18 Jan 2020
Strategies to navigate the 2020’s
Evidence in our opinion appears to point to low future returns for most asset classes. We discuss the earning power of New Zealand equities above, which applies similarly to global equities. Research has shown that historical 10-year bond returns are closely linked to the initial 10-year bond yield, which means bond returns might not even beat inflation.
It is probably safe to assume that, whatever happens, it will not happen in a nice linear fashion and over the next decade there will likely be some material up and down moves. This has been described as going nowhere in an interesting way.
What then should an investor do? The table below highlights the potential options for investors to consider.
|1: Do nothing||
Often sitting on your hands and doing nothing is a good investment trait. Too often behavioural biases lead to too much trading and particularly selling low and buying high that patience can avoid. However, when your starting valuation points to low long-term returns this strategy seems predetermined to deliver plenty of ups and downs (i.e. risk) for very little long-term reward.
|2: Hide in cash||
This again is often a valid strategy as interest rates often increase in the latter stages of a bull market to try and slow an inflationary or overheating cycle, so moving to cash does not seem too painful. This time around though cash seems guaranteed to give you negative real returns for the near future at least. Cash does though have one very useful property it protects capital and gives you dry powder to invest in assets, if and when they become attractive.
|3: Time the markets||
This sounds so elegant and attractive, simply sell when markets are expensive and buy when they become cheap again. In practice it is virtually impossible to execute*, you may time the odd move but doing it repeatedly would need all the luck of the Irish and more.
Even the most sophisticated quant/managed futures hedge funds generally struggle around the turning points of markets and prefer established trends.
|4: Search out margin of safety||
Even when a stock market is at all-time highs and appearing to offer low future returns that does not mean that every stock has the same attributes. There are quite often individual stocks or sectors that are more attractively valued and offer an important “margin of safety” as originally noted by Benjamin Graham and expanded on by Seth Klarman. These opportunities are obviously much more plentiful after markets had had a major sell off (e.g. post GFC) but still exist at other times but require a patient and in-depth research process to identify.
|Moderate||High||Yes, but not easy|
|5: Employ some portfolio insurance||
When you are potentially looking at range bound markets for an extended period of time, then riding the ups and downs is not an overly attractive proposition (see option 1) but if you could add some “insurance” to protect against the material down periods (i.e. protect capital) you can then take advantage of the ups when they occur without needing to “time” the markets. Sounds obvious doesn’t it? This can be done by buying put options which cost a premium upfront (like insurance) and provide significant rewards if the underlying assets fall or volatility picks up. There is a downside though, as like insurance, you pay premium upfront so this will blunt returns if markets remain benign.
|Low||High in the event of market crises||Yes, but costly in benign markets|
* Even the most sophisticated quant/managed futures hedge funds generally struggle around the turning points of markets and prefer established trends.
For each option we have added a traffic light colour of risk, reward and executability. As you can see nothing has 3 greens all have some drawbacks or costs to be considered but in our view option 1: doing nothing is potentially the worst option.
At Castle Point we employ options 2, 4 and 5. We spend a lot of time searching out investments with a margin of safety (option 4) and where we can’t find these we are quite happy to park assets in cash (option 2) as we continue searching. In addition, in our Ranger and 5 Oceans Funds we employ portfolio insurance (option 5) to help us protect investors capital during any upcoming market selloffs.
We are looking forward to what the 2020’s will bring, it is shaping up to be a fascinating decade for investing and one that is likely to require many more tools in the tool box than the smooth ride we had in the 2010’s.