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This months commentary from Saltus Fund Management


The last few years in markets have been dominated by wild swings in sentiment and returns, leaving investors generally wary and not a little weary as well. Equities, the asset class that most UK investors are familiar with, have oscillated sharply with the FTSE 100 producing returns anywhere from -23% to +21% for any given quarter over the last decade. An investor’s end experience has depended very crucially on exactly when they have invested - towards a market high or low? Subsequently, given the regular falls of the last few years, we have noticed the thrust of client questions on portfolios moving away from, ‘How much could I earn if things go well?’ towards, ‘How much could I lose if things go badly?’.

These questions are particularly pertinent today because the way in which a typical private client portfolio is constructed forces a manager to track a benchmark which has a very limited diversification between asset classes. Additionally, it lacks explicit provisions to limit the downside when markets tumble. Typical UK portfolios put the majority of assets into one geography (the UK), within securities that only ‘work’ when prices move in one direction (up) and which concentrate heavily on only two asset classes – large cap equities and government bonds. The end result is that when prices of UK stocks and bonds move downwards, so do portfolios, before moving up again when (or if) markets recover. The up and down pattern of returns that managing money in this manner is condemned to deliver is well known to advisors and is an increasing source of frustration. The latest asset allocations from the APCIMS private client indices confirm again that current strategies continue to have 85-90% of money allocated like this, which leaves one wondering how we can avoid a repeat of the roller coaster return rides of which we are so wearily familiar.

Given the predictability of the shape of returns in a typical portfolio, it would be tempting to fall into the market timing trap - constantly trying to adjust asset allocation to selling out at market peaks and then reinvesting at market troughs. Yet we know from volumes of research and hard earned experience that ‘market timing’ like this is fraught with difficulty. One just has to glance at the Wikipedia page on the subject to note the noisy debate and multiple issues associated with timing strategies. Or you could just as easily reflect on recent UK experiences. Our stock market has nose dived c.-20% twice on Greek political issues over the last two years – not the standard investment risk one would associate with the UK equities and not an easy one to time.

Most portfolios avoid the market timing issue by default, by keeping asset allocations relatively static whatever the prevailing investment climate. One of the most persuasive reasons for this is that future returns are unpredictable and that one should stay invested in order to not miss the best days. This is a crucial point. Studies, such as those of Javier Estrada at the IESE Business School in Barcelona*, have shown that historically, missing the best 100 days in the UK stock market over a generation (taken here as 42 years) would have left a portfolio c.97% behind where it would otherwise have been – a hefty figure but only half the story. If it had missed the 100 worst days over that same period of time, it would have been a massive 4370% better off (and this study only went up to 2006, missing out our recent crashes). The numbers are even more staggering if we broadened our stock investing to international markets. The same study showed on average that missing out the best 100 days of 15 international stock markets would again leave one c.97% ‘worse off’. Missing the 100 worst days in those markets would have left you a mind boggling 26,500% better off. If there are any lessons at all from history, the standout one from this research is that investors should focus very, very hard indeed on protecting the downside when investing in stocks and not worry too much about catching every rally.

After a few moments reflection, one could be forgiven for thinking that the research reflects common sense. There are many studies on peoples ‘loss aversion’ attitudes but perhaps the reality of an advisor dealing with real clients is the best guide – we know investors may wish for high returns but can cope without them. A large loss to someone’s invested capital is a different matter – it can have devastating consequences. In defence of the fund management industry, more sophisticated portfolio solutions are now available to consumers alongside the traditional. ‘Multi-strategy, multi-asset class’ is perhaps the most widely known attempt to offer something different to what we have been used to.

In recognising that the last few years have reminded us that we live in a complex, inter-connected investment world where ‘unknown unknowns’ have often led to nasty surprises, we would offer two guiding principles that may help an investor for the future. Whatever your risk profile may be, have your portfolio manager (a) manage your funds with an explicit attempt to avoid downside and (b) keep the portfolio as widely diversified as possible. We don’t know what the future holds but we do, at least, know a little on how to better prepare for it.

* Black Swans and Market Timing: How not to generate Alpha by Javier Estrada, Fall 2008

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