Sticking to stocks and cutting bonds is what investors should be prepared for
As I write this, the Russian-Ukrainian conflict continues with its social and economic effects felt around the world, prompting investors to seek answers to what it means for them, especially with growing concerns about of inflation.
In this environment, investors’ first instinct is to withdraw money from the markets. Indeed, the customer activity we’ve seen year-to-date suggests that this narrative is winning to some extent. At times like these, it’s important not to lose sight of long-term investing principles drawn from decades of financial history.
One of the lessons is that if you’re really worried about inflation, the worst thing a long-term investor can do is sell stocks or private assets, because those are the main assets that can protect against inflation over the next decade. The question would then be how do we position ourselves?
The first step is to put a plan in place. For most affluent or emerging investors, the number one goal of an investment plan – after purchasing insurance policies to help provide financial cover in the event of death or health issues – is to prepare retirement. The challenges of this process are enormous. Generally, in life, the more you try to predict the future, the less confidence you have in those predictions.
If that’s not enough, inflation has to be taken into account, especially when it comes to such long horizons. While inflation has become more topical in the past 12 months – as annual consumer price gains hit their highest level in 40 years – the truth is that the impact of inflation is generally underestimated because you can’t see it on a day-to-day basis.
Against this backdrop, most financial asset classes, with the exception of cash and deposits, generated returns that retained their purchasing power. Global equities and private equity led the way, delivering an annualized return of 8.5% and 13.6%, respectively, in the 10 years to September 2020, well beating inflation. Bonds have also performed well since the early 1980s as central banks declared war on inflation and structural disinflationary pressures kept the downward trend in interest rates and bond yields intact.
Don’t just rely on the past
Of course, history can be misleading when we are more concerned about the future. We believe it is becoming increasingly difficult for bonds to generate strong returns going forward and outpace inflation. Lower starting yields mean bonds are likely to lose purchasing power for investors, even assuming inflation normalizes towards 2%.
Even higher yielding, or sub-investment grade, bonds are expected to return just over 2% per year for the next seven years. Therefore, we believe investors will need to have an alternative plan to keep up with, let alone fight, inflation.
The ultimate hedge
We have good news. First, we expect equities and private assets to continue to provide a good hedge against inflation in the years ahead. Second, in financial markets, the longer your time horizon, the more confidence you can have in the expected outcome – although you get a wide range of return forecasts over the next 12 months, longer-term return expectations are generally relatively similar.
Finally, long-term expected returns have generally proven to be reasonably accurate and can therefore be used as a decent yardstick when it comes to planning. The second and third factors are often not widely known, which is probably why most people find it so difficult to plan for the long term and commit to short-term investments instead.
What the above analysis also shows is that future returns are likely to be lower than those of the past decade. It is therefore even more important for investors to focus on building core allocations centered on global equities and private market assets.
Thus, short-term equity market weaknesses, such as the one we are experiencing, should be used as an opportunity to increase equity exposure, if appropriate. There are still many investors who hold excessive cash or are overly dependent on bond investments.
If this remains the case, I think it would contribute greatly to people losing their purchasing power to inflation and not achieving their financial goals. In the meantime, if an investor is inclined towards short-term opportunistic trading, I think they should be limited to a smaller portion of the overall portfolio.
Such a holistic approach to investing has been a proven way to secure your financial future against the vagaries of war and inflation and whatever life throws at you.