It’s clear that investors are currently very focused on certain parts of the market. In the US, the S&P 500, the index measuring the performance of top companies, currently has a forward price or earnings multiple (a common measure of value) above 20. This compares with an average of 17 during the past two decades. But is this strong position good enough when it comes to a robust investment strategy?
To understand what’s happening it’s useful to consider what many investors expect when planning over the long-term. For example, when planning for retirement there’s a general acceptance that most of us don’t save enough. As a result, a certain level of risk is needed to grow retirement funds, especially given inflation.
In the wake of COVID, the level of risk which most investors need to take on is likely to increase in order to prop up pension plans. This raises a range of issues – including the implications for policy, regulation and which investment frameworks should be used. Another challenge is low interest rates which have shifted the balance of power from savers to creditors. So, what does this all mean if you need to make long-term saving decisions in today’s world?
There are two main factors to consider:
First, there is a fundamental shift in the risk/return dynamic across traditional asset classes. The balance has been exceptionally good for 40 years, during which a simple 60/40 portfolio of US equities and 10-year bonds has delivered a 7% return. But high valuations across equity and bonds, and the prospect of increasing inflation, make it harder to see how this will continue.
Second, while high equity prices don’t necessarily mean markets will fall, it does mean volatility is likely to continue. The connection of stocks and bonds has recently been firmly negative, allowing for easy diversification, but there are reasons to believe this will come to an end. As equities and bonds become more connected, overall portfolio risk increases. As a result, it’s likely that fund performance will be more volatile in the future.
Ultimately, investors need to take these shifts on board but there are a couple of steps which can help:
- Any goals must be clearly defined, including, for example, choosing a “real” return target that takes inflation into account. So, bonds, which are likely to deliver negative real returns, will need to be factored out of portfolios especially given that government policy (in the light of COVID) is likely to be inflationary. As a result, more weight on equities will need to be at the heart of any retirement portfolio.
- The investment framework itself needs to be considered too. This requires tilting factors such as income (the long-term performance of dividend-paying stocks), value (the buying of “cheaper” stocks), a focus on companies in faster growing economies (often emerging markets) and identifying companies with growth momentum (often smaller companies) alongside traditional bets to provide enough sources of return and a spread of risks.
In today’s climate there is a real risk of hardship for retirees. The unprecedented financial interventions in the COVID crisis show that we have entered a new era. Portfolio construction must adapt to provide good returns over the long term. If real rates have to be anchored at low or negative levels, it may require a shift in mindset to allow increased risk in a portfolio. Saving for retirement is about to become more challenging. It is better to face up to the new reality than ignore it.