What is still cheap nowadays? How can the average investor sustainably invest his money? Interest rates are at unprecedented low levels, the equity markets seem overbought and investments in “magic” gold is not what it seemed to be anymore either. So what is there left? Should we just hide cash? I have asked myself exactly these questions a lot recently. What could a conservative investors invest in? What could my family invest in?
I do have many investment and especially trading ideas for myself. However, currently, these are still of very speculative nature and not sustainable long-run investment approaches. But, how can anybody invest his money to at least maintain purchasing power without worrying countless nights over the riskiness of the investment?
Some experts expect the equity markets to crash soon (harder than ever before), others wait for a turnaround in the interest to rate policy. People want the “good, old stable times” back. However, maybe we will be waiting for this for a long time. Already two years ago financial journalists argued that interest rates could not be sustained at low interest levels like at that time. Additionally the stock market was supposed to be overvalued already then. Yet, the bull-market continued and now we are in year eight of this cycle, a lot longer than the average bull-market.
Maybe we all should just admit that no one of us has any idea where the markets are going. I recently read some analyst opinion saying that he expects the Dax to advance to 15000 before retracing back to a level of 12000 in 2017. I really don´t believe that many analysts, if any, can predicts moves like this that accurately. Who knows, maybe it is not even necessary for sustainable portfolio returns.
But if we have no idea what the future will bring, what can we do? There are many people in media and academics supporting the “stocks for the long run” argument. Historically, US stocks have yielded around 5% real return with a volatility of 18%. So, why not just invest in equities and on average gain 5% in the long run with some “minor” ups and downs? After all we survived the 2007 financial crisis as well and are back to new highs. There are two things I want to mentioned here. First of all, this long-run after all might be actually very long. In the late 90s started the so called “lost decade” which marked ten years during which the US stock market was basically were flat. Yes, today the markets are at new highs but is the general investor likely to be able to wait for ten years for his investments just to break even? I don´t think so. Secondly, let´s never forget the Japanese case. Up to 1989 probably every Japanese investor would have believed the “stocks for the long run” argument until, finally, it was not convincing at all anymore. If you would have invested your capital in the Japanese stock market at the peak in 1989 you still would be down around 50%, almost 30 years later! How can we be sure this could not happen to the US, to Germany, to the UK? I think that we cannot.
Probably the most important aspect of portfolio performance is something that has been mentioned in media and academics almost too much in recent decades and has become a almost a cliché. It is the concept of diversification. Can diversification solve all our problems? Well, maybe not, but it can help to significantly increase the return-risk trade off. Legendary Hedge Fund investor Ray Dalio calls diversification “the holy grail of investing” and runs his passive “All Weather” fund based on the notion of optimal diversification. We will come back to this later. Let´s have a look at the concept of diversification first.
Diversification in a portfolio sense refers to the fact that a portfolio with many uncorrelated assets allows to maintain the weighted expected returns of the individual. The volatility of the portfolio will be lower than the weighted volatilities of the individual securities however which improves performance.
For example the expected return of a portfolio consisting of two stocks equals their weighted expected returns:
E(rp) = w1r1 + w2r2
where E(rp) is the expected return of the portfolio, w1 and w2 are the weights invested in the two assets and r1 and r2 are their expected returns.
However, the variance of the portfolio does not equal the weighted variances since correlation plays an important role.
V(rp) = w12V(r1) + w22V(r1) +2w1w2Cov(r1,r2)
where the new term Cov(r1,r2)is the covariance of the two assets and describes how the two assets move together. Thus, the variance of the portfolio depends on the variances of the individual securities and the additional covariance, which measures whether the two securities on average move together or in an inverse relationship. The less covariance there is the more the two securities act like hedges for each other and the portfolio variance decreases. Adding even more uncorrelated securities to the portfolio allows to further decrease the variance as we can see on the chart below. As the number of securities increases the portfolio variance decreases.
Based on diversification some academics advise to invest in the market portfolio (i.e. a market index such as the S&P 500) since it is supposed to be the most efficiently diversified portfolio. Additionally, real estate, bonds and commodities allow for further hedges since they are supposed to be weakly or negatively correlated to stocks.
There is one problem however. Is there one such thing as correlation – one number describing how assets move together? I doubt it! Correlation is a name that we give an average of how assets have moved together in the past. But correlation does change. Below we see the correlation between bonds and equity markets for two time spans, 2003-2008 and 2009-2013.
As we can see between 2003 and 2008 there was a negative correlation between bonds and equities. Since 2009 though, this relationship has changed and recently there has been a positive correlation. This has very strong implications for diversification since the change destroys many hedging opportunities.
There is not such a thing as correlation but there are different determinants that make asset classes move. As these determinants change so do asset prices. In “Hedge Fund Market Wizards” Ray Dalio provides an example of this. In a time of volatile economic growth expectations stocks and bonds will be negatively correlated because decreasing growth would result in both weak stock perfromance and declining interest rates which is beneficial for bonds. If, however, inflation expectations are volatile, stocks and bonds will be positively correlated since interest rates rise in an attempt to counteract inflation. Increasing interest rates are detrimental for both bonds and stocks. This shows how the nature of the determinants influences the co-movements of assets classes.
Instead of looking at the average covariance it seems much more justified to take the drivers of different asset classes into account. The question should be: “What makes asset prices move?”.
And here Ray Dalio´s hypothesis comes into play. He defines four different states of the world, based on four scenarios: low inflation, high inflation, low economic growth, high economic growth.
On the continuum below we see how inflation and growth form four states of the world. For each of these states there are corresponding asset classes which tend to perform well in a specific situation. For instance, stocks perform well if there is economic growth, bonds are especially strong during times of flight to quality and commodity prices increase during inflationary times. In allocating ones assets, it is important to invest in security classes covering all the possible states of the world. Of course, some asset classes will decrease in value while others will appreciate but as Ray Dalio puts it, on average assets will outperform cash unless we are in a severe depression.
In his book “Money: Master The Game” Tony Robbins conveys to the average investor how to apply the “All Weather” fund strategy. Beneath, you see a possible asset allocation: 30% in stocks, 55% in bonds, and 15% in gold and other equities. Firstly, the asset allocation is based on an American investment horizon and can be adjusted for other markets. Secondly, the relatively low proportion of only 30% in equities seems striking. This is due to the extraordinary risk that equities incorporate. Equities are a lot more risky than bonds are. So if you construct a 50% stocks 50% bonds portfolio what you do is basically exposing your portfolio strongly to the risk of equities. That´s why I was “strongly surprised” when I recently read in a financial newspaper experts advising to put up to 60% in stocks for 2017. Of course, this approach catches more of the upside but the downside is leveraged as well.
But what happens if interest rates rise? Wouldn´t bond prices decrease sharply resulting in a crash of the portfolio value. Well, one cannot preclude any possible events but it is likely that losses in the bond portfolio due to increased interest rates would partially be balanced by stock gains. As Robert prince, co-chief investment officer of Bridgewater Associates points out, interest rates are more likely to rise in an environment of accelerated economic growth leading to inflation. Thus, while bonds depreciate equities and commodities would yield strong returns.
A final thought about the equities to invest in. There are many possibilities for various strategies. The question is what do you want to be exposed to? The American economy, the German economy, Emerging markets or the whole world? Do you want to be exposed to the value anomaly or the low-volatility anomaly? All this is possible with the help of passive investing and in the next post I will shed some light on some of the anomalies that you can invest in. But what you do depends on your preferences and your risk-appetite. There is no one-size fits all approach just as there is no certainty about the future and the weather we will have one year from now.