The first half of 2022 has been characterised by higher than usual uncertainty resulting in a selloff in markets. The key reasons for this are:
Inflation risk: Inflation has continued to surprise on the upside and has reached levels we have not seen in decades.
Geopolitical risk: The Russia / Ukraine war continues, exacerbating inflation risk but also generally raising alert levels because a nuclear power is at war.
Central Bank policy risk: To quell inflation, central banks globally have embarked on aggressive monetary tightening by raising interest rates. This coincides with the unwinding of central bank balance sheets through quantitative tightening.
Economic growth risk: Fears of inflation and monetary tightening, if overly aggressive, pose a risk to growth.
The re-pricing of assets has been swift. The future looks more uncertain, and this elevates the riskiness of future cash flows.
What else do we know?
Risk is the reason why excess returns (returns above cash) are available. It is uncertainty that causes assets to be priced at a discount so that investors can expect to be rewarded for taking that risk.
Assets with unchanged prospects can be bought at significantly discounted prices compared to more elevated levels a few months ago.
Volatility is normal. Every year has its rough patches that test investor resolve, but despite this calendar year performance over the last 42 years on the S&P500 has ended positive 75% of the time
The US 10-year yield has moved from 1.5% to 3% this year. This means that an investor investing in this instrument would earn twice as much today than they could have earned 6 months ago.
Volatility should not derail a long-term asset allocation. A well-structured plan can aid in weathering volatility and limit emotionally driven reactions. It is at times like this that the greatest investment opportunities arise.
Market timing has proven to be damaging to the average investor because of behavioural biases that lead us to buy high and sell low. At PortfolioMetrix our objective is to maximise the returns we capture from the market over the long term and part of that process is to remain invested during the uncertain times. Traditionally, the average investor has paid a hefty price as they have fallen prey to the so-called behaviour gap:
We do not know when the war will end (or whether another one will start), inflation will peak or if a recession can be avoided. In fact, there is quite a lot that we do not know. It is for this reason that we diversify our portfolios. We aim to avoid excesses and select fund managers that allocate capital judiciously and have disciplined investment approaches that are complementary. We prefer to stay focused on the things that we can control and that add value over time. This involves building well-diversified, risk-managed portfolios that have the highest probability of achieving their long-term objectives, albeit with a few bumps along the way. We believe these portfolios used within a sound financial plan avoid the pitfalls of capitulating at the worst of times and potential wealth destruction.