“I’m getting old, and I need something to rely on”
These lyrics from a beautifully melodic Keane classic (Somewhere Only We Know, 2004) speak directly to the problem of the modern-day investor. Even if ‘alternative UK rock’ isn’t to your musical taste, we can agree with the sentiment. Just what can investors rely on as they build their future financial security?
Here are a few simple rules of thumb that investors of any age – and musical taste – can rely on.
Inflation is not your friend
Most of us have an estranged relationship with inflation. We pick up sporadic news of how it’s doing via monthly reports on government statistics. We get a sense it wears down our spending power from year to year. And if interest rates rise with inflation, it hurts us through higher mortgage and loan payments. However, many of us fail to grasp the serious damage inflicted on our long–term wealth by inflation. Unless financial returns are greater than inflation in the long term, your financial strategy is making you poorer.
Bank of England base rate, less inflation
This chart shows the official rate underpinning all UK bank retail deposit rates, after the effect of inflation. A pension portfolio of £500,000 will today offer an income of £25,000 per year if you choose to buy an annuity, using a 5% annuity yield. If we invest that £500,000 pension pot for 20 years at the current negative real interest rate of -1.1% (Feb/Mar 2019), the value of the pot in today’s terms would fall to £396,738 using monthly accumulation. Using the same annuity rate on that pot will offer an annuity of £19,837, which is a 21% loss of real purchasing power; i.e. a one-fifth reduction in wealth. This is before any management fee is considered. So, inflation really isn’t your friend when it comes to cash.
Volatility is your friend
That’s right, it may feel painful when the value of an investment drops, but diversified investing is all about putting your capital at risk across different markets and geographies in order to obtain a good return. The rule of thumb is: no risk, no return. And if you’re comfortable taking a higher risk with your investments, you are right to expect higher returns in the long term. However, there are three caveats to bear in mind:
a) Financial market volatility means that assets lose value as well as appreciate in value. Capital is at risk.
b) Past performance is no guarantee of future returns. So that means, for example, you can’t expect a return over the last 12 months to be repeated in the next 12 months. The chart below shows simulated calendar year returns using Nutmeg’s Fixed Allocation Portfolio C, which is the mid-risk option in our fixed allocation range. Remember these are simulated historic returns using our current fixed allocation portfolio and are for demonstration purposes only. We have used a fixed allocation portfolio to demonstrate the return without the impact of intervention of our investment experts.
Calendar year simulated returns – Fixed Allocation Portfolio C
c) Time Diversification. The longer you’re prepared to wait, the more you should get paid for taking risk. In other words, volatility is a friend who sticks by you over the long term. At least, that’s the theory. But as the next chart shows, it very much depends on what period you’re looking at. The chart orders assets by their volatility between 1990 and March 2019. The NASDAQ US technology index passes the time diversification test. It has the highest volatility and the highest returns. This is true across the whole period as well as in the two sub-periods shown on the chart.
Clearly there is much idiosyncratic risk still impacting the risk-return behaviour of other equity markets: FTSE100, Emerging Market Equities, Europe-X-UK and Japan. Without such idiosyncratic risks, we would expect these lines to be upward sloping in line with time diversification – i.e. higher risk, higher return.
Asset diversification is your friend
Holding a mixture of income–bearing assets and growth-related assets across geographies and asset types helps to improve the trade-off between risk (volatility) and return.
a) The chart below shows annualised long–term simulated returns for Nutmeg’s fixed allocation portfolio range (A to E). As we move up the risk spectrum (say, from C to D), long term returns rise. And importantly, this positive slope is repeated in the two sub-periods. This result was not achieved in the separate asset returns (previous chart), so part of the story here is that asset-diversification is boosting confidence in the rule of thumb: higher risk, higher return.
b) In addition to improving the risk-reward trade-off, asset–diversified portfolios also seem to help shorten the time to recovery after an adverse move in portfolio value. The next two charts show a generally shorter simulated down move and recovery time for Nutmeg Fixed Allocation Portfolio C compared to those for large UK companies (FTSE 100). This year’s first-quarter recovery in the value of the portfolio was as rapid as the slide in the fourth quarter of 2018 – all over in three months. Patience seems to be as strong a virtue as diversification.
Active management can be your friend
If idiosyncratic factors are so prevalent in individual assets (see chart in 2c), then having a professional investment manager taking these factors into consideration when constructing a portfolio can help the risk-return profile. Fixed allocation portfolios are backward-looking in their construction. Active management can look forward and detect structural shocks (e.g. Brexit, China-US trade or geopolitics) and react to this idiosyncratic risk accordingly.
So, in conclusion, there are four things investors can rely on…
Inflation is not your friend and is wealth-destructive if capital is not receiving an above-inflation net return. Substantial cash holdings over the long-term are rarely wise unless individuals need that liquidity for a particular purpose.
Volatility is your friend if you’re invested in a globally diversified portfolio which minimises the idiosyncratic risks for individual asset classes. The more diversified risk you take, the higher your longer–term returns should be.
Active management can be your friend. It can help cope with idiosyncratic risk through forward-looking judgements and asset allocation changes. Investors with a very long-term horizon who are comfortable with market fluctuations may not need the comfort of active management. But many investors prefer the assurance that someone is looking over their portfolios, taking comfort from the fact that changes will be made when the manager feels idiosyncratic risk is not being rewarded.
Patience is your friend. We have seen that in well–diversified multi-asset portfolios, recovery times are shorter than in single asset values. Patient investors, who don’t cash-in their investments after a slide in value, have in the past seen their portfolio value recover in a time period usually shorter than the period of decline.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.