by Wylie Tollette, Franklin Templeton Investments
In some ways, the world fundamentally changed in the first quarter of 2020. March alone has shown how long-term market trends can change literally overnight. And yet, we still confront familiar tradeoffs as we turn to rebalancing and positioning our portfolios for an uncertain future. In between trying to figure out how to adapt personally and professionally to the rapidly changing COVID-19 pandemic, virtually all investorsâindividual and institutionalâare about to confront a challenging set of decisions.
What should you do, and when should you do it? This brief list is intended to help provide investors of all types a framework to address these questions.
- First, take a deep breath
We have experienced the fastest decline from record stock market levels to a bear market in recorded historyâfaster even than the 1929 crash that started the Great Depression (see chart below). Markets appear to incorporate new information more quickly these days but are still prone to over- and under-reactionâparticularly when faced with an uncertainty like the coronavirus. It is virtually impossible to predict the exact peak or trough, or the behavior of market participants over the short-term; nor is that likely a worthwhile endeavour.
It is understandable that investors feel like their heads are spinning. Step back from that Bloomberg terminal or TV screen, take a deep breath, and try to picture the long view. Many of us have experienced severe market corrections before. And weâve successfully navigated our way through them, one way or another. We will see our way through this challenging time as well. Red numbers eventually turn green.
- Take the long view
This may be a clichĂŠ in the investment industryââthat is what they always say after a terrible quarterââbut we believe taking a long-term view is truly essential in framing the asset allocation decisions ahead and positioning a portfolio for success. The asset allocation choices underpinning our portfolios are themselves based on long-term assumptions. The reptilian portions of our brains have evolved to react quickly and instinctually to immediate threatsâso called âfast thinking.â1 Taking the long view is particularly important in the middle of a global virus pandemic, which likely activates our flight-or-fight response where reptilian thought processes can alter our usual investment decision making process.2 Focusing on 3-, 5-, and 10-year performance can help engage âslow thinkingâ and facilitate more rational decision making.
As Sir John Templeton said, âto buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest rewardâ.
- Think risk first
As investors, we cannot control returnsâsimply recall the last 6 weeks. But, we can control the risks we take (for the most part) in each part of our portfolios. Returns are essentially the âresult setâ of those risks. Many investors donât fully understand their actual risk capacity until tested, as it likely was in the last six weeks.
Weâve just come out of a decade where central banks dampened volatility through unconventional monetary policy, so the recent spate of volatility has felt particularly shocking. Better to reconfirm your tolerance and capacity for volatility and align your forward-looking asset allocation with that (now better understood) risk capacity. The alternative is to bumble ahead in relative ignorance. It is better to make an explicit set of decisions than to implicitly lurch ahead.
One bright spot: viewed from a valuation perspective (the way Benjamin Graham thought about investing3), the typical portfolio is actually lower risk now than that same portfolio was six weeks
ago. It probably doesnât feel that wayâmore like you might be holding a grenadeâbut one shouldnât focus on feelings when it comes to investing (see âfastâ vs. âslowâ thinking noted above).
- Rebalance thoughtfully
Recent market performance is exactly the type of event where a disciplined policy of rebalancing back to strategic targets thrives. You are not going to get the timing exactly right (see above on calling peaks and troughs). But rebalancing is part of strategic asset allocation, and it is usually built on capital market expectations that look out 7, 10, 25 years or longer. So should your calculus of whether your approach to rebalancing is successful. We recommend starting to average your way back to target ranges over the next few months as the outlook becomes clearer, rather than a âbig bangâ approach of returning precisely to targets.
Even if you were ill-prepared for the recent downturnâsay, for example, by having failed to rebalance out of equities as they rallied through the end of 2019âmost investors have the time horizon to focus on the 3-, 5- and 10-year returns. And, those are generally the numbers that really matter anyway.
- Have more liquidity than you think you might need
While the current crisis looks different from 2008, some things stay the same: thereâs no substitute for liquidity. When markets are melting down, few things are as handy to have on hand as cash and other truly liquid assets. Even goldâthe stereotypical âsafe-havenâ asset for nervous savers and investorsâwas negatively impacted; in other words, âcash is king.â In the event investors with near-term liabilities decide to allocate a year or two of projected cash demands in cash and short-term sovereign bonds, this may allow a portfolio to avoid selling long-term assets in the short term when markets remain volatile.
- The denominator can dominate
As at the quarter-end, investors with significant illiquid or private holdings will soon find that their public market assets have dramatically re-valued. Meanwhile, private holdingsâwhich tend to rely on appraisal-based valuation on a quarter or more âlagââare still sitting pretty (if stale) with 31 December 2019 market values. This will likely make the illiquid asset classes in a portfolio look larger than they truly are, as the values are surely impacted by recent market turmoil but accurate prices are not immediately observable.
