Investment strategies for volatile markets

GLOBAL INVESTOR 3.07 17
Investing
across cycles
Over the past 30 years, the dominant tenet of academic investment theory has been that investors
should focus on strategic asset allocation, i.e. diversifying portfolio risk by investing in different
asset classes such as bonds, equities, real estate and commodities, and then use modern portfolio
theory introduced by Harry Markowitz in to build the best possible combination of assets
with the adequate risk and return profile.
Cédric Spahr, Head of Alternative Investment Research and Portfolio Analytics, Reto Meneghetti, Alternative Investment Analyst
During this time, the leading finance academics were busy telling
investors that, since investors were rational and markets perfectly
efficient, trying to forecast their future movements was pointless.
The best thing investors could do was to determine an asset allocation
that corresponded to their financial goals, liquidity needs and
risk tolerance. The longer the investment horizon was, the safer
the returns on equities became. Jeremy Siegel authored a famous
book titled “Stocks for the Long Run” epitomizing this standpoint.
The problem remains that, in the worst case, during the period
to 2006, it sometimes took over 20 years to achieve higher
annualized returns on Swiss equities than on Swiss bonds, with the
figures for the USA being fairly similar.
The key issue is that profit opportunities in financial markets
come in waves that can last several decades and are then followed
by severe periods where bonds or equities can suffer large losses
over relatively short periods of time, as described in Giles Keating’s
lead article on stock market cycles. If you invest at low tide, you
might reap outsized benefits when the rising tide lifts all the boats,
but at high tide, the risk of capital loss can be substantial. Figure 1
shows the depth and length of cumulated losses in percent (drawdown)
suffered by investors who bought US equities at the top of
the market and how long it took them to recover their initial investment
in real terms. Equity bear markets can easily destroy
20%– of the initial investment value. The time needed to recoup
the initial investment has historically lasted between four and
ten years. Experience reveals that US equity investors have at
times had to stomach long periods of losses before reaping superior
long-term returns on equities. That being said, equities have
indeed offered superior returns over the long term, which makes
sense, given that shareholders bear the most financial risk and
should logically be entitled to higher returns than corporate bond
holders for instance. Investors who had the nerves to buy at the