4 Key questions facing investors as we start 2020: Q&A
Question: What is your 2020 (to 2030) outlook?
Following the global financial crisis in 2008, interest rates sank across the developed world and stocks launched a 10-year bull-market run. Markets have cheered rising earnings and lower interest rates, but seemingly few people have paid attention to how long this accommodating landscape could last.
Put frankly, markets are out of balance. And we expect rebalancing to come in the next decade. Performance gaps today between value-style stocks and their growth counterparts and between U.S. and non-U.S. stocks have widened to historical extremes. Looking across history, economies and markets tend to be cyclical—trees don’t grow to the sky, as the German proverb puts it. So, we expect the next 10 years of returns to look very different to those of the last 10 years. Our view isn’t based on proverbs so much as market fundamentals.
The good news for our investors is that these rare extreme performance gaps have historically been followed by high relative returns for valuation-driven investing approaches. Whilst these periods of strong cyclical returns leave investors susceptible to performance chasing, they can bring the best long-term opportunities for contrarians. In this sense, we believe benchmarks are vulnerable to larger downside risk than normal, although we do see opportunities by investing in unloved markets and diversifying in a manner that protects against the risks ahead.
How will 2020 play out? That’s anybody’s guess. But we see opportunities for investors willing to be patient and stick to a valuation-driven approach.
Question: Why are “risk-adjusted returns” more important than just “returns”? People just care about the bottom line.
When we talk about risk-adjusted returns, we are focusing on delivering the maximum amount of return, for a given level of risk, as opposed to just generating returns without regard for the risk taken in achieving them.
This is an important distinction, because as humans, we like what’s easy and try to avoid what’s not. For investors, returns are easy, while risk isn’t. Risk analysis feels opaque, theoretical, and even counterproductive during the good times. When returns are rolling in, it’s easy to ignore risk, then a crash happens and it feels as important and alive as ever.
The lesson is simple: ignore risk at your peril. But we’d add to that—you need to focus on the right types of risks. We can usually bundle this into two core forms; 1) downside risks to your portfolio, or a permanent loss you can’t make back, and 2) overtrading risks, including poor timing decisions that trigger a permanent loss (especially those that would otherwise be temporary). Things like leverage, valuations, or becoming technologically obsolete are true risks. On the other side, volatility feels like risk, but we’d argue it is less of a concern. For example, a market bobbing up and down is less risky than a market that carries unsustainable debt levels.
So, yes, risk-adjusted returns are important, as long as they are defined in the right way. We’d even say risk management can make you money, as reducing drawdowns in market falls can be as important (if not more so) than keeping up with the market as it rises. This is especially true when you consider things like sequence risk, which is important for retirees. If your investment collapses by 50% in year one (from a market crash), it takes more than a 100% return to get back even, as you will be drawing on the capital when the balance is low.
Don’t be fooled into thinking goal attainment is all about catching positive returns. Those that think this way are procyclical, which is a risky way to invest. Markets are unpredictable, and investors can only take what they give us. To reach financial goals, consider those things you can control.
Question: Can you explain why being diversified across a range of asset classes will help investors outperform?
Diversification is often called “the only free lunch in investing” because the theorists have shown it increases portfolio efficiency by improving risk-adjusted returns. That is, you can get more return potential for a given level of risk, or you get the same return potential with less risk if you diversify. Diversification definitely helps, however we believe its application needs clarification.
First, what is diversification? At its core, diversification means finding assets whose returns are less linked to those of other assets—that one asset zigs as another zags. Many are content for this to refer to past returns—that is, they look at how correlated the past returns of Asset A are to Asset B, and, the less they are correlated, the more diversified they are. But we believe that we can’t look only at past returns to determine diversification for the future—we also need to consider diversification of the underlying fundamentals. A simplistic example is if Asset A is the stock of a company, and B is its debt. On paper, these are completely different assets and therefore provide diversification. To us, the investment success or failure of these assets rest on the same fundamentals—the business success of the company—and thus do not provide fundamental diversification.
Second, what does it mean to outperform? In any given year, diversification will deliver (by definition) lower returns than those for the highest-performing single asset class or security. However, when we broaden performance as being over an entire market cycle, we believe a multi-asset portfolio will typically beat single asset classes, especially on a risk-adjusted basis. Diversification can power this outperformance by limiting losses in down markets, meaning it can “catch up and pass” the high-flying asset classes, like equities, despite underperforming in rising markets. The rub here is a human one—can you stay invested through good times and bad?
Question: If a manager trails the benchmark over three or five years, despite delivering positive returns, should we be worried?
The question here is really about measuring investment success. So, let’s start with a sanity check—people aren’t usually investing for the sky. More often than not, people aren’t motivated by beating a benchmark or their friends, but rather, reaching their goals. This immediately brings the use of benchmarking into question, where we cite a misalignment between benchmark design and goals-based planning.
The best benchmark is one that is forward-looking and aligned to your financial goals. In a perfect world, every investor deserves their own framework to benchmark success, with transparency, measurement, and perspective all to be embraced. The challenge, of course, is that a forward-looking assessment is incredibly difficult to quantify, and there is no such thing as the “one-size-fits-all” approach.
Benchmarking tools—such as those we use—are powerful, but you cannot unshackle the backward-looking nature of them. What matters to an investor is whether their investment might be expected to help them achieve longer-term gains into the future. This mismatch requires care and highlights an important point around process versus outcome. There are many moving parts, some of which you can control—risk taken, assets held, timeframe considered—and many others you can’t.
Specifically, it is entirely possible to have a strong process (or a good decision) with a bad outcome, just as it is possible to have a poor process with a strong outcome. However, more often than not, a strong process will prevail and result in strong outcomes and vice versa. This is a key reason why we stress that people make comparisons over a longer time horizon—it allows the strength of the process (or the combination of many decisions) to unveil itself.
To round this out and answer the question directly—three to five years is a decent progress check, however looking backwards is unlikely the answer. We wouldn’t be so worried, as long as the inputs (people, process, parent, costs) continue to stack up. Remember that you can’t reap the benefits of a manager’s strong past performance.
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