Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
Simple is not so sweet in the current environment. In a world of global uncertainty, investors should place a premium on diversification. The siren song of the simple portfolio may be difficult to resist, but its appeal is based on recent performance that is unlikely to be repeated over the next decade. Prospective long-term returns of a simple 70/30 or 60/40 stock/bond portfolio are unappealing. At the most fundamental level, diversified portfolios—structured to earn returns comparable to their rate of spending at tolerable levels of risk—provide a better long-term strategy for meeting the common investment objective of seeking to preserve or grow purchasing power while supporting a steady flow of spending.
It is getting rather late in the economic cycle, and investors have quite a bit of geopolitical and macroeconomic uncertainty to digest in the year ahead. As such, investors should evaluate portfolios’ ability to weather a wide range of stress environments including those that have been in hibernation in major developed markets since the 1970s—the risk that economic contraction could be accompanied by rising inflation expectations. Diversification into assets that have fundamentally different sources of return than equities and bonds (e.g., royalty funds) or into assets that have attractive prospective returns and the potential to do well should inflation expectations rise may prove to be additive to portfolios.
Simplification into a 70/30 portfolio has produced attractive returns over the market cycle that began in 2009. However, experienced investors know that markets are cyclical. Just when it seemed that value would never outperform growth, commodities were doomed to a long cycle of supply/demand adjustment, and banks were to be priced like utilities forever, markets changed their mind. Oil producers slashed capital expenditures severely for two consecutive years amid modestly expanding demand; Treasury yields increased and the yield curve steepened, flattering bank profit margins; and economic growth stabilized. Market leadership rotates over time. If you are not willing to accept that markets rotate, you will miss the bend in the road while focusing your gaze on the rearview mirror. We suspect the future holds what we have seen time and time again: the tide eventually turns and diversification protects investors from maintaining too much exposure to the worst-performing assets, which are often the best recent performers.
While timing is anyone’s guess, valuations are sufficiently elevated that we do not see a way for an inexpensive, indexed portfolio of global stocks and bonds to meet most investors’ return objectives. In fact, if valuations, inflation, and fundamentals were to return to normal conditions over the next decade, we would expect a 70/30 portfolio to produce a real return of about 2%–2.5%.* Even without valuations mean reverting, it is difficult to develop a plausible scenario where the return after inflation would be much more than 3.5%, unless earnings growth improved significantly and/or multiples expanded further.
Valuations aside, a diversified portfolio strategy provides investors seeking to preserve or grow purchasing power while supporting a steady flow of spending a better means for achieving such objectives without being forced to sell assets at depressed prices during bear markets. Based on our conservative long-term performance assumptions, a diversified portfolio with the same level of expected volatility as a 70/30 portfolio has an expected return nearly 100 basis points higher, annualized, and is expected to create more wealth even after spending more over time.* The higher returns come from expected incremental returns from various sources including illiquidity premiums, pursuit of more diverse market risks, and active management. Such higher expected returns enable higher spending over time, with the benefits compounding over longer horizons. As investors consider where returns will come from in the future and how the transition from low yields/high valuations to more “normal” conditions may evolve, investing in a diversified basket of assets that balances between return seeking and stability will be particularly critical.
Celia Dallas, Chief Investment Strategist, Cambridge Associates
Originally published on January 17, 2017
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