A key decision for investors in 2018

Fidelity International

This cartoon represents all of us trying to call a top in the equity market. There are of course three possible outcomes in that endeavour: too early, too late or just right. Some of us may be lucky and get it just right, but for financial planning purposes it’s best to assume you’ll be either too early or too late.

Erring either way is expensive. Our estimate of equilibrium P/E ratio for the S&P500 is 16, so it would have been very easy to have observed the PE ratio at 21 this time last year and viewed the market as expensive. Yet de-risk then and you’d have missed a 2017 return of 22%. If and when the equity downturn comes, I’d be surprised if it exceeds 20% - there have only been two such occurrences: 2000-2002 and 2007-2009. As ever, investing is a risk-reward trade-off. It strikes me that investors have one of two choices: accept the risk of a downturn and stay invested in risky assets, or de-risk early and accept that return opportunities may be missed. It’s vital to be clear on that decision as the action required is quite different in each case. In not taking that explicit decision I fear many are implicitly assuming they’ll be able to exit at exactly the right time. That’s a brave assumption.

Let me take you through the two choices:

Stay invested

Regarding my personal portfolio positioning, I have a tolerance for risk and therefore I’m happy to remain invested. But I’ve taken that decision fully expecting to go over the cliff at some point. I’m explicit on that.

I’ve assumed a bad case scenario is a 20% drop in equity prices. I have approximately a third of my assets in equities, so my portfolio could face a loss of 6%, that’s tolerable for me. Furthermore, in these two occasions when equities had downturns in excess of 20%, the bond market returned 30% and 17% respectively (as measured by the S&P 7-10 year Treasury index). Therefore, regardless of the valuation of fixed income, I’ve increased bond duration in my portfolio to help hedge against an equity downturn. To put numbers on this, my portfolio is 70% in a 10 year bond index, and 30% in equities. If I experience a 20% drop in equities and 1% drop in bond yield, I’ll still post a positive portfolio return.

Whilst a lot of assets are expensive, there are pockets of value. European equity is one that attracts my eye, but the asset class I’m very drawn to are emerging index linked bonds. The event that gives me nightmares is a dropping equity market driven by higher yields. That unlikely scenario would presumably occur if inflation returns in force, and in that case EM index linked bonds would do well, and their real yields are attractively high.

De-risk early

My deputy is more risk averse. He’s already de-risked, arguing momentum has driven returns, fundamentals are only moderate, and the market has had a great run. He feels the drawdown could be bigger than 20%. Other than opportunity cost, the problem with de-risking, is that the lowest risk assets are the most expensive of all; they guarantee you a reduction in your purchasing power. Therefore, what’s important, and what my deputy has done, is to recognise that he’ll experience certain negative real returns all the while he has de-risked.

I wouldn’t be happy with that, and it’s that difference which largely separates us. So, if you are going to de-risk, don’t overdo it, and make sure you de-risk in an even way ensuring you keep a balanced portfolio - that means diversifying across asset classes and regions. Pertinently to a de-risker, the Asian debt market is usually underexposed in global fixed income portfolios.

Good luck in 2018. If you make a new year’s resolutions, resolve to clearly decide: de-risk or not. Would you rather clash that cymbal too early or too late?

Written by David Buckle, Head of Investment Solutions Design

For further insights on what to expect in 2018, please visit our website


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