In Yoram Lustig’s last post, he introduced multi-asset investing and started to explain why the approach should be used in 2013. In this installment he looks at expected capital market conditions.
Expected capital market conditions
The 1980s and 1990s were a golden age for equity markets. Global equities returned over 12% per annum during these two decades of optimism and excess. All that investors needed to do was buy stocks and watch their money grow. Why would anyone invest in anything but stocks? The concept of asset allocation – appropriating and shifting investments across a mix of asset classes – was redundant. Even the deep but brief 1987 stock market crash did not frighten investors. Who cared about risk when equity markets kept going up and up?
But then the internet bubble exploded in 2000. The happy days were over. The decade since then has been challenging, to say the least, for investors. We have had two equity bear markets, one in 2000, and a second in 2008 which dwarfed the first. The global financial system was on the verge of a meltdown ignited by the collapse of Lehman Brothers.
Equity markets have returned about 1.5% per annum since 2000, broadly moving sideways during a lost decade. Simple buy and hold investment strategies have returned just about nothing in real terms after adjusting for inflation. Some say that the age of rallying equity markets is over. We should expect more of the last decade (i.e. volatile equity markets) rather than the heyday that was enjoyed in the two decades leading to the turn of the second millennium (i.e. secularly rising equity markets). So equities are not what they used to be.
The cousin of equities is bonds. Bonds, or fixed income investments, have enjoyed a long-term rally since the beginning of the 1980s, handsomely compensating investors for holding them. The equity market crashes have only further boosted bond returns as investors rushed from risky equities to the safer hands of bonds. The unprecedented conventional and unconventional measures that central banks and policy makers have taken to stimulate the global economy after the carnage of the 2008 global financial crisis have pushed bond yields downward; pushing bond prices further up (a bubble?).
Bond yields are approximately the expected returns for bonds over their maturity, indicating that investors should not expect to even make positive real returns from investment grade government bonds. When the 10-year gilt yield is 2.0% that is roughly what you are going to get by holding the gilt; this would not even beat inflation. Winter is coming! So bonds are not expected to do much in the coming years either.
In 2012 financial markets were mainly driven by politics, less by economic factors. The actions, or lack thereof, of the European Central Bank (ECB), on one side of the Atlantic, and those of the Fed, on the other side, created a risk-on, risk-off environment depending whether markets were positively focusing on supportive actions or negatively focusing on economic concerns.
This environment created choppy returns for many investment types, such as commodities and hedge funds. While ten years ago investors seldom focused on risk, risk has taken a front seat after witnessing spectacular market collapses and blow-ups of hedge funds and financial institutions. So the lesson is that the risk is at least as important as return.
While global financial markets have been through long patches of uncertainty in the past and eventually recovered (1930s Great Depression, 1970s bear market), the conditions of uncertainty and volatility can continue for many years. Whether we are in a Japanese lost-decade scenario or not, the days of the 1990s are gone; investors cannot just buy equities and expect them to soar. The solution to preserve and appreciate capital is to harvest returns across asset classes and dynamically invest across asset classes when and where opportunities arise. This new regime of capital markets calls for multi-asset investing.
Successful multi-asset investing, however, requires skill. Being in the wrong place at the wrong time can have adverse consequences and can quickly destroy wealth. On the other hand, multi-asset investing can protect wealth. For example, when equity markets enter a risk-off environment, moving some assets to bonds can help protecting the downside and supporting returns. Being dynamic is essential when investors cannot rely anymore on equities or bonds to deliver easy returns.
In Yoram Lustig’s next post, he will look at the performance of active portfolio management.
Yoram Lustig is the author of Multi-Asset Investing: A practical guide to modern portfolio management – available to buy from Harriman House.