Is this time different? How to structure your portfolio during volatile times.
Written October 2022
It’s difficult to find many investors with strong convictions at the moment. Inflation is scaring monetary policymakers into higher rates, but the supply chain is freeing up, and US mid-terms are usually good for stocks. However, with Putin increasingly cornered by HIMARS and Rocket Man Kim declaring his nuclear nation, what might be the trigger that sends us fully bearish?
Even with Sir John Templeton’s four most dangerous words in mind, maintaining asset allocation throughout volatile market conditions is a precarious experience for investors and advisers, but prioritising a strategic, top-down strategy is likely to carry a more significant weight to long-term performance. According to studies cited by the CFA institute this decision accounts for more than 90% of investment returns, whilst individual securities selection only 7%. So instead of chasing the past performance of popular active funds or the low-cost allure of tracker funds, why don’t investors and advisers spend more time analysing their macro allocation more proactively?
We can’t time the market. This is accepted, and most investors know the behavioural finance perils of trying it, such as The Tech Bubble in 2000 - a euphoric buying spree that led to one of biggest bubble implosions since Tulip Mania, the bank-fuelled Credit Crisis and, in recent times, the Crypto Bubble - just ask Elon Musk.
For the advisory industry, a proactively managed asset allocation, i.e. getting strategically in and out of equity markets, is out of the question. Regulation prevents short-term tactical shifts that aren’t consistent with a client’s medium to long-term goals, Attitude to Risk, and Capacity for Loss. Discretionary powers held by brokers or fund managers, however, do allow these decisions, but given the risk of getting them wrong and straying from regulatory asset risk allocations, it’s unlikely a discretionary adviser will move heavily against the herd as part of a tactical reallocation.
The carcasses of poor stock market calls are evident throughout challenging periods. Veterans such as Crispin Odey proclaimed a global Bear Market in 2015, Jim Cramer advised Bear Stearns was not in trouble before the market collapsed in 2008, and in 1988, Paul Krugman said the internet would have no impact on investing. It’s over to the Hedge Funds then? No, unfortunately, most of us aren’t accredited or sophisticated enough to access them, and even if we were, they’re expensive, and there’s little evidence to suggest that many have provided timely macro asset allocation.
Given these timing risks it’s comforting to know that mainstream portfolio construction is disseminated in Modern Portfolio Theory (MPT) which blends negatively correlated assets to maximise diversification and minimise volatility for investors. Allocations are now driven by an equity/bond & alternatives mix such as 60:40 or 80:20. This allows advisers to focus on their client’s medium to long-term goals and avoid making short-term bets or becoming heavily overweighted. When well designed, managed, and reviewed, MPT delivers in reaching long-term or ongoing investment goals, such as growth or income, throughout all stages of a market cycle, whilst also allowing most investors to maintain a steady emotional attitude to their investment strategy.
The success of MPT lies with the skill of the investor or adviser to establish the initial and ongoing correlation of assets to investment goals, behaviours, risk, and return, but it’s here that not all strategies are created equally. If an adviser doesn’t accurately establish and regularly review a client’s goals and capital needs, they might for example, fail to identify short term spending changes and find clients withdrawing funds for a capital purchase in the middle of short-term negative volatility, such as in Lockdown. This is called Shortfall Risk, well known amongst advisers but according to Vanguard, due to the current expectation of consistent equity returns, it has become less identifiable and more aligned with initial discovery meetings than ongoing reviews. Client circumstances change and if there isn’t sufficient, engagement and dialogue between clients and advisers, portfolios can become harmful to financial health.
As Pandemic volatility revealed, investor behaviours and biases are sometimes hidden therefore client discovery can be an evolution. A thorough initial discovery process includes a risk assessment but it’s important to ascertain how personality correlates to investment decisions and feelings, which will set the structure for planning and should form part of regular reviews. Dr. Brad Klontz created The Money Script Inventory for this reason and it’s fascinating to complete an online evaluation, if only for yourself as an investor.
Safety is key in justifying investment; therefore, short-term and emergency funds need to be accurately allocated. The Certified Financial Planner Board of Standards, Inc. recommends three months of fixed, variable, and tax-based expenses for joint earners in a household and six months for single. Short-term spending should be considered irregular expenditures foreseen within the next three years. To this end and to create a better strategy process, spending, and goal-based planning objectives should be categorized into short, medium, and long-term and placed into groups of tax-effective accounts, known crudely as “Pots.” Once accurately defined, it’s important to apply cash management alongside MPT and investment fund allocations. Appropriate asset allocation aligned to goals and management of these strategies can only be maintained if the emergency, short-term spending, and cashflow requirements are regularly reviewed. By establishing categorised Pots as early as possible, investors can enjoy consistent results and feel comfortable in committing more long-term funds during volatile times to a higher-risk budget such as global equities.
Recently, it's become apparent that income investors can no longer rely on the 28-year-old, 4% annual income rule created by Bill Bergen in 1994 to secure their long-term asset value. According to Morningstar, recent volatility means that no more than 3.3% annual income should be taken from an equity portfolio to preserve retirement assets. Therefore, cash flow forecasts must be adjusted alongside a reasonable rate of inflation. From an MPT allocation standpoint, growth strategies still deserve a heavier global equity allocation, such as 100% and 90:10, but for an annual income of over 3.3%, fixed income, higher yield, and alternative assets weighted 80:20, 70:30 or 60:40 are more likely to meet objectives, and with more securities denominated in domestic currency.
Investors and advisers must think ahead and conduct a thorough discovery process but also take an active interest in family, personality traits, lifestyle, and spending plans as they relate to age and stages of a personal life cycle. In doing so, they can use and adapt MPT to their advantage, manage risk, liquidity, investment goals and maintain emotional harmony.
