Lessons from the latest market tantrum

THE fourth quarter of 2018 was the second-worst quarter for global stocks since the 2008 financial crisis. No major equity market was spared. A benchmark of global stocks dropped 13% during the quarter, and 11% in all of last year, recording its biggest annual loss in a decade as investors were spooked by the US Federal Reserve’s interest rate hikes amid slowing global growth and corporate earnings.

What can we learn from the latest market tantrum and how do we use the lessons to position for 2019?

Let’s start with arguably the most reassuring aspect of the latest volatility. As stocks plunged, bonds and other so-called “‘safehaven” assets rose. An index of US Treasuries gained 2.6% during the fourth quarter, gold rose almost 7%, and the Japanese yen strengthened 3.7%. This resurrects the traditional role of these assets as an offset against equities.

The main lesson for investors here is that of the importance of diversification. Our preferred broad-based allocation for conservative investors, spread across Developed and Emerging Market stocks, government and corporate bonds, gold and other alternative assets, lost only 2.1% in the last quarter and 1.3% in all of 2018, significantly outperforming a portfolio focused solely on equities.

One cannot overemphasize the benefits of diversification, especially as we get closer to the end of the current economic cycle. Too often, investors over-allocate towards their preferred asset class and markets, thus taking on inordinate amount of risk, only to suffer significant drawdown when markets turn against them. There is now a significant body of academic research which shows that an investor’s asset allocation contributes most of his/her investment returns. A broadly diversified allocation helps maximize returns for a given level of risk appetite.

Once an investment portfolio is broadly diversified, the next lesson is that of rebalancing the portfolio to bring various asset classes to their desired allocations. This is typically done once or twice a year. The recent market volatility would have made this particularly necessary for most investors.

For instance, the drawdown in stocks in the fourth quarter of 2018 likely reduced their share in the overall investment allocation below the desired level. The pullback would be a good opportunity for investors to rebalance their portfolio by adding to their equity holdings at a more attractive price, while trimming other assets which may have exceeded their desired weights due to outperformance.

Such a rebalancing strategy is a disciplined way of following the time-tested principle of “buying low and selling high.”

The recent volatility also highlights the importance of holding a reasonable cash balance. In early December, when we issued our 2019 Outlook report, we concluded it was time to dial back our positioning in risk assets and raise allocation to cash. The rationale for this decision was threefold. First, USD-denominated cash yields have increased from virtually zero during a large part of the current economic cycle to levels which are now attractive, both in absolute terms and relative to other asset classes, once adjusted for the volatility of various assets. Second, we believed markets will continue to be volatile in 2019 and holding a sizable allocation in cash would help reduce the volatility of the overall holdings. Third, we want to have cash as reserve firepower which can be deployed quickly when short-term, tactical opportunities present themselves.

December’s market tantrum has presented a few such oppor-