As the financial year draws to a close it will soon be time to review what has been a more turbulent year in the global economy. Recent market strength has provided a welcome relief after widespread weakness at the start of 2016.
As humans we like order, we like certainty, we enjoy the perception of control. Unfortunately investing does not always provide us with this. Yet the reason an investor can expect a greater return over the long-term than that available from cash (i.e. from term deposits) is because they are willing to accept short term swings and roundabouts. Otherwise there would be no incentive for the ultimate recipient of your capital to deliver a higher return than what a bank would pay on a cash deposit.
Taking on no risk means receiving very little long-term reward, whereas taking on too much risk, especially risk you are not prepared for, can result in poor decision-making and loss of capital.
The key is to ensure you have the right investment strategy, so that those swings and roundabouts are both manageable and within the realm of expectations. Through the use of diversification and investing over the appropriate time horizon we can also help reduce a large portion of the risk.
Nevertheless a degree of investment volatility will always need to be tolerated by any investor. This is why viewing your portfolio through the right lens is so important.
The graph below shows the value of the Australian sharemarket over the past few years. As you can see, while the graph shows a long-term upward trend, recently markets have gone through a more challenging period:
The cyclical nature of markets
Investment markets are inherently cyclical in nature. Not only are markets subject to the investor behavioural forces of fear and greed, they are also subject to the impact of economic cycles, as economies oscillate between periods of expansion and contraction. In addition governments and central banks are playing an ever increasing hand in trying to influence these cycles, often with less than ideal consequences.
Each asset class (ie bonds, equities, property etc) is subject to its own influences and its own economic cycle. These cycles are often interrelated, complex and at times difficult to predict. Often they overshoot on both the upside, as investors chase ever increasing returns, and on the downside, as investors panic and flee the asset class. Additionally investors can be correct “too early”. Those of you who have seen the movie “The Big Short” will recall that Michael Bury, one of the key characters, went through a significant period of anguish involving losses, before he was ultimately proven to be correct on the US housing collapse.
This is why the correct balance between diversification and asset scrutiny is also paramount. For example while still maintaining diversification Libero Capital has made a conscious decision to remain “underweight” US and European bonds as well as Property at this time in the cycle. While both asset classes have performed very well over the past few years, and indeed over the past 12 months, we feel downside risk currently outweighs upside risk, particularly with global interest rates close to as low as they can go. Furthermore with many of our investors already exposed to property via their homes, we feel it prudent to essentially “diversify away” from the asset class in the Libéro managed portfolios.
The importance of investment time horizon
Despite short-term volatility, over an extended period of time established markets will always revert to an upward trending mean. The value of human capital, efficiency gains and ever increasing scarcity of resources has ensured this since the beginning of the modern economy.
Understanding your own risk tolerance is a key element to ensuring long-term financial security. The graph below shows the long-term expected return for each type of portfolio in the current low interest rate environment. Equally importantly it also shows the likelihood of negative performce in any give year in order to achieve those returns. Note that these figures have been taken from APRA (Government) published figures, so any sources claiming rosier numbers should be questioned.
While periods of losses and/or low returns can be disconcerting, it is important to remember that if a portfolio is constructed correctly, it should always deliver you returns well in excess of those available on cash deposits over the long-term. Even an investor who invested all their money right before the start of the financial crisis is likely to have recouped all of their losses within just a few years, if they had invested into a properly diversified portfolio.
If you wish to discuss your portfolio or risk tolerance, please don’t hesitate to call. We are always happy to discuss client portfolios and assists with analysis regarding your individual situation.
Glen Holder, BCom, DipFP, CA, MAppFin
Director – Investment Management