‘7-point plan for staying patient: You need more than one string to your bow when seeking returns’

You may be familiar with the phrase “having more than one string to your bow”. Back in the days when the ‘bow and arrow’ was a common piece of weaponry for any army, it was the bowstring that would often lose its effectiveness on the way to the battlefield. This was typically caused by a range of factors like simple wear and tear, or weather conditions. To cope with this problem, and due to the fact strings were the easiest part of a bow to replace, archers carried several to make sure one could always be counted on in the event that others were ‘misfiring’. Put another way …

 

... having only one string can have a pretty dramatic, and immediate impact on your future prospects!

 

The same can be said for investors facing a low return, high volatility environment. If major asset classes look expensive at the same time, correlations between them are rising, and yields are at record lows, investors can’t afford to ignore additional return sources beyond those provided by the market.

Just like the archers of days gone by, a modern diversified investment portfolio needs multiple strings. Think of it this way, the first string to your total return is made up of market returns (e.g. your strategic asset allocation). Second and third strings are comprised of any additional sources of excess return from things like security selection (e.g. external manager strategies) and active asset allocation decisions (if you engage in tactical ‘tilting’ around your strategic allocation).

Market returns (the first string) dominate the overall return from a typical diversified portfolio. But when major asset classes themselves are expensive to start with, the future prospects for achieving your required return from simple market exposures are significantly reduced. That is, your first string isn’t getting the job done, hence you need the backup of another string to increase your likelihood of hitting the target.

If all you have is the first string (such as a passively invested strategic allocation across a few main asset classes), then you are more than likely forced into looking to tactical market timing as your primary source of additional return (because in passive investing, it’s the only other string available to you). As we’ve discussed in previous posts, this is a very difficult assignment in a volatile environment. While active asset allocation has a key role to play in smoothing return profiles over time, it relies critically on clear signals as to which asset classes are preferred over others. But what if strong, clear signals are not there?

Enter your second string… security selection. This becomes even more important in times like the present. Just because an asset class looks expensive in aggregate, doesn’t mean value opportunities don’t exist inside asset classes. If you can’t capture value opportunities at the asset class level, you need to look deeper inside asset classes where pockets of value (often significant) still exist.

The old saying ‘volatility equals opportunity’ still holds true. Rapid price movements create differences of opinion on what an investment is really worth, as analysts struggle to incorporate new and rapidly changing information into their valuation models. This in turn creates room for mispricing, which in turn creates opportunities for adding value from security selection.

But who should DO the security selection I hear you ask? For most investors, this is best handled by professional stock-pickers. In the case of diversified multi-asset funds, this means accessing the bottom-up stock selection skills of external, experienced professional fund managers.

Remember, in a low return, high volatility environment every basis point counts. The patient investor ensures there are multiple strings to the bow of their portfolio design – strategic asset allocation, security selection and (where relevant to the investor’s objectives) active asset allocation. Each of these strings should be designed and implemented to take up some of the slack when other strings are not firing to maximum effect.

With the outlook for major asset classes reduced by expensive starting valuations, and significant noise blurring the clarity of asset allocation signals, the need for security selection as an additional string to an investor's bow is as important as ever.

This article forms part of the 7-point plan for staying patient series.

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