How to invest in an expensive market

Daryl Wilson

It seems like we’ve been hearing about how expensive markets are for years. But with limited exceptions, most markets have continued to track higher and higher. Which brings with it a dilemma. It feels ever more uncomfortable putting money to work, but there’s no guarantees markets won’t keep going up. And leaving your cash in the bank means guaranteed low returns.

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

So, what do you do when markets feel expensive? We use a combination of strategies to help us navigate these difficult waters. Here’s a few that might work for you as well.

Maximise returns on cash

Many investors are holding a significant portion of their portfolio in cash. If that’s you, then one of the easiest ways to improve your investment returns is to get the best deal you can on the cash you hold.

There are some great comparison sites like Finder, Mozo, Infochoice, Canstar and Rate City. All provide data from a myriad of banks and financial institutions. Check them out once in a while to see if there are any better deals out there.

Depending on the amount of cash available, it may be a good idea to spread that cash over several different financial institutions. Also, make sure you look at online savings accounts offered by providers such as RAMS (100% owned by Westpac), UBank (a NAB subsidiary), ING Direct and RaboDirect. While their rates aren’t as good as they used to be, they’re generally much better than old fashioned savings accounts and less restrictive than term deposits. And in this investing climate, where prices can move up and down quickly and investing opportunities present themselves regularly, flexibility is key.

Term Deposits can be a good option but the extra return you make may not be worth the opportunity cost of not being able to deploy the money when you want to.

Every now and then stop and take a step back.

It’s easy to get bogged down in day-to-day market changes. But you must regularly step back and check how your overall portfolio is positioned.

One of the ways we force ourselves to think about our portfolio mix is that every time we consider whether to make an investment, and how much to buy, we ask ourselves four questions:

  • Where is the market now, compared to our assessment of fair value?
  • Where is the market compared to long-term averages?
  • How much cash do we have to put to work?
  • How much cash do we want to retain in case we get a better opportunity?

The answers to these questions tend to dictate how much cash we have on hand at any given time. We aim for 10-15% cash on average, but perhaps as much as 25% in times when we think markets are very expensive and less than 10% when they’re very cheap. You will have your own levels you’re happy with. Try to review your cash levels regularly. Set a target range that works for you and adhere to it.

Accept that you can’t predict the future

We often joke about how bad the weather service is at forecasting. But they’re significantly better at it than economists. Also the best fund managers and traders get it right around 60% of the time and over 90% of day traders lose money. So, stop thinking that anybody really knows what’s going to happen next.

It’s OK to have a view on the future. And it’s OK for your portfolio to reflect that view to a degree. But try to also focus on diversification. We apply the 80/20 rule when we construct investment portfolios. Usually over 80% of the investments in our portfolio are a diversified mix of great managers. And less than 20% are high conviction bets on markets we think are significantly undervalued. We try to time markets and study cycles, but we recognise we might well be wrong a lot of the time and we don’t bet too big.

So concentrate on diversification above all else. Make sure you diversify properly though. Owning all four big banks is not diversification. Think about your exposure by asset class. For example, we see a lot of opportunity in commodities right now, including agricultural commodities. It’s one of the few asset classes where values are not close to historical highs.

Do you have exposure to each different type of investment asset? If not, do you want some? If so, are you happy with the level of exposure?

Diversify by Style

Reducing the impact of market downturns without sacrificing long-term returns is the holy grail of investing. One of the things that has surprised us most over the years is just how effective style diversification can be in reducing volatility of returns.

Value and growth are two of the more well-known and common investment styles. But in the current environment it’s much more important to us to have a percentage of our portfolios invested in styles that can make money regardless of what direction markets are moving.

Strategies such as long/short and market neutral usually perform best in poor market periods. An allocation of 5-15% of your portfolio to each of these investment styles/managers can significantly improve your portfolio performance in poor markets. When we feel that markets are overvalued, we tend to increase allocations to these types of managers.

Look for lower volatility investments

When we review fund managers, one of the key things we want to understand is now volatile their investment performance is likely to be. There are various ways to assess this, but one of the simplest is to compare a graph of their performance against a relevant benchmark.

Ideally, we want most of the investments we make to be able to outperform the benchmark over time, but also to outperform most when markets are poor. As with style diversification, reducing the negative impact of poor market periods provides a much smoother return path for your portfolio.

Don’t compromise returns for diversification

Many investment portfolios we see have investments that are almost guaranteed to deliver poor returns. Almost always the rationale is that it helps diversification. If you value capital stability and are happy to accept poor returns, then that’s fine. Otherwise, it’s hard to justify allocations to assets like Government bonds, capital protected products and annuities. They’re dragging you down and in some cases, can be illiquid as well.

Access smaller, more nimble managers

In theory, there are many ways to outperform markets. In our experience, nothing guarantees success. But a few things can almost always help.

Factors that can consistently increase the chance of a manager outperforming include managing a relatively small amount of money, investing in a specialised area and strategies that don’t unnecessarily restrict how the manager can invest. If the manager has a substantial (for them) personal investment in the fund they manage, that’s also a good sign.

We all tend to want to invest with the bigger managers, who largely invest in companies we’ve heard of, with tight investment constraints. That’s a hard way to beat the market. You should consider at least some allocation to smaller funds and managers that can invest freely and differently.

Be ready for opportunity

Most falls in markets are short term blips on the road to future upside. Once markets become aware of a problem, or potential problem, its likely impact is usually overstated. Brexit, Trump election, China slowdown – they’ve all led to short term market corrections which have with the benefit of hindsight been buying opportunities.

So wait patiently, build up cash as markets rise and look to use corrections as a way to put money to work. After a market correction of 5-10%, we might put 5% of our cash balance to work. If we’re right, we’ve bought well. If we’re wrong and markets fall further, we can put more of our remaining cash to work. The same happens in reverse on the way up. As we start to get more worried about asset values, we feel comfortable taking money of the table.

Sentiment and confidence are important

Valuation is obviously an important factor to consider when investing. But we find it also helps to look at factors such as confidence and sentiment. One of our favourite sayings is, “Markets don’t crash when half the world is expecting them to.”

Instead, markets are much more likely to be making at least short term highs at times when confidence is high, momentum is strong and the majority are feeling like nothing bad can possibly happen. This can mean there will be very few buyers left if unexpected (bad) things happen. The more confidence we see out there, the less confident we become.

One good example of some of these indicators is CNN's 'Fear and Greed index', which you can see at: (VIEW LINK)

We bring all these strategies and more together in our Affluence Investment Fund. Good luck with your investing.


Comments

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James Marlay

Excellent post Daryl, some really useful and practical ideas that are accessible to all investors. Thanks for sharing

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Adam Easter

Thanks for posting Daryl, your article was very relevant for ALL investors. On another note, I really like your fund and am looking forward to your portfolio being Lonsec rated so I can access it for clients.

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Daryl Wilson

Thanks Adam. We're about to make the Affluence Fund available to retail clients in the next few days and we're targeting research for later this year.

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