Jonathan Marriott, Chief Investment Officer
Investing is rarely straightforward and making assumptions about the impact of news flow, or the relationship between one asset and another, can be dangerous. People look for patterns in life and use past experience to guide expectations about the future. Economists and mathematicians have tried to model this scientifically, but if investing were just a matter of mathematical modelling, life would be easy. In the last year we have seen events that have been truly unprecedented, reminding us that the past may not be a guide to the future. In these times, we may continue to seek input from economists and mathematicians, but, in the end, investment may be as much an art as it is a science.
Assumptions about risk
No investment is risk free, and we have to take risk to generate return. In the past, investors have presented this graphically to their clients, showing the historic returns for various asset classes relative to their risk. Risk was measured using volatility, which is a measure of how much an asset goes up or down relative to its trend return. Typically, equities would be at the top right (high return, high risk), and cash at the bottom left (low return, low risk). Bonds would be in between, but closer to cash. A curve was then plotted to demonstrate the optimised mix of assets based on their historical relationship. Unfortunately, this is a flawed assumption. Over the last forty years, bond yields have been in decline, falling from double digits to close to zero, and even negative in some cases. These returns cannot be repeated without yields going hugely negative, so the assumption that past performance will be repeated is not so much unlikely as it is impossible.
What about volatility?
Volatility as a risk measure is also problematic. When markets trend steadily, volatility is low, but the higher the market rises, the more expensive it becomes, and is at greater risk of falling. Conversely, when markets collapse, volatility rises, but at their lows they are cheaper. We need to remember that, while a market that has just gone down 40% may not seem less risky than one that has gone up 40%, it is often the case. A portfolio managed strictly to a volatility target will tend to sell assets when the market is down and buy when it is up. In March last year, the VIX Index of volatility hit 82 when the S&P 500 Index had dropped over 30%. Today, the VIX Index is at 16, while the S&P 500 Index has doubled from its March 2020 low. When looking at investments, we need to look forward for a guide to risk, rather than backwards.
Can economic data help?
Economic data, in general, is a measure of what has happened, not what may be about to happen. Some of the survey data may be more forward-looking, but sentiment is swayed by present conditions. Some people see the economy as a guide to market direction. While a flourishing economy is generally good for company profits and equity markets, the relationship is more complicated than that. If a strong economy leads to inflation, and consequently interest rates rise, this can be negative for both bonds and equity markets. In recent times, there has been speculation that the US Federal Reserve will start to tighten monetary conditions by tapering its asset purchases. If the economy is weaker, this is less of an imminent threat. As a result, weaker than expected data has actually led to higher equity markets.
Meanwhile, the stock market does not necessarily reflect the economy. This is particularly true in the UK. Over 75% of the earnings of the companies in the FTSE 100 Index are from outside the UK. A weaker UK economy may mean lower interest rates for longer and a weaker pound, but that is positive for international companies listed in the UK. For example, when the UK voted for Brexit in 2016, the knee jerk reaction was a fall in UK stocks and the pound, but the FTSE 100 Index rapidly rebounded. That rise in the FTSE 100 Index following the referendum was not an indication that the UK economy was going to do well out of Brexit. The fall in the pound showed fears of exactly the opposite. When we look at individual businesses, they may be even further divorced from national economics than the index as a whole.
Art versus science
I prefer to think of risk as the potential to lose money. When constructing portfolios, we try and create a balance, where the upside reward is greater than the downside risk. In a sense, we want lots of volatility on the upside, but little volatility on the downside. In doing this, we look to diversify the risk to make sure that not all the bets are pointing in the same direction. Our Investment Committee starts with a detailed look at economic conditions and analyses where we have risk in the portfolios. However, these factors alone do not drive investment decisions. In the end, the decisions are more qualitative than quantitative, in other words, more of an art than a science.
In any investor presentation, there is a risk warning cautioning how past performance may not be a guide to future returns, and yet most investors will still ask about past performance. While making assumptions is dangerous, it can also be dangerous to assume that it is different this time. However, the pandemic and the associated collapse and recovery of the economy are truly something never seen before; we must therefore look at any assumptions we make based on historic relationships with a degree of caution.
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