Recession-proof your portfolio
Investors who stick to a strategy and maintain a suitable asset allocation will have a better chance of protecting their wealth
Asset allocation – the split between different asset classes in your portfolio – is the most important consideration
These times of deep uncertainty and high sharemarket volatility will have many investors re-assessing their portfolios. It can be daunting – do you sell, buy, or hold the line? There is no right answer to this, but there are a number of things to consider before you make any changes. First, uncertain times should not be met with equally uncertain responses.
“You want to be careful about moving too far away from your normal strategy,” says Stuart Fechner, director of research relationships at Bennelong Funds Management.
“If your normal approach is to not move too far away from your long-term asset allocation, think twice about doing it now during this uncertain and volatile environment. If you get it wrong, you’ll do a lot of damage to your longer-term outcome.”
It’s comparable to driving through unfamiliar suburbs without a map during a storm. The chances of reaching the intended destination aren’t crash hot.
“It’s like you’re trying to play catch-up before you’ve started,” says Fechner. “Some may get it right and add value, but it’s fraught with risk.”
It’s therefore better to have a strategy in place before the storm hits.
If you make the changes after the market has tanked, it’s probably too late – you’ll likely just crystallise the losses made on more volatile stocks.
In the same vein, by the time a recession hits it’s usually already anticipated, and if it’s anticipated then it’s also been priced into markets.
“On average markets have gone up during recessions,” says Chris Brycki, from robo adviser Stockspot. “It’s proof you shouldn’t be out of the market during a recession, because at that point it’s too late.”
But why do stockmarkets go up when the economy is going down.
“Government and central bank support has fuelled a price rebound, which is now at odds with the uncertainty of our Covid-19 economy,” says Max Cappetta, chief executive at Redpoint Investment Management. “Equity markets remain attractive to cash-starved investors seeking income and to those seeking growth.”
Brycki says the market’s not just pricing in earnings this year or next year; it’s discounting cash flows in five and 10 years.
“Over the last few months central banks have loosened monetary policy in an unprecedented way. That, combined with other government measures, has put a rocket under risk assets,” he says.
It’s all about allocation
A sound strategy doesn’t mean a static portfolio. Investments can change in a way that’s consistent with a common strategy that applies for both good times and bad.
Asset allocation – that is, the split between different asset classes in your portfolio – is the most important consideration.
Research by Vanguard found that from January 1990 to June 2016, 89.3% of its return variations were due to asset allocation.
“Broadly diversified portfolios with limited market timing tend to move over time in tandem with overall financial markets,” says Vanguard’s head of corporate affairs, Robin Bowerman. “Market timing and actual security selection had a relatively small impact on return variability over the long term.”
Asset allocation, while arguably the most important aspect to investing, is often overlooked.
“The issue we see mainly is that investors don’t look at the asset allocation part,” says Drew Meredith, financial adviser at Wattle Partners. “We look at asset allocation on at least a quarterly basis, and we make substantial changes.”
In general, assets fall into one of two categories: defensive and risk. Defensive assets include cash, bonds and gold, whereas risk assets are generally shares.
“It’s hard to predict what’s going to happen, so your asset allocation is just about your investment horizon and your appetite for risk,” says Brycki. “You should always have an allocation to growth as well as defensive assets.”
This means diversification – the only free lunch in finance. Diversification should be between asset classes and also between sectors within equities.
“Diversification is important, but it’s not about diversifying between banks and resources,” says Meredith. “Every new client has concentration risk. I speak to people who have 25% of their portfolio in banks and wonder why they underperform.”
On the defensive
Defensive assets do the heavy lifting during market falls, not after. The whole idea is for them to protect wealth when the growth assets are falling.
Fixed income is the most common defensive asset class used by investors. The most common assets here are bonds and cash (bank deposits).
Bonds pay a regular coupon, which you can think of as interest or yield. As bonds are traded on the secondary market (as if they’re second-hand), their price goes up and down based on supply and demand. But because the principle bond has to be paid back at some point in the future, the yield will change as a result. So as bond prices go up their yields go down.
Because investors – and central banks – have been willing to pay more for bonds as a safe haven to store wealth when the market is volatile, their yields go down. And because bonds are competing in a sense with bank deposits as a place to safely store wealth, bond yields and interest rates generally move in the same direction.
During a crash, bonds can provide a much-needed cushion against sharemarket losses.
“Our portfolios have government bonds and gold, and that reduced the volatility by 50%-80%,” says Brycki.
However, in line with global interest rates, bonds and cash are paying next to nothing these days.
Gold can provide a way to safeguard wealth when markets fall while still providing capital gains. Moreover, physical gold or gold-related equities (such as gold companies or gold exchange traded funds) are normally negatively correlated with equities, so when one goes up the other goes down.
“Bonds, which have historically provided a lot of protection when markets crash, now have yields near zero, so they’re not providing the protection they used to,” says Brycki. “This can be compared to gold. All Aussies should have gold because it cushions volatility.”
Brycki notes that Stockspot’s portfolios were positive for the 2020 financial year when most super funds were negative, “and it’s really because we have gold in there”.
Go for growth
At the other end of the spectrum are growth assets, which typically mean shares. They provide most of the capital growth in a portfolio, but are also more susceptible to volatility.
While shares are generally risky assets, some sectors still have defensive qualities. How defensive depends largely on the point in the business cycle.
“Defensive assets classes like healthcare, consumer staples and mining have outperformed as the economy slowed and was in its ‘late stage’ of the cycle,” says Jessica Amir, market analyst at stockbroker Bell Direct.
“As we are officially about to enter the new phase, a recession, investors should know, across history, the healthcare sector has been the only sector to outperform in a recession, while cyclical sectors including financials, real estate, consumer discretionary and mining underperform.”
But this recession is a different beast. It’s a global pandemic that has us locked down at home. What do people do when they’re stuck at home? They get on their devices to shop, playgamesandcommunicate via social media.
As a function of that, tech stocks, namely the FAANGs (Facebook, Apple, Amazon, Netflix and Alphabet, owner of Google) are in favour.
“Some stocks are viewed favourably towards higher volatility in equity markets,” says Emanuel Datt, from fund manager Datt Capital. He gives the example of SelfWealth, a discount online broker.
The importance of the online trend is echoed by other fund managers.
“Over the medium to long term it is far more important to correctly identify an area of structural growth, and the companies set to benefit from that growth, than to try to predict the direction of the economy or market,” says Nick Griffin, from Munro Partners.
“With so many areas of disruption occurring at once post Covid-19, the opportunities for investors will bear this out. E-commerce, for instance, has been on a growth trajectory for some time already, and this crisis means the shift will happen even faster. From that point of view, Amazon and Alibaba are two names that are set to benefit.”
Rebalancing
For most retail investors, trying to time the market is almost a fool’s errand. Still, that doesn’t mean you can’t rebalance your portfolio given the current state of the market.
“It’s not about timing the market, but rather adapting to changing conditions,” says Brycki.
Whereas timing the market attempts to predict where the market will go, rebalancing involves buying or selling assets in order to maintain your asset allocation.
The risk across your portfolio stays the same, all things being equal. But the problem is, things never stay equal. The market constantly moves up and down the risk spectrum, so your asset allocation needs to be tweaked to maintain a set risk exposure. Growth assets may have outgrown the definition. Conversely, defensive assets may be providing too much protection because the market is going through calmer times.
Whatever you choose to do, make sure you do your homework and seek financial advice if needed.
Whatever you choose to do, make sure you do your homework and seek financial advice if needed