2021 was another surprising year for analysts. Despite the ongoing health crisis, the surge in inflation and high valuations in absolute terms, the global equity market ended the year with an increase of over 27% in euros.
As the new year dawns, many investors are wondering how to position their investment portfolios. Damien Petit, Private Banking Sales at Banque de Luxembourg, answers questions from the Luxembourg economic and financial magazine Paperjam.
Wouldn't this be a good time to make fundamental adjustments in asset allocation after the rebound of the last few months?
Deviating significantly from their investment strategy in an attempt to anticipate market movements can prove to be value-destroying for investors. Imagine an investor had had access at the end of 2019 to inside information that an unprecedented pandemic was imminent. They would almost certainly have sold all their equity positions. It is just as highly unlikely that they would then have repositioned themselves in this asset class before the impressive and sharp rebound in the subsequent quarters (up over 80% in euros since the low on 23 March 2020). The opportunity cost of changing their allocation in this way would undoubtedly have worked out against them.
Managing a portfolio requires a long-term approach.
Today, in a more inflationary environment, we continue to favour real assets, particularly equities. Real interest rates, which are entrenched in negative territory, do not allow investors to preserve their purchasing power over the long term. Too much exposure to cash and bonds is not advisable in the current context.
After this surge in the markets, hasn’t the equity risk become excessive?
Equity investors are inevitably exposed to volatility. Volatility could increase significantly in the coming months if the health crisis worsens or if monetary tightening in the US is faster than expected. Investors must be able to withstand such increased volatility. However, unlike the structurally negative and permanent effect of inflation on wealth, the risk of volatility diminishes over time. This is very reassuring for investors with a sufficiently long investment horizon. For example, since the turn of the century, over a one-year period, the global euro-denominated equity market has experienced declines of more than 40% and increases of over 60%. These performances correspond respectively to the periods from the end of November 2007 to the end of November 2008 and the beginning of March 2009 to the beginning of March 2010. But viewed over a 10-year period, the annualised return on this market varied between -1.5% and +15%, a much narrower range.
Do equities still have upside potential?
In the short term, it is important to remember that the link between the level of market valuation and future performance is very limited: an expensive market can continue to perform very well and vice versa.
However, there is a close relationship between market valuation and long-term (5-10 years) performance. Current levels argue for the continuation of positive average annual returns over the next ten years, but below those seen over the last decade. It is therefore important to retain exposure to equities. Active management should help improve the portfolio's risk/return profile. The high concentration within the major indices, particularly in the US, remains a potential source of danger for investors who blindly follow these indices. Investors should be bold enough to deviate from the indices, in particular from unprofitable and overvalued companies and focus on quality companies at reasonable prices.
To conclude, at the start of this new year, investors must factor two risks into the management of their portfolio, namely volatility and the risk of loss of purchasing power. Bearing this in mind, if the investor's risk profile allows, quality equities will once again be the investment of choice.
To find out more about how to invest in this inflationary environment, contact a private banker.
