Given the inherent volatility of markets, it’s useful to remind ourselves of strategies we can utilise to meet investment goals. The fundamentals of portfolio construction can help position portfolios appropriately in times of crisis and volatility.
Exploit a long-run time horizon
Investors with a long horizon don’t need short-term liquidity, giving them an edge during market sell-offs. As markets fall, long-term investors have often generated excellent returns by buying quality distressed assets across major asset classes.
Additionally, if the market rewards illiquid assets with a higher risk premium, it makes sense to over-allocate to such assets, as it’s unlikely that they’ll need to sell during bouts of volatility. During financial and economic turmoil, investment horizons tend to shorten due to immediate cashflow needs or because of psychological factors. The last thing that any investor wants to do is sell an asset into a volatile and illiquid market.
The free lunch
Diversification is the rare free lunch available to investors: it can reduce portfolio volatility without reducing its return. A key challenge to achieving diversification is reducing the dominance of equity risk in a balanced portfolio. Even if diversification tends to fail in crises (as correlations spike across asset classes), it can still be useful in the long run. This matters more for long-term investors who face less liquidation pressure during market drawdowns.
Most portfolios have positive exposures to the equity market and to economic growth. This risk is difficult to diversify away, making those assets with a negative correlation to equities a valuable addition. Diversification however has limitations (one of which is the tendency for correlations to approach one during crises) and a strong risk management framework and avoidance of large drawdowns is key in generating good long-run compounded returns.
Risk-free is return-free
Risk-free assets like cash and government bonds no longer generate a positive inflation-adjusted yield and are returnfree. Long-run investors can position for ‘the portfolio rebalancing effect’ that is likely to dominate investment flows in the next decade.
Expected portfolio returns can be improved by increasing the weight of the most volatile asset class. The classic approach is to raise the weight of ‘high-risk, high-return’ equities and reduce the weight of ‘low-risk, low-return’ assets such as cash and government bonds. Taking more risk in this way, and getting rewarded for it, is an easy way to boost long-run returns for investors.
Minimising costs can come at a cost
Passive investing minimises trading costs. However, some costs are worth paying. For example, buying an index fund costs more than investing in a bank deposit, but the risk premium should make the cost worthwhile in the long run. In general, investors should allocate more to active products the less they believe in market efficiency. Minimising costs is not always smart; being cost effective and avoiding wasteful expense is.
The importance of being selective
Market outperformance – through the compounding of returns – can help investors achieve their financial goals. Excess returns can be an important driver of wealth creation, and actively managed funds offer the opportunity to outperform the market. Even seemingly small amounts of excess return can lead to significantly better outcomes.
Over the intermediate term, asset performance is often driven largely by cyclical factors tied to the state of the economy, such as corporate earnings, interest rates, and inflation. The business cycle, which encompasses the cyclical fluctuations in an economy over many months or a few years, can therefore be a critical determinant of market returns.
As volatility is ever-present in capital markets, protection in the form of safe-haven assets and portfolio diversification will be increasingly important for investors. However, today returns from defensive assets will likely be far less than historic averages. Due to central bank action, riskier asset classes like equities appear likely to attract increasing inflows over the coming decade. The traditional methods of portfolio construction – a long-run horizon, diversification, cost-control, and active investing – remain the best approach to generating sustainable long-run returns.
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