Investing is a delicate balance of trying to maximise the returns one can achieve, while keeping risks to an acceptable level. During times of market turbulence these risks are often front of mind, owing to concerns that things might well get worse. While sometimes things do indeed get worse, in the long run they almost always get better.
We have now seen two very unusual bear markets in three years: the 2020 Covid crash was very sharp and thankfully short, then 2022 saw almost all major asset classes fall in a correlated sell-off. The return of inflation and the enormous decline in wealth witnessed in recent months has meant that investors are unusually wary.
This has all come at a time when interest rates and inflation are on the rise, which has the effect of magnifying concerns. It now appears likely that we have left the lower-for-longer era behind us and by contrast the next few years look likely to see higher, more volatile inflation and a structurally higher level of interest rates.
Despite the period of market dislocation we have witnessed over the last year or so, paradoxically we think that this presents an opportunity and lays the base for an attractive period for those who remain invested, or who are looking to invest for the first time. We would argue that holding a large proportion of one’s assets in cash for the long-term provides false security in this inflationary environment.
It might avoid volatility risk endured by markets, but it is guaranteed to lose money in real terms and currently, with inflation running so high, this approach will undermine purchasing power. To quantify this, in the three years to 31 October 2022, the real value of cash left in the bank account would be 12.5% lower than its original value (calculated using the UK consumer price index). This should be recognised as a key risk for investors or potential investors. Therefore, so long as you have a reasonable time horizon, we would advocate, instead, to be brave and to invest in assets considered to be riskier than cash in order to help to mitigate inflation risk. Furthermore, we believe the market moves in a variety of asset classes in 2022 provide the very opportunities to help to deal with the threat from inflation.
For example, bonds have begun to offer more attractive returns, and if a good quality bond with a short duration is held to maturity then volatility and default risk can be dramatically reduced. This is a good illustration of how active management can be beneficial – it is considerably more difficult to profit from these opportunities if one invests in a passive index. One needs to be able to research and buy the best individual investment opportunities in order to maximise one’s return without adding unnecessary risk.
In a similar vein, falls in equity markets have presented some attractive stock valuations – but only for those willing to undertake an active search to find them. When looking at potential investments it is important to remember that a reasonable time horizon should be adhered to, particularly with regard to equity investing. And, it is the future value that ought to matter, and not necessarily the route that the valuation takes along the way. Further, equity returns tend to be higher if the investment is initiated at a period of low valuations, which is often in years where share prices have fallen sharply. Robert Shiller of Yale University demonstrated this in his work on the returns recorded from the US equity market between 1880 and 2012. In figure 1, the ten-year price-to-earnings (P/E) ratio is plotted against the returns recorded over the following ten years, which demonstrates higher returns following periods of low P/E ratios. As the trendline shows, when valuation multiples fall (x-axis), the subsequent ten-year returns rise (y-axis).
Recent events therefore appear to have presented conditions that have historically signalled strong subsequent equity returns at the index level – certainly stronger returns than those that might have been anticipated at the start of 2022. This is not to say that all equities will provide this profile; many companies will continue to struggle if interest rates and inflation remain elevated and some will fail, but an active approach can help to identify those companies which will survive and thrive.
We would argue that not only does a more inflationary and more volatile environment favour active investors, it is also expected to favour a more diversified portfolio.
For example, alternative assets allow exposure to a wider range of factors and revenue streams than equities and fixed income. This can support an investor during periods of uncertainty and enhance returns by accessing different areas of market exposure when compared to a traditional equity/bond portfolio. Alternative assets are not immune to some of the same economically cyclical factors which affect equities, but they can provide a good store of value in real terms. Some alternative assets are also well positioned to provide tactical exposure to thematic areas enjoying structural support, such as the energy transition or infrastructure upgrades. By blending such assets into a portfolio the risk-adjusted returns can be enhanced over time.
Many investors, including charities, are fortunate to have long-term investment horizons. This affords them the possibility to invest in a wide range of assets, but also to be brave and to stay invested during apparently dark nights. We believe that being brave, maintaining a longterm view and having an actively managed, diverse portfolio of the best opportunities will stand investors in good stead.
Ian Enslin is a charity investment manager at Waverton
Charity Finance wishes to thank Waverton for its support with this article
