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OPINION

Shock-proof portfolios

Shock-proof portfolios
February 4, 2022
Shock-proof portfolios

We are in uncharted waters. Not only is the Bank of England forecasting a big drop in real household incomes this year, but we could also see interest rates rise by more than at any time since 1989-90, which means nobody under the age of 50 has professional experience of such increases.

These, though, are just particular manifestations of a general problem – that the future is inherently unfamiliar and unknowable, and so investors must confront what Maynard Keynes called “the dark forces of time and ignorance which envelope our future”.

One way to do this is to ensure that our portfolios are resilient to shocks and surprises. Here are some ways of making them so.

Liquidity matters. One of the greatest catastrophes that can befall an investor is to be a forced seller. One way to prevent this is to manage debt carefully: could you refinance your loans in a crisis? Could you cope with interest rates rising by 2-3 percentage points or more? Another way is to hold cash – and more so if you own illiquid assets such as a buy-to-let property, commercial property or private equity. It’s sometimes said that holding cash allows us to buy bargains in a distressed market. But it has another virtue. It minimises losses. The worst loss on cash is simply the real interest rate, which is unlikely to be more than minus five per cent over the next 12 months. But the worst possible loss on equities, gilts or gold is much more than this.

Beware of diversification. Diversifying among equities alone – be it across countries or across industries – is an unreliable way of spreading risk because if markets fall sharply most stocks usually get dragged down. Yes, the last few weeks have been unusual in seeing the All-Share index hold up in the face of a drop in the S&P 500, but this is thanks to rises in a few huge UK stocks such as the oil majors. This is not a pattern to rely upon. To protect ourselves from big falls in global stock markets we need non-equity assets such as bonds, gold, foreign currency and of course cash.

Watch leading indicators. Nobody can avoid every fall in the market. Some losses are inevitable. History, however, suggests we can do some things to protect us from huge losses, because there are lead indicators of bear markets. A strategy of selling equities when prices fall below their 10-month (or 200-day) moving average; when long-term yields fall below short-term ones; or when the dividend yield is unusually low would have got us out before the worst bear markets of 2000-03 or 2008-09. Right now, only one of these indicators – a low dividend yield – is troubling. But of course, this will change.

Don’t assume the future will resemble the past. Of course believing that 'this time is different' is a great way to lose money. But nor should we assume it won’t be. UK and US equities have in the past recovered from every setback, which has encouraged the idea that equities are a great long-term investment. But this is only a small sample of history. There are more worrying precedents. For example, the Nikkei 225 is still almost 30 per cent below its 1989 level. And Philippe Jorion and Will Goetzmann have shown that many markets have in the past been wiped out. Of course, the chance of such a calamity in the near term is negligible. But we cannot be so confident of the longer term – which is why we should be short-term investors.

The danger that the future won’t resemble the past doesn’t stop here, though. Recent history tells us that simple asset allocation works very well. But it might not continue to do so: significant rises in interest rates could see combined sell-offs in bonds, equities and gold, for example. And while past relationships between the dividend yield or yield curve and subsequent returns have been strong, we know that statistical relationships – even those with a good theoretical basis – can break down. In fact, it’s possible that the predictive power of the dividend yield for future returns has already done so. Yes, we should use these tools. But we must not be too dependent upon them.

Adjusting your portfolio might not be enough; you might need to change your lifestyle.

Some of us can adapt better to big losses than others. If you can downsize your house, cut some spending, work longer or leave a smaller bequest you are better able to bear losses than those who cannot do such things comfortably. It’s not just in our finances that we need resilience. We need it in our portfolios as well.

Here, though, is a reason for optimism. Christoph Merkle at Aarhus University has shown that UK equity investors who lost money during the financial crisis reported being less unhappy than they expected to be. Which suggests that many of us are more psychologically resilient to loss than we think we are. This isn’t wholly encouraging, however. Would we see the same thing if losses were accompanied by, say, high inflation or political unrest? The experience of the 1970s suggests perhaps not.

I know, I know. All this seems miserable. And that’s the point. Focusing upon capital preservation requires us to forego some of the returns we’d get if we see normal times. If you need high returns – either because you’re scared of missing out or need to build up your wealth – you must sacrifice some resilience. There isn’t always a trade-off between risk and return (defensive stocks do better than speculative ones, for example), but in this context there is.