Most of the time, investors don’t need to think too much about market timing or asset allocation. The long-term trajectory of financial markets is up and the only sensible thing to do is to be fully invested and allow the odds to work in your favour.
As we enter 2018, however, right now doesn’t feel like most of the time. Nine years into the current equity bull market and with well-known and successful investors like Jeremy Grantham and Neil Woodford muttering darkly about investment bubbles, every investor’s New Year’s resolution should be to look at their portfolio and understand the risks they are taking.
If you try to call the top of the equity market, one of three things will happen. You will get it just right, be too early or too late. The chance of the first is vanishingly small, so what matters is how you want to be wrong. Do you care more about losing what you have accumulated in recent years or watching from the sidelines as others make profits that you have consciously foregone?
Pain early or late
Whichever misjudgement you choose, it will probably be expensive, especially if you are over-exposed to the equity market, as most investors are. A year ago, you could have looked at the valuation of the US sharemarket and concluded that it was over-priced. Shares then cost about 25 per cent more, as a multiple of profits, than their long-term average. If you had de-risked your equity portfolio at the beginning of 2017, you would have missed out on a 20 per cent rise in the S&P 500 and even more on the basis of the Dow Jones Industrials index or the Nasdaq.
Anyone bailing out of the market today risks a similar opportunity loss. In every market peak since the 1920s, returns have tended to accelerate in the six months before the market changes direction. On average, missing out on the final year of a bull market has meant leaving 20 per cent of gains on the table for someone else.
Being late is just as painful. Between 2000 and 2002, the US benchmark index fell by nearly 50 per cent. Between the peak in 2007 and the bottom of the market in 2009, the fall was closer to 60 per cent. These are the exception not the rule but there are plenty of other examples of market falls of between 10 per cent and 20 per cent. Even these are worth avoiding if you can. Remember, a 50 per cent fall in the value of a portfolio requires a 100 per cent recovery simply to get back to square one.
So if, like most people, you feel the pain of a loss more than you enjoy the pleasure of a gain, you are probably thinking about protecting what you’ve got. How might you do that?
If you are really risk-averse, you may decide that the market has been driven by excessively loose central bank policy that is now reversing, that valuations have gone too far and that the market has had a fantastic run. You will, therefore, swap all your investments for cash. Anyone doing this needs to understand that it comes with a significant cost. It’s not just the opportunity cost, it’s the fact that assets with the lowest risks, such as cash, also guarantee the lowest returns. All the while that you are ‘de-risked’ you will be losing money in real terms.
Minimising the damage
The good news is that you don’t need to do this. If you are prepared to accept that a portion of your portfolio will indeed go over the cliff when the market inevitably turns, you can still minimise your losses and maintain some exposure to any final upswing in the market by injecting some balance into your investments.
To see how this worked the last time an equity market bubble burst, let’s jump back in time to the 1999-2003 boom and bust. In 1999, emerging-market equities delivered a total return of 72 per cent, while Japanese shares returned 67 per cent. A well-diversified global equity fund would have given you 31 per cent, while the defensive assets in your balanced portfolio would have looked drearily pedestrian at 6 per cent for cash, 3 per cent for corporate bonds and a modest fall in the value of any government bonds you held.
The following year, as the equity bubble burst, the emerging-market equities that had topped the table in 1999 were the worst performers, losing more than 25 per cent of their value. The Japanese shares were not far behind. Offsetting those falls, however, were cash, with a slightly higher return than the previous year, and double-digit returns from all types of debt: emerging-market, corporate and government. In 2001, it was the same story. By 2003, however, emerging market equities were the top performers and government bonds were at the bottom of the list.
One of the problems with how we think about our investments is that the media encourages us to think it’s all about equities. This is natural. Shares are more newsworthy because they bounce around more than bonds and are more closely linked to the ups and downs of corporate news. But this focus on shares encourages us to think in black-and-white terms about the market. If your New Year’s resolution is to take some risk off the table, don’t overdo it and don’t swap one unbalanced portfolio full of equities for another stuffed full of cash.
At this uncertain point in the cycle, you can’t be too diversified.
TOPICS: asset allocation, investment