Originally published by Cuffelinks
The possibility of rising interest rates, uncertainty about President Donald Trump’s policy directions, rapidly rising government debts and the risk of a ‘hard’ Brexit have given Australian stock investors plenty of worries in 2017. Added to this is the threat of an Australian housing bust, with UBS recently calling the top of the market.
How can investors, particularly those nearing retirement, protect themselves and their portfolios against such market volatility?
Unrealistic return expectations
The ASX Australian Investor Study 2017 revealed a disconnect between investor risk profiles and their return expectations, with 60% of retirees wanting ‘stable or guaranteed returns’, but an even higher 81% of younger investors seeking the same. Yet 21% of the most risk-averse investors still expect annual returns over 10%.
A December 2016 report by State Street Global Advisors predicted a long-term (10 years plus) return from global equities of only 6.2%, with just 1.3% from global government bonds, while US inflation is expected to average 2%.
For a typical balanced portfolio comprising 60% equities and 40% bonds, this equates to an after-inflation return of just 2.24%, which is insufficient for most investors’ investment objectives.
Added to this is the risk of a significant stock market downturn. Long-term US data shows a bear market occurs once every 3.5 years, with an average fall of 35%.
Another such plunge now, as seen during the GFC, would devastate the retirement savings of millions of Australians, with those nearing retirement and existing retirees not having the luxury of extra working decades to recoup such losses.
Property may not be a safe haven either, given that the Sydney and Melbourne residential property markets have been rated among the world’s most overpriced. Any crash in this sector would inflict further woes on a banking sector already reeling from the budget’s recent bank levy and increased capitalisation requirements.
Bank deposits, while protected by government guarantee up to certain limits, are not offering sufficient returns, given the current inflation rate. And while bond yields spiked on Trump’s election, yields have since eased back on concerns over whether Trump’s planned infrastructure spending and tax cuts will get through Congress (let alone if he is impeached).
Unfortunately, in the search for yield in the current low interest rate environment, as the GFC has slowly faded from investors’ minds, there has been a worrisome return to riskier growth assets by older investors, who should be seeking lower volatility investments.
Lower volatility solution
Combining a low-return investment, such as cash, with high-risk investments such as shares and property, does not necessarily produce a high overall risk-adjusted return, particularly since falling share prices can flow on to property prices if overall economic conditions deteriorate.
Many of the world’s leading investors, such as Yale University’s endowment fund, have pursued an alternative approach not heavily dominated by share market risk, such as in alternative investments, leading to Yale’s superior performance.
To guard against increasing volatility, investors should consider allocating part of their portfolio to a highly diversified ‘all-weather’ investment strategy, such as a market neutral fund. This has the ability to perform equally well in both rising and falling markets. It should have little or no net exposure to global equity markets, with an overarching focus on capital preservation, a high level of diversification, and little or no leverage, with the aim of producing a high risk-adjusted return.
The theory behind a market neutral investment is that rather than the risk and return being reliant upon the overall market’s movement, it is dependent instead on individual share selection, a risk that the investment manager has greater control over.
In a broad market crash such as seen during the GFC, even highly diversified portfolios of blue chip shares suffered substantial losses. As Warren Buffett famously said, “Only when the tide goes out do you discover who’s been swimming naked.” Australian investors, particularly those in their 50s, simply cannot afford to be caught out in a market storm.