pitfalls of behavioural tendencies that may cloud investors’ judgement.
Staying uninvested for fear of market corrections can come with a high opportunity-cost of lost returns.
Two other factors are increasingly considered in building portfolios today:
Align your portfolio with your values: The desire To invest responsibly has never been stronger among investors. This involves integrating some combination of environmental, social and governance factors, ethical values, or investing in a way that impacts or promotes global sustainability. This no longer needs to come at the cost of portfolio diversification or total return. Establishing such guidelines is easier in the initial stages of constructing a portfolio.
Be globally diversified: It makes sense to build truly diversified portfolios that can take advantage of global opportunities not available in domestic markets. It also allows for a fuller diversification of risk between regions and across asset classes, potentially delivering higher risk-adjusted returns while smoothing volatility through time. Alternative assets (such as private equity and hedge funds) which behave differently to traditional asset classes like equities and bonds should also be an important allocation for investors.
Challenging markets and fresh capital
With the current market cycle closer to its end than its beginning, it is a more challenging environment for major asset classes, and medium-term return expectations are being lowered. In the current environment, more subdued return expectations reflect low interest rates and high asset valuations. When constructing portfolios, investors may need to either accept a lower forecast return or increase risk in order to reach their return objectives.
This is a different argument from delaying the implementation of capital because the market is maturing. Staying uninvested for fear of market corrections can come with a high opportunity-cost of lost returns. In 1997, the US equity market was viewed by many as expensive and late cycle but it rallied almost 60 per cent before correcting in 2000.
Instead of delaying implementation, strategies for constructing portfolios in the later cycle should involve: i) implementing portfolios that may have a larger cash position than normal; and/or ii) implementing a risk profile for a growth investor that’s more balanced in order to access greater liquidity at a point in the future should more attractive investment opportunities be present.
However, it’s key that this still involves implementing a strategic asset allocation that allows the interaction of typically inversely correlated asset classes (such as equities and bonds or alternative assets) to provide the buffer in returns when risk appetite dissipates. And vice versa.
The exact nature of the cycle ahead is always uncertain. Portfolio construction is as much about establishing risk and return characteristics as it is about stepping away from the pitfalls of behavioural investing. Without such structure, the emotions involved in making buy-and-sell decisions – particularly at times of market dislocation – are uncomfortable and unwelcome, and often lead to sub-optimal portfolio positioning.
Scott Haslem is chief investment officer at Crestone Wealth Management.