The traditional approach to trying to balance the risk and return properties of a portfolio is through diversification. Holding a certain level of risk assets alongside a number of safe assets should, in theory, smooth the journey.
The idea is that these assets compensate for each other at different times, thus delivering a fairly consistent level of return through both risk-on and risk-off market environments.
However, we have only to think about how many times investors have been surprised on either the up or downside in recent years to understand that market movements are not always logical. Experience has shown that risk characteristics are not static.
No single asset can be guaranteed to behave in a particular way in a certain environment. This is explained by the role of human emotion in investors’ decision-making processes.
Conventional financial theory suggests investors are rational and always make objective investment decisions. In fact, studies show that markets move far more than is justified by underlying fundamentals.
This is because investors’ perceptions of risk can change suddenly according to sentiment, rather than simply factual analysis of fundamentals. It is why a ‘set-it-and-forget-it’ approach to asset allocation is unlikely to be successful.
The role of human emotion in driving financial markets and asset pricing means that even if you could predict the outcome of every future event, it is impossible to know for certain how investors will respond, and therefore how markets will move.
As such, allocating assets based on attempts at economic forecasting is unlikely to be successful on a consistent basis.
It is more useful for investors to focus their energies and resources on the one thing they can know – how assets are priced in the context of the current economic environment.
Constructing a carefully considered valuation framework provides a disciplined way of assessing which assets are priced to deliver the best prospective returns. But it is important not to be overly mechanistic about this. The next layer of the process after establishing which assets are attractively valued is to ask, why?
Understanding whether assets are justifiably or unjustifiably cheap is key to defining true risk from volatility. The former represents the chance of permanent capital loss due to a bad investment.
The latter may offer opportunities to those who recognise when markets are moving for non-fundamental reasons, as emotionally driven volatility is usually temporary and can thus be exploited for those with the emotional fortitude to take it on.
Although the global economic environment suggests we should expect volatility to persist for some time, a flexible yet disciplined global multi-asset approach to asset allocation provides the best chance of investors being able to use this volatility to their advantage.
