A time to buy?

Investors don’t like what they are seeing on the horizon and have increasingly been taking the view that cash is king. Depressingly, bonds, equities and commercial property have all taken a significant performance holiday.

However, market gyrations are nothing new and the ability to ride out such events is a key trait that ensures investors get rewarded. Unfortunately, a sizeable chunk of the investing population captures materially sub-market returns simply because they do get squeezed out of difficult markets, only to re-enter when conditions have improved and the market is substantially higher.

It is likely that many of your clients will be particularly anxious about the stock market falls, especially if they have invested too much of their savings in equities. These clients will already have endured significant losses. Many private investors had not appreciated the risks they were taking in their portfolios, and this has not been helped by an investment industry that has been keen for their clients to buy ever more funds or stocks, often driven by the need to generate commissions or stockbroking fees, such that a client equity weighting in excess of 70% has been considered the norm. Many “balanced managed” investment funds have been exposed as neither balanced nor effectively managed, and a portfolio predominantly made up of equity unit trusts, or a selection of individual shares, has been shown not to provide the diversification that private investors require.

It is not surprising therefore that these investors, fearing further losses, are getting squeezed out of markets, looking for the safer haven of cash and, potentially, planning to return to stocks again when the coast is clear.

However, the likelihood of them being able to time their way in and out of market tops and bottoms is minimal at best. When it comes to market timing, they should heed the words of renowned economist J K Galbraith, who said: “We have two classes of forecasters: those who don’t know and those who don’t know they don’t know.”

So, what can your clients do then? Well, as ever with sensible investing, the answer is “asset allocation”. Whilst we cannot predict the future performance of different asset classes with any degree of certainty, what we can identify is that over the long term these asset classes can relate to each other in predictable ways. For example, the price of property in the UK usually bears little resemblance to movements on the London Stock Exchange, but share prices in London often mirror those in New York, Paris and Frankfurt.

Correlation, or lack of it, is important because it affects the diversification and volatility of portfolios. If an investor held just UK and US equities, then a market fall in the United States is likely to take the whole portfolio in the same direction, as the UK and US stock markets are highly correlated. However, if they added index-linked gilts, commercial property and alternative investments, which do not correlate so closely with western markets, the portfolio would tend to be better diversified.

By understanding the strength of these relationships, assets can be blended together to reduce risk and, in many cases, improve potential returns. Ideally we would like a mix of negatively correlated assets so that when some of our holdings are going down, others are going up, but where all assets have the potential to reward us in the long term.

Even with the reduction in value in most asset classes over the last year, a diversified multi-asset class approach will have protected a portfolio’s downside much better than a traditional equity-dominated strategy. By holding a range of different asset classes, such as equities, Government bonds, commercial property and alternative investments, but without too much emphasis on any one asset, risk can be more effectively managed.

Then, by consistently and systematically rebalancing back to target asset allocation weights, one can maintain the appropriate risk exposure on the portfolio, but also take profits in the better performing asset classes and average down the relative purchase price of those that have lagged. At once we are behaving as a contrarian investor, holding a diversified portfolio, with below average volatility, which can gain traction in the markets without any need for particular insight on anyone’s behalf.

While such an approach will still be showing losses in recent times, if properly constructed it should weather most storms and rebound more efficiently from the inevitable bear markets. So, the best advice for your clients who hold suitably diversified portfolios, would be to sit tight and try to avoid getting frightened out of a sensible investment approach only to buy back in at higher levels.

However, experience suggests that, sadly, many investors will get squeezed out of the markets, while most cash will probably stay where it is, and will then chase the market when it is already substantially higher.