February 2022
Some investors have asked us how to handle a falling market as many of their investments are losing a lot of money. Here is a summary list of our suggestions about what can be done to stop the unnecessary pain, and adapt portfolios to the new environment.
1. Recognise the Game has Changed
Investors have been conditioned in recent years to think that the FED (US central bank) has their back and will be there to bolster markets after any meaningful fall. But while this has been the case in the last few years, the rise of inflation and its attendant political challenges mean that this may no longer be the case, and it is certainly not currently. Inflation is now the key issue for the US population having hit high levels over 7% for 2 months in a row.
Inflation hurts the poor and the middle class who make up the majority of US voters. A significant majority of US voters don’t own much in the way of anything that benefits from price increases and haven’t benefitted meaningfully from historic asset price inflation. Hence a heavily politicised FED may be forced politically to prioritise fighting inflation ahead of boosting investment markets. They do this by reducing stimulus and raising interest rates. Unfortunately for investors, fighting inflation through reducing balance sheet expansion and raising interest rates only works by crushing demand first. This means economic demand and demand for equities need to get crushed as a necessary precondition to central banks effectively fighting inflation, if they attempt to do so. We might think of this as a policy mistake or a central bank choice, as other measures of fighting inflation (such as addressing supply and labour force issues) are better than anything central banks can do – but it is what it is and comes attendant potentially dramatic effects on mainstream markets.
Effectively, one needs to acknowledge the investment cycle, as we highlighted in our article in early January “Four Ways to Massively Improve Performance in 2022:
https://www.livewiremarkets.com/wires/four-ways-to-massively-improve-performance-in-2022
By recognising that the game has changed, investors can pivot their portfolio approach from what has worked in a bull market driven by disinflation and interest rates moving to 0, to what works better in a bear market caused by inflation, higher interest rates and reduced stimulus and demand (as massive stimulus packages are withdrawn and inflation bites into real wages growth).
The first thing that astute investors can and are doing is reduce the risk of losing money by selling or reducing assets that don’t work outside a bull market, and which are at risk of building larger losses. Importantly, it is not losing small amounts but losing large losses in bear markets that destroy investors’ long term geometric returns. By way of illustration of this, if you lose 33% you need a massive 50% gain to get back to even; lose 50% and you need 100% gain just to stay still. Furthermore, the journey of the investor is far from pleasant when you are in large losing territory much of the time. Far better not to lose the 33% or 50% in the first place as there is no good cure, but only prevention.
2. Buy What Works Better When Interest Rates are Moving Up Not Down
Simplistically, the assets which are less likely to work when inflation and interest rates are rising are financial assets such as most bonds and credit instruments, and interest rate sensitive assets such as stocks and property (this also depends on the relative rate of change of interest rate). You may recognise these as the assets that dominate the portfolios of most individuals, advisers and super funds, and probably your own portfolio. It makes sense to better diversify portfolios and create a more balanced portfolio by reducing these interest rate sensitive assets in favour of assets and strategies which are less interest rate sensitive – as well as those which are more resilient to geopolitical shocks and a weaker economy.
The assets which are better suited to rising inflation and interest rates include numerous alternatives. These alternatives include skill dependent rather than market dependent managers, market neutral and long short funds, volatility funds, insurance strategies, some CTAs, commodities such as oil and gold, and small subsets of the equity and property market such as shorter duration equities including resources, farmland and water. You probably don’t own much of these currently and hence aren’t protecting capital from losses as well as you could be in early 2022. The asset classes don’t have the marketing and media budgets of the mainstream approaches so you probably don’t know as much about them.
Importantly, these assets are less likely to lose large amounts over an inflationary period compared with the financial assets mentioned previously. Not losing much in tough periods is the name of the game for long term returns and compounding, as well as the more risk averse. By potentially making money or not losing as much, the assets and strategies mentioned are far better suited to protecting capital and enabling long term compounding of your wealth, and particularly so compared with financial assets which are being meaningfully devalued. Furthermore, they offer a way of crystallising and cashing in strong equity and property gains of the last few years permanently, while still offering growth potential in the future.
3. Take Advantage of Volatility
2022 will likely provide great buying opportunities from the large amount of volatility caused by inflation, changing central bank priorities and policies, and geopolitical risks and conflict. By not being fully invested in risk assets, investors have the opportunity of increasing exposure to these assets selectively at a later time when they may be cheaper and better value. One way of doing this is instead of being invested in long only funds predicated and reliant on markets always going up, is investing in aligned and more flexible funds that are investing dynamically and which can change their equity weightings for you. A heavy focus on valuation combined with market sentiment and technical analysis can help these funds pick when it is most prudent to buy risky assets such as most equities. Most importantly, these funds can better align portfolio design and portfolio managers with investor preferences for absolute rather than relative returns (“positive” rather than “driven by benchmark” returns).
4. Emphasize Better Value Niche Assets
As market over–enthusiasm and deleveraging occurs, the most commonly held assets are the ones most at risk. More niche assets which aren’t “over owned” with leverage and which have their own fundamental and differentiated driver of returns are less likely to do poorly in market falls. Precious metals are but one example of this which benefit from rising geopolitical tension. It makes more sense to own precious metals in the current environment than an overpriced long duration stock in a commonly held ETF that disappoints its aggressive growth assumptions as stimulus is withdrawn. Better still is a truly diversified and actively run portfolio of differentiated assets and strategies, with numerous diversifying return sources of which precious metals is just one, and which is not entirely dependent on any one strategy working.
In summary
There is much you can do not to be a deer in the headlights. Inflationary periods haven’t been seen for a long time and most investors need to learn how to adapt to this different environment while it lasts. The ostrich approach with a portfolio suited to an entirely different economic regime doesn’t work well when inflation is here. If you’re losing large money, it’s probably because your portfolio is poorly diversified and extrapolating history that is no longer with us, rather than being adapted to the times. It is far more prudent in current circumstances to adapt to the new investment environment, and buy a broader mix of assets that provide diversification and resilience. This includes a wide range of alternatives, managers that can take advantage of volatility, and better value niche assets. True diversification is the only free lunch in town right now and there is a delicious smorgasbord on offer to choose from. Venison and ostrich is missing from the menu.
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