So far, it has not been a good year for small investors’ financial and, probably also, physical health. Even for conservative investors, the question is not if they have lost money but how much they have lost.
In June and July, the international financial markets seemed to end the nightmare of many investors as stock prices began to rise significantly. But uncertainty is again prevailing.
Many investors are asking whether their advisers’ strategies of adopting a balanced portfolio based on the theory that the bond and equity markets are asynchronous, i.e. stocks and bond prices move in opposite directions, is indeed the best strategy.
The diversification benefit of holding a mix of bonds and equities has undoubtedly not been evident in recent years.
Money managers and investment advisers’ responses to retail investors’ concerns are that there are unprecedented exogenous events and macroeconomic factors to explain why the balanced portfolio theory is not protecting small investors at this time.
COVID-19 and the impact it had on the supply chain, the war in Ukraine, rising geopolitical tensions in Eastern Europe and Asia, soaring inflation, a European energy crisis, a global economic slowdown, and a fast-weakening euro are a combination of realities that no analyst forecast up to last year.
Even as the effects of COVID seemed to be receding at the end of last year, central bankers were reassuring everyone that rising inflation was a ‘transitory’ phenomenon that would not last for long into 2022.
An air of optimism gained force in 2021 when the EU agreed to borrow billions of euros to promote the regeneration of member states’ economies after COVID, focusing more on digitalisation and investment in the green economy.
The investment world was once again afflicted with irrational exuberance that helped to build a bubble of most assets, including meme stocks – shares of a company that has gone viral online, drawing the attention of retail investors. The big bubble that seemed to keep inflating up to last year now appears to be bursting.
Global ultra-conservative investors kept their money in bank accounts that hardly paid them any interest. Asset managers pushed hard to convince these investors to mobilise their savings and start dipping into the debt and equity markets to get better returns.
COVID-19 and the impact it had on the supply chain, the war in Ukraine, rising geopolitical tensions in Eastern Europe and Asia, soaring inflation, a European energy crisis, a global economic slowdown, and a fast-weakening euro are a combination of realities that no analyst forecast up to last year
Some investors did so, fearing inflation would eat out a significant slice of their capital. Still, Morgan Stanley and JP Morgan report that their clients have been selling out their long-term holdings, suggesting they have little faith the midsummer rally can last.
Those who invest exclusively in the local financial markets need to understand the structural weaknesses of these small markets. They need to ask themselves, for instance, whether local bond issues are paying the credit risk premium linked to the issuer’s operations. Most of these issuers are unrated. The legal jargon in the prospectus often takes more care of protecting the issuers from misrepresentation liability than ensuring that unsophisticated retail investors avoid financial ruin.
Local investors need to ask themselves whether the local equity market has enough depth and width to give small retail investors a viable option for diversification and protection from unreasonable swings in equity prices due to small transactions on any particular day.
Publicly available financial analysis of local companies remains scarce and not always unbiased. This only adds to the challenge of investors deciding where to put their money.
Euphoria and despair are the worst risks all investors should avoid, especially those with low risk tolerance.
Peter Atwater is an academic writer and author of the forthcoming book The Confidence Map. In an article in the Financial Times, Atwater proposes changes to the balanced portfolio theory that is the rock base of most investment strategies.
He argues: “A balanced portfolio needs investments that reflect a wide mix of feelings from euphoria to despair – where individual pieces of the pie are warming and cooling simultaneously. If investor confidence is mirrored in valuations, the result should be a portfolio balanced not by asset type, but by its composition of cheap and expensive assets.”
Retail investors will do well to detach themselves from dream scenarios seen through the rose-tinted glasses of analysts and asset managers. The sudden reversal of optimism in the future direction of financial markets in August and September shows how easy it is for midsummer dreams to become nightmares.
No one can predict how markets will move in the coming months and years. Atwater rightly argues that “investor demand, asset prices and investor confidence move as one”.