Despite huge political uncertainty in recent months, we’ve been experiencing some of the least volatile equity market conditions ever. Which must be good news for investors, right? Not exactly.
A lack of volatility means a lack of opportunity, and combined with historically low interest rates and bond yields that are struggling to beat inflation, investors are finding themselves forced to choose between taking greater investment risk to achieve half-decent returns or accepting lower returns for a good night’s sleep.
The fear of missing out
This scenario is giving us great cause for concern. Investment risk is highest when prices are high, and few can envisage a reason for them to fall. Precisely the conditions we have today. Regardless – thanks to this low-return environment – investors continue to invest in risky assets. They’re finding it hard to conceive of a catalyst which might cause a sell-off, and they live in fear of missing out on the returns achieved by others around them.
Managing risk can be more important than seeking returns
Our investment process is not based on searching for catalysts, trying to pre-empt the moment when markets pull back. It’s a fruitless and impossible exercise. Instead we objectively analyse investments to balance the prospective rewards with the risk of loss. There are times when return prospects are good and we invest because the price compensates for the apparent risks. There are also times, like now, when the scales tip away from returns, resulting in the need to focus more attention on the potential risks.
Patience is a virtue
Our strategy of navigating markets dominated by the fear of missing out is to employ one of the more powerful tools in an investor’s toolbox – the virtue of patience. We’ve positioned portfolios so that we can benefit should markets remain calm, and our clients can participate in positive returns. However, we have also tilted portfolios to reduce our exposure to areas of the market that might be vulnerable, and invested part of the portfolio in securities which would appreciate in volatile times. If risk does manifest itself, there will still be some short-term volatility for clients to endure, but we would be able to rotate the portfolio to capitalise on improved return prospects.
Current investment strategy
Our portfolios are less invested in equities than normal, and we have cut back our investments in higher-yielding bonds. At the same time, we’ve added to government bonds, as while they are likely to generate low returns, they would also likely rise in price should equities fall.
We are invested in good credit quality corporate debt, which allows us to both generate returns, and protect the portfolio while we patiently wait for opportunities to invest more capital into the equity market. The equity portion of our portfolios continues to invest in the best companies in the world, with strong balance sheets, global franchises, and sustainable high returns on capital. These companies are well positioned to compound your wealth, while reducing the risk to your capital. They also insulate the portfolio from the risks associated with the uncertain Brexit transition.
The investment landscape is always changing, and it is important to remain disciplined at all times. Despite the benign economic environment and optimism in financial markets, our process employs caution when the price of assets is high, since there is little margin of safety.
Philip Smeaton is chief investment officer at Sanlam UK