The new year is well underway and with it has come the usual flurry of expert predictions. So, in that great tradition, Innova Asset Management unveils its 2017 forecast: we don’t know what’s going to happen!
But that’s OK, nobody else does either. So why listen to them?
Last year’s shock Brexit vote and Donald Trump’s US election victory were surprises only because ‘expert’ opinion was so broadly accepted as fact. It’s not the first time that experts’ powers of prediction have been shown to be false (the Soviet collapse, the Y2K bug, the global financial crisis) and it certainly won’t be the last.
Several studies have underlined the folly of forecasting by pollsters, economists, investment analysts – and even fund managers.
For example, consultant William A. Sherden analysed the track records of experts across meteorology, economics, investments, technology assessment, demography, futurology, and organisational planning in The Fortune Sellers: The big business of buying and selling predictions, and found that none consistently made accurate forecasts.
Twenty years after his book was first published, little has changed.
So what exactly can we know and on what should investors base their decisions?
Manage risk, don’t chase returns
Investors want to know where they can make money. So-called experts then meet this demand by attempting to pick winners (we rarely see an assessment of past predictions unless they’re right).
Fortunately, building successful portfolios isn’t about predicting the best-performing asset class over the short term. It’s about combining a range of assets that will perform differently through various economic environments to deliver sustainable long-term returns that meet investors’ requirements.
While nobody can predict investment returns, risk and correlations with absolute certainty – or they’d be able to run a perfect portfolio – risk is the most knowable component. Risk is what can blow up a portfolio and derail returns.
We define risk in multiple ways: the likelihood of losing money, the average and maximum magnitude of those losses, and volatility all contribute to the risk of a client not achieving their goals. Investors are more likely to win over the long term by losing less. Those who have seen an investment halve in value have already experienced this: they know they then need to post a 100 per cent return just to break even.
Risk presents itself in many forms and can crystallise under different scenarios – and this is where investors must focus.
The risks we face today
A strong portfolio needs to be built to withstand risk and allow returns to compound over time. Investors have a right to be skeptical. They are facing an array of potential new risks on the horizon and know that experts have failed to predict previous crises – and will fail again. But while the actual trigger events behind each historical crisis may differ, stretched valuations have been a consistent warning signal of rising risk.
US equity valuations have been as extreme as they are now at three other times in history: prior to the Great Depression, the tech-wreck, and the GFC. That’s not a prediction – but it is a clear warning sign and strongly suggests that future long-term returns will be pretty poor from here.
Markets have been acting under one dominant scenario incorporating all of the potential upside of a Trump presidency. However, it remains to be seen how much of what he said during the election campaign he meant, how much he will want to implement, and how much he will be able to implement.
A wiser approach is to view the full range of potential risk scenarios and build a portfolio with a range of assets driven by different risk factors. For example, a portfolio dominated by equities and bonds will perform poorly if inflation rises quickly because they share this common risk factor. However, rising inflation will probably be positive for assets such as inflation-linked bonds, gold or commodities, assuming starting valuations are reasonable, and assets such as floating-rate corporate bonds can provide protection against a rising rate environment.
Investors can incorporate these assets into their portfolios or into related strategies such as managed futures or volatility trading strategies. Other baseline risk scenarios could be falling economic growth, deflation or, god forbid, a combination of both.
Unfortunately, most so-called balanced funds still take a simplistic approach to diversification and remain dominated by equities (60-70 per cent). Equities tend to suffer under multiple scenarios: recessions or periods of high inflation and deflation. This is the key reason balanced funds posted double-digit losses during the GFC.
Strong portfolios require effective risk management based on true diversification – not predictions, which have the accuracy of tossing a coin.
