In the past five years, the markets have crashed several times, destroying value. This has eroded investors’ confidence in traditional diversification. Many are now very risk averse and are looking for what they consider to be havens for their money.
This risk-averse approach exacerbates, rather than reduces, the problems investors face in the long term.
Institutional and private investors looking to preserve pensions and savings are confronted with a widening “funding gap” between expected liabilities and future assets and revenues. While the financial crisis reset the asset level lower, it didn’t reset future liabilities. Very risk-averse investments and the resulting low yields in the asset mix of investors will not make significant progress in shrinking this gap.
Indeed, many of the havens are not as free of risk as assumed. The explosive growth of money supply has exposed the dollar to inflation risk, for example. We cannot be certain when inflation will increase but we need to know the consequences for our long-term wealth.
In addition, long-dated US government bonds, another perceived haven, have rallied as interest rates have fallen. With rates now at rock bottom and likely to rise, investors with portfolios containing long-term sovereign debt may be stuck with low interest rates and negative returns.
Risk aversion among investors is also manifested by a flight to shorter-term instruments, and large groups of investors have shortened their investment horizons.
But investors need to adapt to a new reality and adjust their timelines if they want to achieve their goals and take advantage of “time horizon arbitrage”.
Consider Warren Buffett, whose approach to managing risk involves investing in assets he plans to hold forever. Twenty years may be a reasonable investment timeline for many shares, as well as for property and other less liquid investments.
This may seem like a long time, and investors won’t experience many 20-year cycles during their lifetimes, but pension funds and governments need to plan ahead for several generations. Investors should be well aware of investment timelines and how they fit into their investment mix.
It is essential to diversify strategically as well as tactically. For all investors, combining diversification and a long-term investment vision is a better approach to ensure good future returns than over-allocating to havens.
Recent history, when many investment categories lost value simultaneously, may have served to undermine belief in the value of diversification, but in the long term diversification remains a highly important risk-management tool.
Investors need to look carefully at the “building blocks” of their asset allocation and use the benchmarks that reflect future success, rather than those based on past success. For example, capitalisation-weighted indices reflect market shifts of the past; equal-weighted and other indices may be better indicators of future growth and return.
Alternative investment opportunities, such as property, hedge funds and tactical asset allocation, have a weaker correlation to listed markets and can stabilise portfolios without creating adverse long-term effects on returns. Risk diversification is necessary within alternatives such as property, including different sources of risk and return, geographies and cash flow characteristics within the category.
In the long term, the greatest risk that investors run is to remain risk averse for too long, building portfolios based on short-term phenomena instead of on long-term realities and therefore falling well short of their goals.
Risk management’s role is not to avoid risks but to ensure that they are intended, well understood and compensated for to help achieve longer-term investment goals.
A long-term vision allows time horizon arbitrage. By basing actions on the long term, investors can achieve results by taking advantage of others’ reactions to short-term market events. This means riding out short-term volatility, which requires discipline and patience. As a risk manager, it’s important to be aware of volatility but to avoid being intimidated by it.
A long-term approach can capitalise on the short-term perspective of others, adding to and holding assets in a portfolio that will become valuable in the future.
Wylie Tollette is the senior vice-president and director of performance analysis and investment risk at Franklin Templeton Investments.