Diversification is the only way to truly protect capital and ensure that investors are not overly impacted by the next downturn, according to Franklin Templeton Investments’ Anthony Coffey.
The multi-asset portfolio manager said investors need to learn the lessons of the past as the market continues to rise to new highs and bonds yields plummet to record lows.
“Ten years ago, the world was standing on the brink of the global financial crisis,” said Coffey. “US stocks, as measured by the S&P 500 Index, hit record highs in October 2007 before falling by more than 50 per cent over the next 17 months.”
Performance of index over 10yrs
Source: FE Analytics
However, as the above chart shows, the S&P 500 has eclipsed the ‘highs’ of 2007 and is up by 197.81 per cent over the last decade causing some investors to grown nervous about a large market correction.
With valuations looking frothy, the manager said now is the time to look at what investors can do differently if another crisis were to take place.
Most investors experienced some pain during the financial crisis but those that fled both stocks and bonds in favour of cash because they couldn’t stand watching their investments plummet were particularly badly hit.
For many of those investors this proved to be catastrophic, as making the wrong move at the wrong time – i.e. selling near the market bottom and missing out on the rebound that occurred in 2009 – led to huge losses.
“These days, there is no shortage of market commentators suggesting that investors should sell stocks and bonds before another possible market crash,” Coffey said.
“And some investors may listen to their advice, believing they can reach their investment goals by buying and selling stocks and bonds at exactly the right time.
“We believe it’s difficult for any investor to time the market. We prefer to take a more disciplined approach to investing by sticking with a set mix of global stocks and bonds, rebalancing from quarter to quarter, regardless of market conditions.”
Schroders’ FE Alpha Manager Kevin Murphy, agreed with Coffey, noting in a recent blog post that even though he runs a purely value mandate, the strategy should form part of a wider portfolio.
“We have a firm belief in the primacy of value as an investment strategy. That belief, however, does not translate into blind faith in its powers- or a conviction that on its own the approach will be suitable for everyone,” the manager said.
He noted that there is no such thing as a strategy that will outperform all the time, with his value funds also more risky than other asset classes, meaning it may not be suitable for everybody.
Performance of fund vs index over 10yrs
Source: FE Analytics
Indeed, his Schroder Recovery fund, which Murphy runs with fellow FE Alpha Manager Nick Kirrage, has outperformed the FTSE All Share in four of the last six calendar years but has lost significantly more than the market in 2015 and 2011 during times when his style has been out of favour.
“We do not seriously argue that every investor should unquestioningly put all their eggs in a single –value-shaped – basket,” Murphy added.
To make a truly diversified portfolio, Franklin Templeton’s Coffey said investors need to put aside their prejudice against fixed income and select a mix of global bonds and equities.
The chart below highlights how broad asset classes have moved in different directions over the past 20 years, but Coffey noted that it was important to find stocks and bonds that are not correlated and historically haven’t moved in the same direction at the same time.
Performance of global stocks vs bonds over 20yrs
Source: Franklin Templeton
When considering equities, he said investors should consider selecting investments from across broad areas of the market.
For instance, investors should draw from across the market capitalisation scale, with Coffey noting that small-cap stocks tend to have greater risk/return profiles than larger, more established companies.
The multi-asset manager also recommended investors diversify by industry, adding that cyclical areas of the market are likely to be more sensitive during downturns than non-cyclical industries.
Finally, he said, investors should look to spread their investments across different geographical locations. For example, emerging market stocks can offer more growth potential and greater volatility, compared to those in more developed economies, but come with heightened risk.
Turning to fixed income, Coffey said “we believe it makes sense to have some exposure to global bonds, and diversify outside of one’s home country”.
“In addition, global bonds don’t tend to move in the same direction as stocks, particularly during periods of uncertainty,” he said. “Although past performance is no guarantee of future performance, global bonds rose 10.9 per cent in 2008 and outperformed equites broadly that year.”
The biggest problem for investors however, particularly in the current environment, is the fear of missing out, but Coffey added that investors need to think about the long term.
“Some investors may feel they are missing out on potential returns when stocks or bonds rise above their set allocation levels during bull markets and their strategy calls for paring them back by rebalancing,” he said.
“During those times, we believe it’s important to remember that investing isn’t purely about returns; it’s also important to maintain a portfolio with the appropriate risk level for one’s long-term investment goals—not putting too many eggs in one basket, so to speak.
“Most importantly, we believe a disciplined investment process takes the emotional element out of investing. In our view, that can lead to a better outcome than simply following the crowd and selling indiscriminately during times of crisis.”