Asset allocation needs a long horizon, conviction… and patience

By Tommy Garvey

We believe that the worth of an asset is ultimately determined by the value of its underlying fundamental cash flows. Unfortunately for the rational investor, Mr. Market obstinately refuses to behave in such a reasonable manner with prices, at least in the short-term, driven mainly by sentiment and speculation.

I am sure that no-one believes, for example, that the FTSE All-Share was really worth some 11% less on 10 February 2016 than it had been at year-end 2015 and that, equally mystifying, it had recovered all of those losses just two weeks later.Thankfully, over the longer term, equity prices are anchored to fair value through the mechanism of mean reversion.  Indeed, valuation is the closest thing to a law of gravity in finance and, for this reason, a dynamic approach to asset allocation can prove extremely effective at compounding wealth over time. Even more optimally, we believe a dynamic approach that uses valuation as an anchor gives an investor the best chance of navigating the short-term storms of excess volatility – capturing much of the upside of equities while seeking to avoid some of the extreme drawdowns. GMO has been successfully forecasting seven-year annualised real returns across a range of asset classes since 1994, as shown by the chart inset (click to enlarge).The challenge with a dynamic asset allocation approach is the need for patience and, in particular, the ability to resist the temptation to be fully invested at all times. The fear of missing out can entice investors to chase returns by buying expensive assets in the hope, or maybe belief, that they will become even more expensive. Although this can initially prove fruitful, history shows us that buying expensive assets is usually a pretty reliable way to destroy the value of your capital.Markets certainly look barren at the moment – of all the major equity regions, perhaps only ‘value’ stocks in the emerging markets look to be trading at close to fair value. Of course, genuine long-term investors can adopt a reasonably zen-like outlook in relation to the current underwhelming opportunity set. They know that we have been here before and that protecting capital now will stand them in good stead for the future.It is, therefore, essential not to underestimate the ‘option value’ of (the much, and often unfairly, maligned) cash. Although cash holdings can lead to a drag on short-term performance, we believe such a position is compensated, particularly when we are in an expensive world as we are currently, by the knowledge that there will be an opportunity in the future to convert this dry powder to risk assets at much more attractive prices.As well as patience, the other attribute that a long-term dynamic asset allocator needs is fortitude. The best opportunities inevitably arise as a result of extreme drawdowns and I can do no better in this regard than to refer you to our chief investment strategist Jeremy Grantham’s February 2009 letter “Reinvesting when Terrified”. Once you determine that it is time to increase exposure to risk assets, this can be implemented passively or actively depending on investor preference.One asset class that can only be implemented using an active approach is alternative investments. These can be extremely useful at times like the present, when on a valuation basis markets around the world look expensive and returns on cash are paltry. While alternatives don’t necessarily provide uncorrelated returns to other risk assets, they can offer ways of accessing similar risks with potentially different payoff profiles. In particular, the shorter duration of alternative assets should make them less susceptible to big drawdowns than stocks and bonds in the event of interest rate rises.There is no doubt that we are in a midst of a very challenging environment. However, taking a long- term disciplined approach focused on valuation gives investors the best chance of achieving their objectives over a full market cycle (indeed, we believe that dynamic asset allocation has a role to play for any long-term investor… whether that investor is a defined contribution or defined benefit pension plan, insurance company, charity, foundation, the list goes on…). Remain patient but cast a wide net and, when a compelling valuation opportunity presents itself, don’t be afraid to move purposefully and with conviction.Tommy Garvey is a member of the asset allocation team at GMO