Aggressive monetary policy tightening that began in 2022 across major developed economies precipitated considerable fluctuations in asset class performance. Consequently, we are often asked about our projections for specific asset classes and whether deviation from established investment strategies to exploit emerging trends is recommended. Such shifts could entail reducing fixed income allocations due to diminishing returns driven by rising interest rates, augmenting cash positions, or transitioning to Guaranteed Investment Certificates (GICs) in a favourable yield environment. However, the challenge posed by these alternatives lies in altering your investment strategy which, even if done with perfect market timing, can significantly impact the terminal value of your portfolio.
A key benefit of working with a financial advisor is their ability to understand your longer-term wealth goals as well as their dedication to consistent strategy focused on maximizing your terminal portfolio value. Delegating day-to-day portfolio management decisions can help foster strategic discipline which can often be challenging for individual investors to maintain, particularly during times of market uncertainty or emerging trends. Thus, it can be helpful to have someone assist with navigating uncertainty while capitalizing on opportunities to increase risk adjusted returns. In this report we detail how deviating from a pre-established investment strategy can adversely impact the terminal value of a portfolio.
IN DEFENSE OF A DIVERSIFIED PORTFOLIO: THE BENEFITS OF NON-CORRELATED ASSET CLASSES
Before central banks began raising interest rates in 2022 to quell inflation, fixed income and equity investments mostly displayed a negative correlation (Figure 1). This meant that when equities were losing value, fixed income investments were gaining value, and vice versa. This benefitted investors by providing important diversification benefits to a portfolio where one asset class would help stabilize the overall portfolio if the other was down.
The benefits of holding non-correlated assets in a portfolio include, but are not limited to:
• Risk reduction
• Enhanced returns
• Income generation
• Capital preservation
• Flexibility and rebalancing
• Reduced volatility
The recent pace of interest rate hikes in response to a surge in inflation has caused a divergence from this historical trend and led to a situation where the two asset classes were more positively correlated. Why has this occurred though?
INFLATION EXPECTATIONS
If there are concerns about inflation, both fixed income and equity investments can decline simultaneously. Inflation erodes the purchasing power of bond coupon payments, making them less attractive. Persistently high inflation can also raise input costs for businesses, weighing on profit margins and potentially leading to a decline in stock prices.
INTEREST RATE EXPECTATIONS
When investors expect interest rates to rise, it can negatively impact both fixed income and equity assets. Higher interest rates can increase borrowing costs for companies, which can weigh on equity valuations. At the same time, bond prices typically fall when interest rates rise.
As both asset classes are negatively affected by these factors, it can cause them to move in tandem, reducing the diversification benefits traditionally expected from holding a mix of equities and fixed income. However, as these forces diverge – inflation is slowing while monetary policy seems to have peaked – we may see a re- emergence of the traditional benefits offered by non- correlated asset classes.
TIME IN THE MARKET VERSUS TIMING THE MARKET
We are often asked what direction a particular asset class is heading. The response to this is, inevitably, that a disciplined investment process is much more important than correctly predicting a price level or even direction. To highlight this, the following is a short case study that looks at various examples of market timing in an effort to support a process-driven approach to investing. For this analysis, consider four investor types (Figure 2) to broadly represent the extreme ends of market timing.
First, there is perfect timing, where an investor is able to perfectly time the bottom of major troughs and deploy cash. Second, there is the worst timing, where cash is consistently deployed at market peaks. Then, there is consistent investing, where an investor ignores the direction of the market and consistently deploys cash every month. Finally, there is not investing and waiting for the perfect time but never finding it. All four investors have $500 each month that they can either put into savings and earn the U.S. 3-month T-bill rate – a rate commensurate with a money market fund or GIC – or invest in the stock market.
In this scenario the perfect and worst market timers save until either a major peak or trough is reached, at which point in time they would deploy all their accumulated cash (Figure 3). This process repeats itself throughout time and, thus, these two investors would have a mix of cash and equities. The consistent investor is fully invested in stocks at all times while the investor who waits on the sidelines earns the rate of interest on a 3-month T-bill.
The investment time frame is 40 years, a reasonable horizon for long-term investing. The S&P 500 composite.
While there are many peaks and troughs over this time frame, the six major ones indicated in figure 3 represent the timing opportunities. With the parameters set out, what were the results of this exercise? Can perfect market timing negate time out of the market?
The best outcome of the scenarios that were looked at is consistent investing (Figure 4). Consistent monthly contributions while remaining invested provided even better returns than perfect market timing, while perfect market timing easily surpassed the worst timing. All three handily beat not investing where the accumulated savings earned only the 3-month T-bill rate.
All four investors had the intention of making money, they just had different opinions on how to do it. This also means that there were actually three investors trying to time the market; not investing was in essence trying to time the market, but the time simply never came. The negative consequence for this lack of participation is a terminal wealth value that is less than 1/5th of the worst timing that invested at every major market peak. Put another way, even with the worst timing, an investor will still do better by simply remaining invested. It may seem like a poor time to deploy cash when major indices appear to be near a top, leading investors to wait on the sidelines until they believe it is opportunistic to reinvest in the market. However, this type of waiting can be very costly over the long run. Looking at the best market timing, it shows that an investor would accumulate ~57% more wealth than the worst market timer, a substantial amount for the effort that would be required. However, even with perfect market timing, the portfolio’s terminal value was ~3% lower than one that opted for the consistent investment strategy.
The main takeaway from this exercise is that trying to time the market, even if done perfectly, can be costly. An investor might win the battle (potential for better near- term returns) but lose the war (lower terminal portfolio value over the long run). Therefore, following an investment plan accordingly without deviating significantly is the optimal strategy. If the long-term goal requires 60% in equities and 40% in fixed income, then the optimal strategy is to strictly hold that percentage consistently and not try to significantly modify that allocation at supposed tops and bottoms.
THE POWER OF CONSISTENCY OVER TIME
The global economic environment since 2022, characterized by significant interest rate hikes and market volatility, poses new challenges for investors. The historic correlation patterns between fixed income and equity investments have shifted, causing both to be negatively affected by rising interest rates and inflation concerns. This change has led many to question whether adjusting established investment strategies in response to emerging market trends is wise.
A detailed case study examining various investment approaches over a 40-year period underscores the advantages of consistent investing. The findings revealed that even with perfect market timing, consistent investing outperformed all other strategies, yielding returns superior to even perfect market timing. On the other hand, adopting a passive, wait-and-see approach, akin to attempting to time the market without ever taking action, led to significantly reduced wealth accumulation.
While the allure of capitalizing on short-term market trends can be strong, the evidence suggests that a disciplined, consistent investment approach, rooted in a pre-defined, well-thought-out plan, is the most effective means to achieve long-term wealth objectives. Deviating from such a strategy, even with the benefit of being able to perfectly time the market, could be detrimental to the terminal value of an investment portfolio. Therefore, maintaining a strategic discipline and resisting the temptation to make impulsive decisions is paramount for optimal long-term wealth accumulation.
UNLOCKING WEALTH: THE VALUE OF SOUND ADVICE
source https://rosenbergdri.ca/unlocking-wealth-the-value-of-sound-advice/
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