Chris Hestelow

Australian shares are up over 10 per cent over the past year, and their global counterparts have performed even better, with the MSCI and ACWI index up around 28 per cent over that period.

That’s according to Allan Gray investment specialist Chris Hestelow who points out that both markets are trading at a very significant premium compared to history across a number of valuation metrics.

“As investors, this is often where we feel safest,” Hestelow says.

“We have a tendency to extrapolate what has happened recently out into the future, so when times are good, we expect the good times to keep going. In fact, euphoric markets are actually the most dangerous times for investors.”

The temptation, he says, is to pile into areas that have already done well. The biggest risk is to overpay for assets and destroy capital in the process when prices fall.

To provide a counterbalance to potentially overvalued equity exposure, portfolios need to have defensive assets. Most multi-asset portfolios use fixed income securities, such as bonds, to achieve this.

Over the long term, equity markets and fixed income markets have been negatively correlated – such as when equity markets rise fixed income falls, and vice versa. Fixed income has done a good job of cushioning the impact of weaker equity markets, though less so in recent years, as movements between the two markets have become more closely correlated.

But fixed income is not without its own risks. If inflation proves to be more persistent than the broader market expects, and yields rise, bond prices may fall, Hestelow points out.

It makes sense to have significant diversification within an investor’s defensive assets.