It’s what you know (and just ain’t so)
Daniele Antonucci
Co-Head of Investment & Chief Investment Officer at Quintet Private Bank
There’s nothing better than catching up with market thinking and returning to old classics when on holiday; that’s what we all love to do, after all. Mark Twain couldn’t say it better: making our vocation our vacation is the secret to success. Turns out, Mark Twain was a prescient investor. We should have listened to him when we debated whether the inflation spike would be short-lived or long-lasting: “Buy land, they’re not making it anymore”. And, with things out there so uncertain, his insight seems to resonate now too: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”. So how do we deal with uncertain outcomes, shifting conviction levels and, generally, with a world that’s inherently unstable? The answer is portfolio diversification. Hear me out.
Portfolio diversification is the practice of spreading your investments around so that you limit your exposure to any one type of asset. The idea is that they do not have the same return drivers – each will perform differently at different times.
Why stick to one country when you can have the world? Different things could drive different stock markets around the world. And, more often than not, the best performing stock market tends to change from year to year.?
Similarly, why stick to stocks when you can also access other asset classes? Cash, bonds, funds, and many other investments, each have different return and risk characteristics that can help seize different opportunities while mitigating different risks.?
Don’t put all your eggs in one basket
Coined in the early 1600s by the author of Don Quixote, Miguel de Cervantes, the saying “Don’t put all your eggs in one basket” has become a valuable metaphor for explaining how you could manage your risk when investing.?
If you invest in just one company, you rely solely on it to do well. And, as we know, various factors – such as company and sector news, government and central bank events and decisions, and wider economic trends – can cause the markets to go up and down.
Not putting all your eggs in one basket means that, by investing in a range of assets, you can balance the poorly performing investments with ones that are doing better, and local events (say, Brexit or Russia’s invasion of Ukraine) could have less of an impact. Diversification can help reduce the volatility of portfolios.
One of the keys to successful investing is learning how to balance one’s comfort level with risk against the time horizon of the chosen investment strategy. Invest too conservatively and the growth rate of your investments won’t keep pace with inflation. Invest too aggressively and you could excessively expose yourself to market volatility, which could erode the value of your assets to an extent that makes recouping your losses difficult.?
Think about a goal 20 or 30 years away, like retirement. Because your time horizon is long, you may be willing to take on additional risk in pursuit of long-term growth, assuming that you’ll usually have time to regain lost ground following a short-term market decline. In that case, a higher exposure to stocks may be appropriate.
But here’s where your risk tolerance becomes a factor. Regardless of your time horizon, you should only take on a level of risk with which you’re comfortable. So, if you’re relatively risk-averse, you may want to consider a more balanced portfolio including high-quality fixed income assets – ?even if you’re saving for a long-term goal.?
Why chasing the ball isn’t a good strategy
The first thing you’re taught when playing sport is: don’t chase the ball, stick to your position. Go to any kids’ match, and you’ll see all the players ignoring this advice. They chase the ball and run around, leaving no defence in place. If your investments are all doing the same thing, your portfolio probably lacks a defence.
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That’s where the danger is. Investing isn’t about picking winners. Of course, that plays a role, but it’s not easy to spot the star player. Instead, building a good team with all players working well together is something you can apply yourself to.
If we could fully control how investments performed, the world would be a vastly different place. We can’t. But we can spread our money to be ready for the unavoidable unpredictability that’s out there.
No strategy can guarantee that the value of a portfolio increases without occasional setbacks, as no one can make assets appreciate and markets trend higher. It might feel uncomfortable to put hard-earned money into areas that aren’t doing well – but when things improve, and eventually they do, you’re more likely to be in the right place at the right time by applying a portfolio diversification strategy.
How does it all work in practice?
Those who stay invested over the long run in a well-diversified portfolio tend to do better than those who try to profit from turning points in the market. And that’s what we do.
Of course, this doesn’t mean investors shouldn’t take advantage of opportunities offered by the market and instead invest once and wait. So, we tilt our portfolios according to whether we believe valuations are attractive, the key market technicals make sense, and the catalysts we identified are playing out (or not, therefore requiring an adjustment to our investment strategy).
While our outlook lays out our base case for the next 6-12 months, we’re not married to pre-set conclusions. We care more about how we arrive at those conclusions: the mechanics – our understanding of the cause-effect logic behind them. As things inevitably change, the same mechanics could point to different conclusions over time.
Here’s how we’ve positioned our flagship portfolios
1. Prefer quality bonds vs equities and riskier credit: Year-to-date, our asset allocation continues to perform positively, driven by our long-term allocations to global equities and bonds. Despite the positive performance, our tactical 12-month view remains cautious. Truth be told, the summer has been volatile: government bonds and stocks sold off simultaneously at times, a ‘no place to hide’ dynamic that investors have come to know all too well, especially last year during the inflation and interest rate spike. Along with some of our instrument selections, this has detracted from absolute performance, though in a relative sense our cautious stance did mitigate the downside. We’ve invested in high-quality bonds – especially US Treasuries – over riskier equity markets and high-yield bonds. We expect central bank rates in developed markets to be close to or at the peak, but we don’t see rate cuts in the near term. And we still think that investors are too optimistic about economic and earnings growth.
2. Government bonds a high-conviction call: The yield of developed market government bonds is attractive and, taking a 12-month view, we think it allows investors to lock in a reasonable rate of return without taking excessive risk. The yield of short-dated bonds, in particular, is higher than the earnings yield of the S&P 500 or the FTSE 100 equity indices, highlighting that the risk/reward for equities, a more volatile asset class, looks tough in the near term. As the UK inflation outlook remains uncertain and we forecast extra Bank of England rate increases, we’re not raising our exposure to gilts just yet. However, we acknowledge that they look increasingly more attractive. Eurozone government bonds may begin to look appealing too, and we’re also undertaking research in this area. Conversely, in our view, the additional yield of lower-quality bonds seems too small to take the extra risk, especially as markets haven’t fully dealt with the impact of past interest rate hikes, and so default rates may pick up more than expected.
3. Stay defensive within equities: We’ve invested in low-volatility equities in the US and Europe and quality dividend payers in the US. Relative to our long-term allocation, we’re also positioned with a lesser weight to US equities (slightly) and Eurozone equities (somewhat more markedly). While low-volatility equities continue to make sense to us, if we were to establish that dividend cuts were less likely in a scenario where the US economy were to continue to defy recession expectations, this could be a catalyst to reassess our dividend exposure. Furthermore, our single-line portfolio holdings remain biased towards investments which we believe demonstrate solid long-term growth prospects, strong balance sheets and attractive valuations. These attributes can serve as a buffer in the event of a reversal in market sentiment.
4. Light and shade in Asia-Pacific including Japan equities: Against our expectations, Asia-Pacific equities have lagged global equities. Performance has been mixed. Japan, Taiwan, South Korea and, lately, Indian equities have all performed positively, and in the case of Japan, we were positively surprised; however, Chinese equities have disappointed. The post-Covid activity surge has recently slowed in China, driven by a global manufacturing slowdown and renewed property weakness. Here, we’re watching whether Japan’s reform story and cyclical pick-up have further to run. In a sense, positive inflation is a healthy development for Japan as long as the Bank of Japan doesn’t upset global markets with a sudden change in monetary policy, which is what we’re watching. In China, we’re monitoring whether stimulus does come through in China. If not, that could prompt us to reassess our positioning in this market.