Managing your wealth in times of uncertainty

If the question being asked had been "How to manage your wealth in times of certainty?", the answer would have been short and sweet: "Invest 100 per cent of your assets in those investments offering the highest rates of return".

Sadly, the real world is not so black and white: the only certainty is uncertainty. Starting out from that premise, investors have no choice but to order their affairs by putting in place a strategy geared towards avoiding undesirable outcomes, with the definition of what ‘undesirable' might be hinging on the individual investor's specific demands and circumstances.

What am I looking for from my wealth and investments? How can I achieve my objectives or, in other words, what is the range of investment opportunities open to me capable of delivering the rates of return I am looking for to achieve my goals with an acceptable degree of risk? What restrictions and obstacles am I likely to run into as I seek to attain my investment goals?

Behind this string of questions lies a much deeper, more fundamental issue: what sort of arrangements should I choose and put in place to manage my investments? Am I capable of making all the decisions for myself? Do I have the time available and the requisite knowledge and expertise to put my strategy into practice? Should I draw on the services of the experts? If yes, which one(s)? The list of crucial preliminary questions outlined above is far from exhaustive, but let's now look at some possible answers.

Once it is acknowledged that the future, by very definition, is coloured by uncertainties, the most simplistic and straightforward approach would be to stitch together a standard asset allocation split between debt instruments (bonds and the like) and real or material assets (equities, real estate, etc.). Using some rudimentary arithmetic, such an asset allocation can be computed on the basis of the investment objectives defined in advance. In order to do this, investors would need estimates of projected long-term rates of return that the various asset classes accessible to them are likely to generate.

Expected returns

Decisions will be based on expected returns taking due account of current valuation levels of assets, with investors making a sound, but reasonable assumption in a world dogged by uncertainty that the inflation-adjusted return on capital is comparatively stable in a system in which resources are allocated according to a capitalist-style model, for example, 6.5 per cent plus inflation for US equities, including dividends, over the very long term.

Armed with such data, investors will apportion their wealth to the two categories of assets — nominal and real — allocating them across the board in line with risk premiums on offer, for example, a portion in sovereign bonds, a percentage in corporate bonds, a few high-yield bonds, some emerging-market debt and, among equities, a balanced-weighted proportion diversified over 10 to 20 stock markets.

When it comes to choosing specific investment vehicles, investors will favour active instruments for bonds, apart from sovereign debt, while, on the equity side, ETF shares or other passive funds would fit the bill neatly.

Lastly, investors will make sure that currency exposures are not exaggerated, the optimum ratio hinging on the comparative weightings between nominal and real assets, with hedging being employed, where necessary, to safeguard against exchange-rate risk.

Once this investment decision-making process has been completed, the investor will then have to make a key decision about monitoring strategy and reviewing it at intervals.

If the pre-decision analysis work is undertaken properly, the asset allocation and portfolio should be sturdy enough to cope with any external shocks and temporary swings in value that will inevitably occur. A strategic allocation will help the investor sleep more soundly regardless of those short-lived, short-term blips that commonly haunt financial markets.

As a result, the decision will be made to review results achieved regularly by measuring performance against a number of yardsticks, particularly by comparing returns with the chosen medium- and long-term goals.

A quarterly timetable is realisable, but not more frequent than that, with two ‘situational' assessments a year being quite adequate.

The purpose behind this is to avert the dangers of investors reacting rashly to the pressures of day-to-day news and events which can lead them to be carried away by emotional responses, disregarding reasoned argument, often at the expense of considerations about long-term returns.

This will thus help investors to avoid falling into the trap of being overconfident in their abilities to predict the future when faced with a barrage of adverse and disheartening news. The analysis and reviewing of results will also give investors an opportunity to look again at the targets that have been set and to re-appraise those parameters used to determine the objectives.

It is perfectly feasible to be fully aware of the inherent uncertainty of the future, but still be determined to hone the approach outlined above. Investors essentially have three ways in which they could do this.

The first would involve broadening the range of investment opportunities available by including illiquid asset classes, such as private equity or property.

These markets offer investors the prospect of attractive additional returns in exchange for accepting the restrictions that such investments impose. Choosing the strategy and someone to manage the strategy will be vital as the disparities in return between good and bad managers in such investment fields are much wider than in markets where trading is more liquid. Once the long-run asset allocation has been settled on, the same process as described earlier for the ‘liquid' portion of the portfolio can be followed although due heed will need to be taken of the allocation accorded to assets with low liquidity in the portfolio overall.

The second way to improve the investment approach involves fine-tuning the selection and diversification of risk premiums on offer by conducting a more comprehensive and forward-looking analysis of those key underlying trends at work in the global economy. The findings from such an analysis can be grouped together as ‘secular trend' or ‘mega-trends', that is, those underlying trends whose impact extends over a number of years, generally a decade, and which are often triggered by a turning-point connected to a paradigm shift, such as the launch of the single European currency in 1999.

The third way to improve the risk/return trade-off in the portfolio would be to factor budgeting for risk, in the positive meaning of the term, into active management of some liquid asset classes like equities. By doing this, investors need to bear in mind that the alpha (that is, return over and above that on the benchmark) only counts in dollars or in euros, but does not mean much in percentage terms and can even lead investors into mistakes as we are effectively dealing with a zero-sum game in public markets.

Lastly, the approaches advocated above would be of no use without a few basic principles that we would strive to implement for each initiative. This takes us right back to our opening gambit: the permanent state of uncertainty and the resultant need for investors to diversify their portfolios, without pushing this to extremes.

The shrewd investor

Great fortunes are often built on investing in a single company, but only where the investor has total control and is not just a minority shareholder. However, the outstandingly successful entrepreneur is in reality only the very tip of a large iceberg made up of all those many others who have failed.

Secondly, strange as it might seem, execution and implementation of decisions count as much as all the planning and vision. The most striking feature of John Paulson's short-selling of securitised sub-prime bonds is not how clairvoyant his sceptical view of the US housing market and its financing shortcomings was, but rather his ability to convert his shrewd and insightful assessment into an impressively lucrative return, running, in this case, into several billions of dollars. This is what distinguishes the brilliant money-making investors from the crowd: their ability to apply their correct analytical view like a powerful lever to a sizeable base of capital.

The writer is Chief Investment Officer at Pictet Wealth Management.