Trends: Are cautious investors walking into a perfect storm?

Thomas-Becket-700.jpgYou don’t always get what you ask for. With global markets in uncharted water, traditional low-risk assets might not be what they seem and those investors asking for cautious portfolios may actually be getting some of the riskiest. The last few years have seen markets move into new territory, and the consequences mean we need to reassess what we thought we knew previously.

In a world of low interest rates, the demand for a ‘safe’ yet rewarding place for cash has spiralled. In some parts of the world negative rates has meant hiding money under your bed produces a better outcome than depositing cash. Better still, investing the cash into defensive areas of the market has seen healthy returns for what historically has been little risk. But we live in extraordinary times, and what may have been safe historically, could well be pregnant with risk in the future.

We should begin by realising that ‘risk’ is an inherently challenging thing to assess. Rather than fashionable terms such as ‘volatility’, it is perhaps best broken down into three areas at the forefront of clients’ minds. Firstly, we must consider our tolerance for loss in the short term from our investments. Secondly we should consider the probability of our investments meeting our longer term expectations. Finally, it is most important that we protect our real level of wealth as we fight against the damaging effects of inflation. Characteristically, cautious investors are those most concerned by these three factors.

Since we have entered the world of zero interest rates, central banks have led an unrelenting procession higher across all markets. This cannot last forever and the cost of rewards in recent years will have to be paid for in the future. Given this, the probability of a rough patch for all asset classes only increases as time passes.

With yields at record lows and all fixed interest markets now having much longer duration than in the past, fixed interest markets have never had a worse risk-reward profile. But it’s not just the manipulated bond markets that are vulnerable. The secondary effects of the ‘hunt for yield’ has seen profiles of other quality assets change too. As valuations in high quality companies’ shares and prime property investments have spiralled, they have reached levels where there can be little scope for further upside.

The average cautious portfolio is currently bursting with these assets, which may have reaped rewards in recent years but they have undoubtedly also accumulated risks over the same period. If interest rates and inflation begin to normalise in the coming years, then returns from traditional cautious portfolios will be greatly limited. Worse still, they may lose money in the short term, fail to meet long-term aims and even fail to protect against inflation.

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A number of warning shots have now been fired. None louder than in February when rate setters appeared more hawkish, sending treasuries, gilts, investment grade credit, utilities and Reits significantly lower. This wake-up call showed that there is no place for complacency in markets and a reassessment of cautious asset allocations is well overdue.

We feel the solution to the cautious conundrum can come from diversification and innovation. Thinking outside the box and allocating away from traditional core assets can help to reduce risks. The outdated mix of quality fixed interest investments, equity income, cash and property, will not provide the security it once did. These assets may still have roles to play as part of a cautious portfolio, but they should no longer be the cornerstone they once were.

Investors need to look at what is in the asset mix by way of underlying investments. Diversification at just the asset mix level may not be the saviour it perhaps once was; there is a need for innovation and diversification beyond what we have come to see as the norm.

John F. Kennedy once said, “Change is the law of life. And those who look only to the past, or the present, are certain to miss the future.” The distorted market created by policymakers has shifted the risk-reward paradigm across all assets and the time has now come for cautious investors to embrace change.

Key takeaway: Cautious investors have reaped the rewards over the past few years, but the traditional cautious portfolio no longer meets its description. Without a change in mindset, cautious investors are potentially walking into a perfect storm.

Tom Becket is CIO of Psigma Investment Management.