Are your foundations secure?

It has been well documented that this year has been a challenging one for investors, with most traditional asset classes – equities, bonds and gold – losing significant value. Even cash, once you take into account inflation, has lost significant purchasing power as well. However, I find it useful to put this in context: including this year, there have only been 4 years in the past 150 years that we have seen both US equities and bonds lose value. Over the same period, a 60:40 equity-bond portfolio lost value only 9 times. Therefore, what we have seen this year is very rare and is very likely to be relatively short-lived – measured in months from now, but highly unlikely to be measured in years. ?

Of course, it is natural that after such a performance, investors are sceptical about forward-looking returns. We tend to anchor our forward-looking expectations around many different things, including recent performance. This explains why strong performance over the past 1-, 3- and 5-years (disclaimers stating otherwise notwithstanding) is one of the primary decision-making points for many investors. I believe this bias, whether it be after strong gains or after strong losses from different assets, is one of the costliest biases among investors.

That said, in the short-run, there are indeed a lot of uncertainties to worry about, given still-elevated inflation and a seemingly unilateral focus among central banks on bringing it lower. Those who are worried about the outlook need to think about the best way to deal with this.

We think, today, investors are at risk of making two key errors. First, sell all their investments and go into cash. The problem here is threefold. One, you are effectively locking in the losses already made. Two, when markets recover, and recover they will, such investors are likely to be left behind. Finally, cash looks almost certain to lose further purchasing power in the coming 12 months.

The second error is ignoring the golden rule of diversification and taking a very narrow investment exposure that is aimed at benefiting from the current environment. The problem is that such investments are often high-octane exposures that can move dramatically in both directions. If the environment changes, these investments can lose value very quickly, much more quickly than a more diversified portfolio.

We prefer a third option: remain committed to a foundation portfolio that includes investments in a diverse set of asset classes and geographies. Of course, if you are worried about the short-term outlook, you can raise some of your allocation to cash. However, you should acknowledge that this comes with risk of underperforming in the future. If it helps you sleep at night, comforted in the knowledge that that money could be invested at lower levels, and keep the majority of your money invested in a diversified basket, then this may well be a price well paying. But acknowledging the risks of such action upfront should help you to act in a more measured fashion.

Meanwhile, there is nothing wrong with allocating a limited amount, based on your risk tolerance, to high-octane opportunistic investments. They may be volatile in the short term, but they can also be rewarding in the long term and can offer different sources of return to a traditional, foundation portfolio.

Nevertheless, the traditional diversified portfolio is the critical starting point. We call it a foundation portfolio for a reason. It is what you build your financial future on. It should withstand the test of time and the buffeting of different investment climates and economic weather patterns. Its aim is to fund your future liabilities – such as children’s education and retirement – or fund your legacy. Without this, the risk is that your financial house collapses around you and you fall short – far short – of your financial goals.

(Steve Brice is Chief Investment Officer at Standard Chartered Bank’s Wealth Management unit)