Over the past five years, the financial markets have crashed several times, destroying value. This has eroded investors’ confidence in traditional diversification. Many investors are now very risk-averse and looking for what they consider to be safe havens for their money. This approach is exacerbating, rather than reducing, the problems investors face in the long term.
Both institutional and private investors looking to preserve pensions and savings are confronted with a widening “funding gap” between expected liabilities, and future assets and revenues. While the financial crisis did reset the asset level lower, it did not reset the future liabilities. Very risk-averse investments and the resulting low yields in investors’ asset mix will not make significant progress in reducing this gap.
Indeed, many of the “safe havens” are not as risk-free as assumed. The explosive growth of the money supply has exposed the US dollar to inflation risk, for example. We cannot be certain when inflation will increase, but we need to know the consequences for our long-term wealth. In addition, long-dated US government bonds, another perceived “safe haven”, have rallied as interest rates have fallen. With rates now rock bottom and likely to rise, investors with portfolios containing long-term sovereign debt may be stuck with low interest rates and negative returns.
Risk aversion among investors is also manifested by a flight to shorter-term instruments as perceived protection from volatility. As the value of various assets has suffered over the past few years because of the euro crisis, large groups of investors have shortened their investment horizons.
However, investors need to adapt to a new reality and adjust their timelines if they want to achieve their goals and take advantage of “time horizon arbitrage”. Consider Warren Buffett, for example, whose approach to managing risk involves investing in assets he plans to hold forever. Twenty years might be a reasonable investment timeline for many equity shares, as well as for property and other less liquid investments. This may seem like a long time, and investors won’t experience many 20-year cycles during their lifetimes, but pension funds and governments need to plan ahead for several generations. Investors should be well aware of investment timelines and how they fit into their investment mix.
It is also essential to diversify strategically as well as tactically. For all investors, combining diversification and a long-term investment vision is a better approach to ensure good future returns than over-allocating to safe havens.
Recent history, when many investment categories lost value simultaneously, may have served to undermine belief in the value of diversification, but in the long term it remains a highly important risk management tool. Investors need to look carefully at the “building blocks” of their asset allocation and use the right benchmarks that reflect future success, rather than those based on past success. For example, capitalisation-weighted indexes reflect market shifts of the past; equal weighted indices and alternative types of indexes may be better indicators of future growth and return.
Alternative investment opportunities, such as property, hedge funds and tactical asset allocation, have a weaker correlation to listed markets, and can stabilise portfolios without creating adverse long-term effect on returns. Risk diversification is also necessary within alternatives such as real estate, including different types of risk and return sources, properties, geographies and cash flow characteristics within the category.
In the long term, the greatest risk investors run is remaining risk-averse for too long, building portfolios based on short-term phenomena, not long-term realities, and therefore falling well short of their goals.
Risk management’s role is not to avoid risks but to ensure that they are intended, well understood and compensated in order to help achieve longer-term investment goals. A long-term vision allows “time horizon arbitrage”; by basing actions on the long term, investors can achieve results by taking advantage of others’ reactions to short-term market events. This of course means riding out short-term volatility, which requires discipline and patience. As a risk manager, it’s important to be aware of volatility, but to avoid being intimidated by it. A long-term approach can capitalise on the short-term perspective of others, adding to and holding assets in your portfolio that will become valuable in the future.
Wylie Tollette is senior vice president and director of performance analysis and investment risk at Franklin Templeton Investments