Rethinking asset allocation
Henning Stein, PhD
Results-Oriented Investment Solutions Executive | Asset & Wealth Management Change Agent
The die-hard disciples of short-termism
Many investors put a lot of effort into making sense of the world as it stands at any given moment in time. This fascination with the here and now usually translates into a focus on the near future. If you understand what is happening today, the logic goes, you have a decent chance of figuring out what might happen tomorrow, next week, next month and so on – and you may be able to benefit accordingly.
I wish anyone determined to apply such an approach amid the current economic climate the very best of luck – because in the end, if we are being brutally honest, luck is likely to be a major factor in their success or failure. As I have written previously, there is a big difference between genuine investment, mere speculation and glorified gambling.
Even attempts to presage the next 12 months are shrouded in uncertainty, as quickly becomes obvious if we reflect on just a handful of basic considerations. The end of the COVID-19 pandemic seems to be in sight, yet many countries still face rising infection rates and ever-stricter lockdowns. We can expect an economic recovery of some kind, but we cannot be sure of its precise course. Inflation or deflation – or both – may await further down the road.
The experience of recent years also speaks volumes. Conspicuous bullishness gave way to sizeable market losses in 2018, while it hardly need be said that 2020 did not pan out quite as the authors of numerous annual investment outlooks had foretold. The reality is that short-term prophecy is an inherently tricky business.
This is not to intimate that the industry’s informed predictions – or even its best guesses – are worthless. They are products of expertise, insight and accumulated wisdom and are intended to be as accurate and as helpful as possible.
Yet by now it should be apparent that many investors could be better served by the adoption of a much longer-term, “bigger picture” type of view. In tandem, it should also be clear that some of the widely held tenets of asset allocation may need to be rethought.
Challenging conventional thinking
Traditionally, asset allocation has often boiled down to a matter of fine-tuning and percentages. The 60/40 balanced portfolio, as routinely favoured by pension funds and individual retirement savers, may offer the classic illustration of this philosophy.
Ideally, the equities component of the 60/40 model delivers performance – mirroring economic growth – while the bonds element provides stability. Seeking to mitigate risk, many investors adjust the ratio more towards fixed income over time. Data indicates that this has been a solid strategy for much of the past four decades.
Yet nothing in the sphere of investment should ever be taken for granted. It is almost 10 years since a landmark paper by Rob Arnott, CEO of Research Affiliates, questioned this long-accepted “glidepath” and demonstrated that savers might fare better by gradually augmenting – not reducing – their allocation to equities.
It is vital to stress at this stage that I do not cite this example to cast aspersions on fixed income. Far from it: I believe that all asset classes can play a valuable role in a holistic investment solution. Nor am I implying that Arnott’s “inverse glidepath”, as it sometimes known, is innately a cut above what went before.
The point that I wish to make is simply that there is always scope for innovation and disruption. Even an investment model that has seemingly worked so well for so long must be challenged in the hope that a novel and perhaps superior alternative will result. As Einstein said of his general theory of relativity: “It, too, will have to yield to another one, for reasons which at present we do not yet surmise.”
With this notion in mind, an asset-allocation innovation increasingly worthy of note today is thematic investing. This is a concept vastly removed from the bent for betting on what tomorrow, next week or next month might bring; it is also very distinct from the fine-tuning and percentages of the archetypal 60/40 balanced portfolio and similar mainstays. Above all, if pursued correctly, it represents a form of investing that places a patent emphasis on where the world is heading over the much longer term.
Megatrends and beyond
Thematic investing centres on discernible trends that are remoulding our lives and our planet. This requires us to think about significant, structural shifts – as opposed to concentrating on specific businesses or sectors – and to use the here and now as a bellwether for lasting transformation rather than as a pointer for short-lived twists and turns.
The most popular of these themes are driven by technology. Pioneering venture capital firm Social Capital, which describes its mission as “to advance humanity by solving the world’s hardest problems”, invests in the likes of healthcare, space exploration, education and climate change, while one specialist ETF provider has suggested that the five most promising themes today are DNA sequencing, robotics, energy storage, artificial intelligence and blockchain.
In light of the events of the past year, e-commerce is another theme that readily fits this bill. So, too, is the ever-distending reach of 5G wireless technology and all that it entails. The churn of the pandemic has manifestly accelerated several disruptive breakthroughs.
