When asset prices are rising, investors often get caught up in the latest popular fashions or theories about why ‘this time it’s different’. To succeed, however, investors must stand apart from the crowd, demonstrating conviction and patience, and sometimes taking action that goes against the latest trends.
Asset valuation
The valuation of assets (and the price you pay for them) is the single most important determinant of future investment returns over the long term.
It might be hard to find compelling value when equity markets are at elevated levels. Yet, when investing from the bottom up – i.e. conducting intensive research, rather than relying on broad-brush asset allocation – it is usually possible to find opportunities.
When building investment portfolios, we place assets in one of two camps. Either they are return assets, or they are diversifying assets.
Return assets are those we expect to grow in value over time. They tend to be either individual equities or specialist equity-related funds. In the case of funds, it is best to focus on selecting the right managers in the first place and backing people for the long term, rather than regularly tinkering with positions. In the case of individual equities, more regular activity is usually needed, including selling positions that no longer offer a comfortable margin of safety. Yet, even in expensive markets, there may still be opportunities: high-quality businesses trading at undemanding levels with attractive valuations.
The focus on risks
To complement these return assets, it is essential to allocate a proportion of portfolios to diversifying assets that should help preserve capital and offer some protection, particularly during difficult markets. When stock markets are rising and the outlook seems rosy, it is natural to question these diversifying assets. Wouldn’t it be better to invest more in equities? Aren’t these assets just a drag on performance? Is all that protection really necessary?
To generate good returns over the long term, it is necessary to maintain balance in a portfolio
If the aim is to preserve and grow the real value of a client’s wealth, while avoiding large losses along the way, we believe the answer is definitely ‘yes’. To generate good, inflation-beating returns over the long term, it is necessary to maintain balance within a portfolio. No investor can correctly and consistently predict the future direction of markets.
With perfect foresight, it would be possible to move clients’ portfolios entirely into diversifying assets at the very top of the market, and then switch entirely to return assets before the next upswing. In reality, investing will always involve coping with, and preparing for, shocks and the unknown.
Diversification today
There are several warning signs that investors should always look out for, including historically high valuations of equity markets, a desire on the part of investors to take on more risk, and indicators of complacency. These should act as helpful prompts, a chance to reassess whether the diversifying assets you hold are likely to give you the protection you need.
To quote Miguel de Cervantes: ‘To be prepared is half the victory.’ When building this protection into portfolios, the aim is to buy the insurance before the fire.
Conclusion
At times of fear in markets, when anxious sellers are pushing valuations down to attractive levels, investors should act with confidence, seeing the long-term opportunities among the short-term unrest. By contrast, when investors are optimistic and complacency dominates, we believe it is often prudent to proceed with caution.
Whenever risky assets are soaring, a balanced investment approach may not seem exciting, and diversifying assets may feel like a drag on performance. Yet the direction of the economy and financial markets cannot be predicted with consistency and accuracy, and it is always wise to stay protected against major risks.