The big problem with a conventional balanced portfolio

Portfolio management, like any process, is shaped by recent history. The last thirty years have been dominated by a long term disinflationary/deflationary trend; an environment that favours passive investment in equities and bonds. It is therefore little surprise these asset classes comprise 70 - 80% of a conventional balanced portfolio. In addition equities and bonds compliment one another in a deflationary environment; when growth is improving equities outperform, during an economic contraction bonds come to the fore providing diversification. In light of this most asset managers construct portfolios with a reasonably static asset mix (within narrow ranges).

This recent history has dominated the experience of most investment managers and is the foundation of the conventional buy and hold investment portfolio.  Our concern, however, is that there is a growing probability we are entering a sustained period of inflation which could lead to disappointing results from this style of portfolio.

The below table shows investment returns by asset class in a variety of investment environments or regimes.

Asset class total returns (annualised) by regime 1970 - 2016 

If an inflationary environment does materialise we should therefore expect a conventional passive balanced portfolio (equity/bond composition) to deliver subdued returns; on the basis of almost fifty years of analysis this could be as low as +3% annualised compared with +9% enjoyed in a deflationary environment. This will have dramatic implications for the preservation and growth of wealth, especially in real terms (n.b. all above numbers are before inflation and investment costs).

The Harver approach is to seek positive real returns irrespective of the environment, this is achieved by:

• Dispassionately assessing the evidence to understand the regime, thereby avoiding this herd behaviour
• Being nimble. Active management of asset allocation is our primary source of return and risk mitigation, we can (and do) have nil allocations to asset classes if the environment is not supportive
• Defining permanent loss of capital as our primary risk measure, not a relative benchmark
• Employing significant gold exposure when appropriate, particularly in an inflationary growth environment
• Minimising total expense ratios thereby maximising client returns in the long term 

Outlook and Portfolio Positioning

Markets have taken the Trump presidency positively, focussing on the reflationary effects of proposed tax cuts and spending promises, pushing US markets to new all time highs. The heightened risk of a more protectionist "America First" trade policy, as well as the general capriciousness of the new President, is yet to be priced in it seems.

The key evidence we monitor in assessing equity market prospects deteriorated in December prompting us to reduce equity exposure. The outlook for bonds remains challenging due to the reflationary backdrop, and gold has found a base after a setback late last year.

Equities may well continue to push higher but we must respect the fact that risks have risen in the short term and some caution is warranted. All Harver portfolios are carrying substantial cash balances awaiting better investment opportunities.