It seems fair to suppose that these and other themes are likely to serve as sources of return for years and even decades to come. This being so, there should be merit in backing them while they are still emerging and then staying the course – just as some farsighted investors supported the rise of the internet in the early 1990s and are still reaping the rewards today.
Yet this need not be a question of tech alone. In imagining where we could be a quarter-century or even a half-century from now, we might also take into account dynamics such as geopolitical developments, demographics and cultural and social evolution – to name just a few.
For instance, could we identify themes around a globalisation renaissance, further fragmentation, bipolarity or multipolarity? How might democracy, dictatorship, populism or protectionism affect our bigger picture? Would the trajectories of productivity and longevity influence our vision?
Maximising what we know
What is important here, it strikes me, is that we should be unconstrained in our thinking – at least in so far as is realistic. This, too, takes us no mean distance from some of the conventional investment models that have prevailed for many, many years.
Naturally, being unconstrained does not mean making wild forecasts on the strength of gut feeling or blind chance. This would be no better than the “finger in the wind” ethos that some investors employ in endeavouring to envisage the short term.
So it would not be especially useful, say, to build a theme around the prospect of alien invaders conquering the Earth before 2050. Nor would it be particularly beneficial over the longer term to allocate assets in anticipation of the total collapse of society. Instead we merely need to explore where innovation, change and growth are occurring – and to respond accordingly.
In tandem, we need to recognise that various scenarios may be plausible and that continued innovation is liable to further reshape the bigger picture – whether at the edges or at its heart. For example, climate change could remain an existential threat for generations; alternatively, we might defeat it more swiftly and effectively than expected. Another key lesson of the COVID-19 crisis has been that disruption can be incremental or radical, which is why flexibility is crucial.
Invesco’s 2021 Investment Outlook presents a number of asset-allocation recommendations, encompassing base-case, upside and downside scenarios in the wake of the pandemic’s rise. To some extent, this approach mirrors the so-called Rumsfeld Matrix: we have to to deal with known knowns, known unknowns, unknown knowns and unknown unknowns – which is to say that there are almost invariably some things of which we can be pretty sure and others that must remain relatively or even wholly ambiguous.
This is in many respects the essence of thematic investing. Arriving at reliable opinions about the longer term is not about guessing or gambling; nor is it about fine-tuning and percentages. It is about exploring the evidence all around us. It is about acknowledging what is uncertain and extrapolating what we can reasonably infer. Ultimately, it is about maximising what we know. In more ways than one, this may mark the way forward for many investors.
Disclaimer: I work at Invesco. All views and recommendations in this article are solely my personal opinion. They may or may not coincide with company opinion but should never be interpreted as Invesco company statements.
Links
LinkedIn: “The finger and the Moon: elections, focus and long-term thinking”
https://www.dhirubhai.net/today/author/dr-henning-stein-921b41?trk=author-info__article-link
Economist: “Why the crazy upward march in stock prices might just continue”
FT: “Investors wonder if the 60/40 portfolio has a future”
https://www.ft.com/content/fdb793a4-712e-477f-9a81-7f67aefda21a
Research Affiliates: “The Glidepath Illusion”
https://www.researchaffiliates.com/documents/F_2012_Sep_The_Glidepath_Illusion.pdf
LinkedIn: “Let there be light: who will spot investment’s next big bang?”
Social Capital: “About”
https://www.socialcapital.com/about
LinkedIn: “Crisis is temporary – opportunity is permanent”
LinkedIn: “What next for globalisation?”
Scientific American: “Rumsfeld’s wisdom”
https://www.scientificamerican.com/article/rumsfelds-wisdom/
Head of Austria & CEE Distribution bei Invesco EMEA.
4 年A great article! Thanks Henning for bringing together thoughts that we probably all share to some extent and compile this into a very thoughtful analysis and questioning of traditional investment patterns. Excellent food for thought.
Independent Investor | Senior Portfolio Manager | Client Engagement Professional
4 年Dr. Henning Stein, thank you, I couldn't agree more! You are nicely writing down how thematic investing seems to develop to a very interesting and viable alternative to traditional asset allocation models. Innovation surely is one of the keys to success here!
Pitch & Communication Trainer ? Executive Coach ? Advisory Board Member
4 年As always incredible #foodforthought! Thank you Dr. Henning Stein for this piece - it actually echoes the current urge to invest in #climatechange adaptation as well as mitigation. Topic raised again today at World Economic Forum #DavosAgenda