What the recent market volatility means for your portfolio
The past few months have seen the market responding to worries the US Federal Reserve Bank will lift interest rates, which wasn’t such a big deal in the end for most equities but not much fun for bond investors and interest-rate-sensitive stocks, especially during April and early May. The worst-performing assets were Australian banks, which had become pretty expensive for two reasons: they are highly leveraged and under pressure to raise more capital, and because they are interest-rate-sensitive and dependent on foreign capital.
Then the Greek crisis hit the headlines, followed by more evidence of China slowing. The main victims this time were emerging markets generally and commodity producers in particular. Obviously that wasn’t great for Australian resources. All in all, Australian investors felt like they were being hit from all sides.
Unhedged overseas assets, however, provided some respite. Underlying shares did OK but the Australian investor did even better as a weaker Aussie dollar meant holdings became more valuable in local currency terms. This demonstrates the value of exposure to overseas assets and currencies for portfolio diversification.
The new financial year has started with yet more turmoil focused on the interaction between a Chinese slowdown, the emerging markets and the prospect of higher US interest rates and a stronger US dollar.
It’s a pretty mixed up picture and there are many experienced investors who are scratching their heads and not really sure what comes next, particularly with regard to US interest rates. Is this just a pause in the post-GFC bull market or the moment when we find that central banks have used all their arrows?
The big picture is that markets have risen strongly over the past couple of years because interest rates have been kept so low, not because economies have been doing well. Hopefully economies will start humming soon but there are probably going to be some false starts along the way.
All this stuff can make your head hurt and there is little evidence that anyone is any good at predicting what happens next. We prefer to sit back and focus on what prices imply about possible returns over a relevant time horizon, and how much risk you should expect during that time (by which we mean simply how much an investment might fall by). By keeping a long-term horizon and managing our portfolios to their long-term goals we do not have to worry much about short-term fluctuations.
What changes have we made to the portfolios?
- Increased fixed interest weighting out of the quite high levels of cash in most of the portfolios.
- We have also rebalanced the portfolios to take account of the effect of recent market movements.
Why have we made these changes?
First of all, we usually rebalance the portfolios every quarter to make sure they are in line to meet their objectives. If we didn't, and we left it long enough, you might wake up one day to find Australian equities had done so well they dominated the whole portfolio, for example. Then if something bad happened in the markets you would be surprised to find the portfolio fell by a lot more than you were expecting because it was no longer ‘Balanced’.
Over short time periods it would perhaps not make such a huge difference, but it’s just good housekeeping to do this several times a year (usually every quarter). The platform used to administer your investments is actually very efficient and whereas it might cost you $25 a trade and a reasonable percentage in commission to do it yourself, doing it through our portfolios is a fraction of this cost.
The other reason we make changes is when something fundamental happens in the markets that makes one asset cheaper to you or more useful in achieving your goals than another.
Until last quarter the ‘yield to maturity’ of an Australian Government bond maturing in 3 years was just below 2%. With inflation forecast to be around 2%, an investment in government bonds was going to do nothing to help build the ‘real’ value of your conservative income-type holdings. Cash might not offer a much better return but it is much less volatile, so it seemed like a better trade-off at that time.
That is why we have held both a bit more cash and equities and not so many bonds, in order to try to achieve your objectives in what is an especially difficult environment for more conservative investors.
It doesn’t look like much of a difference but with yields edging up above the expected rate of inflation last quarter, the place for bonds in the portfolio becomes a bit more obvious. The asset class is at least very likely to make a positive contribution to the value of your portfolio over the next few years, rather than just cash.
Even when yielding very little bonds can provide diversification, so holding them can still be good idea as long as there are other things (such as equities) which are expected to produce higher returns.
One might also ask why we are still happy to hold lots of equities and haven’t reduced our exposure among the market turmoil of the past few months. Firstly, we think equities offer a better chance of increasing your wealth, if you don't mind the short-term volatility and can stay invested.
Secondly, as markets fall they often start to look cheaper, that is if you don’t think the outlook for future dividends has changed dramatically. We think falls of about 10% in asset classes like Australian and emerging market equities have probably added about 0.5% a year to the likely future performance of those markets. That might not sound like much but over 10 years just that difference would add more than $5,000 to the value of a $100,000 portfolio over 10 years.