Investing is about risk. A recent conversation with a client reminded me that there are many aspects to risk. It is not merely a statistical measure, but it is also about perceptions and beliefs. It is about the unknown, the unfamiliar and the human tendency to trust what feels familiar.
Familiarity vs true risk
This is why large banks, share brokers and fund managers spend millions to secure the naming rights of sports stadiums and entertainment venues – ASB Stadium, Westpac Arena, and Forsyth Barr Stadium are local examples. The message is simple: we are big, we are successful, and we’re here to stay. It’s about trust, not based on results, but based on familiarity.
But trust built on familiarity only goes so far. In investing, there is a scorecard – a measure of returns and a measure of risk – defined not by how comfortable you feel with the organisation, but how your money is growing and in particular, how you fare when the going gets tough. This is the ‘risk’ piece, and it can be measured.
This is what we focus on at Saxe Coburg. We are first and foremost performance driven, and we believe investors should measure performance not only by the absolute return but the risk they face in achieving that return.
Risk is often linked to volatility, and while we agree less volatility is generally preferable, we would rather think of risk as the potential for loss. Thinking about it this way, risk is how much you lose when you get it wrong, or put another way:
Risk is a function of how poorly a strategy will perform if the “wrong scenario” occurs.
Applying this to the traditional balanced portfolio construct of bonds and equities, many investors we speak to consider the traditional 60/40 equity/bond portfolio to be a conservative. We would beg to differ.
While it may appear to be conservative over long periods of time, what will happen when conditions change – when the “wrong scenario” occurs?
What history tells us about balanced portfolios
All you have to do is look at the “wrong scenario” events through history to get an idea of the potential losses facing a 60/40 portfolio.
Major losses in equity markets:
Great Depression Sep 1929 to Jun 1932 – 89%
Nikkei 225 Dec 1989 to Mar 2009 -82%
S&P 500 Mar 2000 to Oct 2002 -49%
Nasdaq Mar 2000 to Oct 2002 -78%
S&P500 Oct 2007 to Mar 2009 -57%
NZX50 Gross Oct 2007 to Mar 2009 -39%
Investors may have been told their 60/40 equity/bond portfolio is “conservative” implying that it carries a low level of risk. However, a bear market will inflict significant losses on this portfolio. Despite the notion that bonds will provide an offset, this cannot be relied on, and even when there is an offset, by far the greatest influence on performance will be the equity exposure.
Balanced portfolios can appear to be low risk for long periods of time until they’re not.
Improving the risk/return trade-off
There are two ways that you can change this risk/reward equation.
- By adding skill
- By adding diversification
We define skill as the ability to protect capital when markets fall, whilst still generating market-like returns over the long term. In every area of life, skill is the offset to risk. Think about it. Why should it be any different when it comes to investing?
Diversification refers to assets which behave differently in different scenarios. Applying this approach requires in-depth research into the plethora of funds available, to identify those which can be relied upon to deliver uncorrelated returns.
Saxe Coburg searches globally for talented managers who we think are capable of compounding returns whilst also protecting capital. We maintain a comprehensive data base of potential managers and for comparison, track a number of local NZ and Australian managers. This in-depth quantitative research identifies both risk and return metrics which assist us in our selection process.
The 60/40 and even 40/60 and 30/70 equity/bond portfolios commonly offered in NZ still expose investors to significant losses.
Research by GMO (Grantham Mayo Otterloo) show six 11-year periods where the 60/40 portfolio barely kept pace with inflation, and in some cases went backwards. Most started with high valuations on stocks or bonds.
Why concentration matters today
Global equity markets are currently elevated, driven by the AI boom. Only once in history has there been more concentration in equities than today, and that was in the 1880’s railroad bubble. Bank of America global research produced the following chart which shows that ten AI related stocks make up 40% of the US market. Other AI stocks comprise 8% lifting the market weight of AI stocks to 48%.
All that to say, risks are high in global equities given the US market is the main driver of global equity market returns.
It could be argued that the NZ market is at a different point in its cycle, but when the next bear market arrives, it is unlikely the NZ market will be spared.
No amount of naming rights, billboards, sponsorship or brand will protect you if you’re not truly diversified and/or have skillful managers overseeing your investments.
If you’d like to discuss the topics covered in this article, please get in touch with Mark or Sam or contact us for a discussion on how we could support your wealth journey.
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