COVID-19 has driven home an important life lesson: Expect (and plan for) the unexpected. When it comes to your finances, this means balancing the need to have some emergency cash available, with the long-term need for inflation-beating returns. What is the best way to think about building your portfolio? Stephan Bernard discusses.
You’ve heard the saying countless times that you shouldn’t put all your eggs in one basket. This holds true for many things in life, including investing. Investment managers often speak about the importance of having a diversified portfolio to protect against uncertain outcomes – does this hold true in the wake of COVID-19?
With practically no investments other than dollar cash holding up in the early stages of this pandemic, investors are understandably asking how they should be investing in this new world. So, is there a new formula to follow?
Extreme situations make us feel like we have to do something different to respond to the current moment; but perhaps the best course of action is to stick to the basics and follow the logic that has proven to pay off over long time periods. This involves considering your objectives and investing in a range of assets – such as equities, bonds, cash and property across geographies – that can deliver returns under different circumstances, while keeping some cash aside for unforeseen expenses.
Think of your overall portfolio as having longer-term and shorter-term components. The investments that you choose should align with these timeframes and your investment objectives. Equities, for example, are typically higher risk and are generally more suited to those who are investing for five years or more. This is because they are highly volatile, i.e. their prices move up and down in an unpredictable manner, but we expect them to reward patient investors more handsomely over time. Cash, on the other hand, offers capital stability, but inflation might erode its value over time. There are many more such asset classes to choose from. Experienced investors typically build their portfolios using a selection of different asset classes, so they can get returns from different sources, as they tend to behave differently under different market conditions.
Practically achieving diversification
Balancing or diversifying a portfolio allows you to take advantage of different opportunities across the different asset classes. But creating this balance can be challenging. As an individual you might struggle to invest directly in a broad range of different asset types. Most of us simply can’t afford to buy multiple properties across the world, build stakes in different companies, lend money to governments and keep a few gold bars in the safe! An easier option is to invest with a reputable fund manager in a unit trust that is mandated to invest in a range of different assets classes, such as a balanced fund.
By pooling the contributions of a large number of individual investors, the fund manager can buy a variety of assets and create a diversified portfolio. When you invest in a unit trust, you effectively buy a slice of the portfolio and leave the task of selecting which assets to include to those with specialist expertise. Balanced funds are ideal for those of us with a long-term investment horizon. If well managed, they can produce pleasing returns, with a lower risk of loss than that of a more concentrated portfolio or a pure equity fund.
Weighing up the long-term opportunities from different assets
When we construct multi-asset class portfolios at Allan Gray (such as our Balanced Fund), we start with a blank sheet, which is 100% cash. We then add selected investments that we think will outperform cash over time, with a margin of safety. For example, if we think cash will return 7% for the next four years, we only invest in equities where our expected total return is at least, say, 5% above this rate. The same process applies when allocating funds offshore.
Every asset we pick is carefully weighed up and considered to help us achieve returns for our clients, while minimising the risk of loss. And just because a particular asset class or share is not performing well today, doesn’t mean it should be abandoned or excluded in the future. The Balanced Fund is also managed to adhere to the retirement fund regulations (which limit the exposure to certain asset classes).
We believe a well-diversified portfolio has many levers to rely on in pursuit of long-term returns, in multiple scenarios, as long as a fair price was paid for those assets to begin with. Assessing what assets are worth is what our investment analysts spend most of their time on – so you don’t have to.
Prepare for the unexpected
Choosing a multi-asset class unit trust is one way to ensure a good mix of assets. But it is also a good idea to ensure that you have the right mix of investments to take care of your different needs. A balanced fund, as discussed above, may be a suitable choice for a long-term objective such as saving for retirement, while a low-risk money market fund may be a good parking place for money you may need to access quickly – for example, as a piggy bank for emergencies.
The COVID-19 crisis has once again confirmed the importance of being crisis ready. If you only have long-term investments and need access to cash, you run the risk of having to withdraw at an inopportune time, locking in losses. History has shown that a recovery should follow a downturn, so if you can remain invested, you give yourself the opportunity to earn returns when they come. Having an emergency fund is one way of ensuring that you don’t have to draw on your long-term investment at the worst possible time – thereby protecting the ‘engine’ of your wealth.
Formulating an investment plan can be a daunting task. A good, independent financial adviser can help you to assess the best investment options for your needs and circumstances. You can read more about this in Part 5.
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