Many portfolios are fundamentally structured to fail investors, potentially quite badly given what we know about investment markets now.
To support my point here, all I’d ask is for advisers to look rationally look at a portfolio of conventional assets today, estimate the medium-long term returns that can be expected from current valuations – assuming some reversion to historical valuation ratings – incorporate fixed interest yields at close to zero and factor in at least one recession. What they’ll find is it is quite difficult to come up with positive annualised returns from many commonly used mainstream asset mixes and easy to see large, and possibly persistent, draw downs in the future term path of returns.
This is the second in a two-part series I’ve written for Professional Planner on the topic. The first article highlights why most traditional investment portfolios are doomed to fail; this article highlights how investors and advisers should respond.
From a broad perspective there are only two responses.
- Totally change investment approaches and be prepared to become much more contrarian, value based and truly defensive (for now at least).
- Stick to conventional portfolios but do a much better job of managing client expectations as to future outcomes, and potentially changing investor behaviour in response.
My natural inclination is response 1 but given the challenges this approach involves and that it is exactly the opposite of the direction many advisers/investors have been moving in recent years, it seems clear that few are suited to the true contrarian portfolio approach this involves. A feature of the current environment is significant pressure to avoid exactly those few investment areas that may offer better long term return prospects – such as value stocks, some emerging markets, out of favour markets like Japan and UK etc – and instead invest heavily into the more expensive growth and defensive areas that dominate indices and ETFs but which are arguably most vulnerable to a derating and poor returns.
You may be able to run such an unconventional portfolio for oneself or family, a small trusting group, or with the benefit of a well-known brand – and a diverse product base – but convincing advisers or investors generally to embrace, and stick with, such an approach in today’s investment world of information overload and short-termism is an increasingly difficult task.
That leaves response 2, largely maintaining the current approach to portfolios – perhaps with some small but tolerable contrarian/defensive tilts – but instead focusing on doing a much better job of managing client expectations as to what such portfolios will likely deliver, and potentially changing investor behaviour, if required.
This is not just about vaguely saying to clients that they need to expect lower returns or that markets will be more volatile in the future. Clients have heard that for years and either don’t believe it or don’t understand what it really means; after 10 consecutive years of positive balanced superannuation returns this attitude is hardly a surprise. However, the likely future story is much more brutal. The low/negative returns that are increasingly inevitable are likely to massively disappoint many client expectations, rupture retirement plans and cause serious financial stress.
Investors need to know
Investors should be more openly told there is now an increased probability their portfolio will fail to meet its current objectives, even over the medium-long term, and that they could suffer large drawdowns in the value of their portfolio along the way. Conventional diversified equity/bond heavy portfolios at today’s valuations but with yesterday’s return projections are a faulty product. For example, they don’t have the same level of inbuilt protection they used to receive from the fixed interest component, when yields were more normal. Investment objectives need to be dramatically lowered despite this bringing into question the benefits such a portfolio may provide.
Of course, these are not the messages advisers want to take to clients now when they are already under pressure from the Royal Commission changes, pressure on fees, declining business values etc, However, it is a message that will likely place then in a better position with clients in the future.
With a more realistic picture, clients can then decide whether to change their financial behaviour in response (for example cut expenses, work longer, give the kids less etc). Further, when the tough times come, these clients are more likely to stick with the strategy, rather than bail out at the worst possible time.
Whatever way advisers and investors go forward they need to more clearly envisage the future consequences. The worst results are likely to come from those unprepared investors (and advisers) who are complacently embracing conventional portfolios now but in/after the next crisis totally give up on those for the more defensive/contrarian portfolios that will likely work well through a more difficult period.
For example, after being out of favour for years, some investors are finally again embracing gold as a component in a portfolio (or looking at doing so). Gold ETFs have seen strong growth over the last year. However, I suspect this renewed popularity may at least partly be simply because gold has performed well recently rather than a clear rethinking of why, and how, to include gold as a component in a robust portfolio in the current environment.
For most therefore, the appropriate and practical response to the challenging current environment will not involve making major contrarian market calls or building a completely new portfolio. Rather, it means doing a better job of managing client investment expectations and being ready to admit that portfolios could seriously fall short of current investment objectives and past returns, and to adjust behaviour as appropriate.
The various storm fronts of near zero interest rates, overstretching for yield, high valuations for growth assets, excessive debts, subdued economic and earnings growth will take their toll. Given larger super balances compared to history, more investors than ever will likely be hurt when things unwind, meaning the reflexive/feedback impact on the economy and markets is likely to be greater than normal.
Investors need to more clearly understand that taking risk does not automatically translate into good returns and that the risk/return outlook of a static conventional portfolio can change markedly over time. The risk indicator on these is currently flashing red.
In the words of American Football star Jim McMahon “Yes, risk-taking is inherently failure prone, otherwise it would be called sure-thing-taking.”
