Stock markets may have produced positive returns last year, but many investors were too concerned with an array of challenges to profit from having a full allocation to equities. The wholesale ratings downgrades of AAA and AA corporates and countries, slowing growth in China, the impending threat of a fiscal cliff in the US, and even claims that the end of time was nigh — to name a few – all weighed on the minds of investors.
While the intensity of concern around these events may have subsided, 2013 is likely to be riddled with headlines that will lead many investors to search for safe havens. However, much like last year, investors should focus more on relative safety and deciding which risks they wish to shelter.
We are past the era when safe haven investments could often be counted on to produce a return that might at least keep pace with inflation. The downside to being safe was simply the opportunity cost of missing out on generating higher returns.
However, in an environment where safe assets are defined solely as being expected to provide capital preservation, the risk of wealth erosion due to inflation and other factors (such as taxes and fees), should be a primary concern for private clients and their wealth managers.
While gold is up considerably over the last several years, it has been highly volatile and failed to perform consistently in the midst of the type of market and political uncertainty for which investors hold the asset.
People seeking ‘safe’ status by investing directly in real estate in high-demand geographies are implicitly incurring concentration and illiquidity risks at the same time.
Investing in capital-protected notes linked to some underlying security or asset class shields the holder from the downside of the underlying investment, but creates an exposure to the risk of the financial counter-party for the note.
And investing in UK gilts, US treasuries, German bunds or simply staying in cash results in the wealth erosion problems highlighted above. In the case of cash, it may be even worse as yields have occasionally been, not just negligible, but actually negative.
Investors need to face these unpalatable truths and recalibrate their expectations of what they might achieve over time without going beyond their risk tolerance.
The greatest focus in portfolio management should be on how to better balance the trade-off of a series of risks (liquidity, concentration, counter party, and wealth erosion due to inflation, taxes, and spending) in this ultra-low yield environment.
As an example, for some clients owning a diversified, high-quality, liquid portfolio of short-duration corporate, inflation-linked, and government bonds may be a better overall solution than trying to find a single ‘safe’ holy grail. Incorporating investments which have some potential for capital growth over time – classically some type of equity exposure – also shifts the focus from solely capital preservation to this broader range of risks, which investors must take into account.
George King is head of portfolio strategy at RBC Wealth Management