Whether a parcel of real estate (for example) is owned by a REIT (valued daily) or owned by a limited partnership (valued quarterly), the actual underlying propertyâs true economic value should be similarly impacted. This phenomenon can make calculating allowable asset class ranges challenging, due to the unknown âtotal assetsâ denominator. A simple solution for allocators to address quarter-end rebalancing is to estimate the mark-down and include this in both the numerator and denominator.
- Capital calls are coming
Private assets are invested based on the managerâs timing, not the investorâs. Once an investor commits capital, it may not be drawn down for years. In the current market, smart private asset managers are going to be seeking bargains and are likely to call capitalâmost likely, at the worst time for allocators. For a typical retail investor, a corollary exists in the form of unexpected expenses or loss of employmentâdifficult to predict and potentially very impactful. These types of events need to be built into your potential liability projections and rebalancing approachâanother good reason to follow tip #5 above.
- Donât sell long-term assets in the short term
This sounds basic, but it is remarkably common, even among sophisticated investors. Following the global financial crisis, one large US institutional pension fund, for example, found its portfolio dramatically outside of its asset class ranges. In anticipation of receiving capital calls from its private equity and real estate managers, public equities were sold near the bottom of the market in 2008â2009 to raise cash. As stock markets recovered over the following several years, it missed out on the rally on those same equity assets. Similarly, some of the more levered real estate projects were taken back by banks at the depths of the crisis and its real estate portfolio is still healing, more than 10 years later.
Unrealised gains and losses are just thatâunrealised. Selling long-term assets with positive forward prospects at transitory low prices violates the first truism of investingââbuy low, sell highâ. See tip number 5 above about maintaining a little bit more liquidity than you think you might need, just in case.
- Diversify
Recently, it has been very difficult to beat a âboringâ 60/40 portfolio of the MSCI All-Country World Index (ACWI)4/ Bloomberg Barclays Global Aggregate Bond Index (see chart below). There are two related reasons: 1) the performance of fixed income; and 2) the risk diversification from the relatively large 40% allocation to bonds during equity market drawdowns. Much of fixed income performance has been due to the behaviour of long-term rates for the past 35 yearsâthey have steadily gone down, increasing the value of long-term bonds and also providing much-needed diversification against equity factors. As sovereign bond rates approach zeroâalready near or below zero in much of the developed worldâinvestors will need to look further and harder to diversify equity risk. Alternative risk premia strategies, infrastructure, real assetsâeven long-shunned inflation hedging assetsâmay start to make more sense for some investors, within a diversified portfolio.5
Finally, we expect markets to continue to be volatile until there is a clear path for both humans, economies and capital markets to navigate the pandemic. Tip #10 is to go back to #1 and read the list from the top, beginning with another deep breath. Keep calm and carry on.
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What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. The positioning of a specific portfolio may differ from the information presented herein due to various factors, including, but not limited to, allocations from the core portfolio and specific investment objectives, guidelines, strategy and restrictions of a portfolio. There is no assurance any forecast, projection or estimate will be realised. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these marketsâ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Derivatives, including currency management strategies, involve costs and can create economic leverage in a portfolio which may result in significant volatility and cause the portfolio to participate in losses (as well as enable gains) on an amount that exceeds the portfolioâs initial investment. A strategy may not achieve the anticipated benefits, and may realise losses, when a counterparty fails to perform as promised. Real estate securities involve special risks, such as declines in the value of real estate and increased susceptibility to adverse economic or regulatory developments affecting the sector. Investments in REITs involve additional risks; since REITs typically are invested in a limited number of projects or in a particular market segment, they are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. Actively managed strategies could experience losses if the investment managerâs judgement about markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments made for a portfolio, proves to be incorrect. There can be no guarantee that an investment managerâs investment techniques or decisions will produce the desired results.
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1. Kahneman, D. Thinking, Fast and Slow, New York: Farrar, Straus and Giroux, 2011.
2. P. Slovic, M. Finucane, E. Peters, and D. MacGregor. âThe affect heuristicâ, European Journal of Operational Research, Vol. 177, Issue 3, March 2007; Shiller, R. âThe Two Pandemicsâ,Project Syndicate, 31 March 2020.
3. Graham, B. The Intelligent Investor, New York: Harper Business, 2006.
4. The MSCI ACWI captures large, mid- and small-cap representation across 23 developed markets and 26 emerging markets. The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities. Indices are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or guarantee of future results.
5. Diversification doesnât guarantee profit nor protect against risk of loss.
This post was first published at the official blog of Franklin Templeton Investments.