Local and international sharemarkets had a stunningly good year in 2012 and this was repeated in the first quarter of 2013. Interest rates are at historical lows and bonds are likely to significantly disappoint over the next few years.
There is a general move towards increasing equity exposure in portfolios and this should in theory increase returns but it does come with the added risk of increased portfolio volatility. Warren Buffett - generally considered the greatest investor of all time - provided some sage advice in his 2013 letter to investors:
- Invest in wonderful businesses: He stated that he’d rather buy “a wonderful business at a fair price, than a fair business at a wonderful price.”
- Look past today’s uncertainty: Buffet believes uncertainty has been constant since the markets were created but markets have always risen over time. Investors should take a long- term view and be willing to invest.
- Stay in the game: Buffet stated that since the long-term outcome of investing in stocks is so overwhelmingly favourable, “the risks of being out of the game are huge compared to the risks of being in it.”
Despite the positivity of equity markets, one still needs to take a measured approach.
Bonds are traditionally in a portfolio to reduce risk and when interest rates are high, (as in recent years), they also provide a very attractive income flow, especially for retirees. However, interest rates and bond yields are now very low and there is a greater chance that they will rise in coming years rather than fall further. A rise in bonds will cause capital losses when ‘marked to market’ and this will depress overall portfolio returns. Interest rates are also predicted to remain at current lows for at least the next 12 months, especially if international investors keep seeking out our bond investments which pay a much higher yield than what they may get in Europe, US, UK and Japan. Bonds may provide a degree of theoretical portfolio protection but our clients will not thank us if their portfolios are producing low returns.
What are the options?
- Low cash rates are possibly the ‘new normal’ for New Zealand and elsewhere for the next few years so investors need to appreciate that income returns from portfolios will fall unless they are prepared to take higher risks.
- Investors with smaller portfolios should accept that capital may need to be eroded to provide the required level of income. This is what happens elsewhere in the world where there have been low interest rates for many years.
- If clients want to continue receiving income from portfolios, then this will need to come more from the equity and commercial property parts of the portfolio than from the traditional fixed interest. This income comes from dividends payable so is potentially less stable than if it was coming from a high quality bond yield. We will need to increase the diversification of the portfolio so as to reduce the risk.
- Consider a higher risk profile: We are happy to discuss your current risk profile and the implications of changing to a higher risk. In theory, a higher risk will give you a higher return over the medium- to long-term but there is an increased chance of losses in the short-term. Any increase in risk profile should only be undertaken after careful consideration of your goals, time horizon, plus your ability to handle potential ups and downs in the market.
- Taking a more active investment approach using high quality multi-sector managers: This is where we would transfer a significant portion of your portfolio to a multi-sector manager and take a higher risk profile with those funds. These managers would have significant latitude to use all asset classes and use tactical asset allocation and a range of derivative products to obtain above index returns without incurring significant volatility.
- Selling down units rather than taking income from the portfolio: A valid alternative for those investors who require a steady income flow is to move away from reliance on income producing assets and move to a situation where the portfolio generates income and capital gain. This accumulates within the portfolio and a regular ‘draw down facility’ is put in place where managed fund units are cashed up on a regular basis to provide the required income. This enables the investor to have the best of both worlds and will probably work well for the next few years.
The financial markets are constantly changing so any investment strategy should be regularly reviewed to ensure it meets one’s financial goals, risk profile and time horizon. Now is certainly a good time to be reviewing how portfolios are constructed especially since interest rates will be low and equities are likely to perform well for the next few years.