Stock markets offer a constant source of learning for financial planners. Markets are constantly changing as businesses innovate and leaders respond to geopolitical shifts, while factors like demographics, climate change and others create instability and uncertainty.
It takes a great deal of fortitude to make long-term investment recommendations in such conditions, while maintaining the humility to accept that some of your recommendations might prove to be wrong.
An average strategy is better than a good forecast
Successfully investing over the long term is very difficult, if not impossible, if you rely on forecasts. Labelling something as a “forecast” makes it seem more scientific than a simple “prediction”. Consider how inaccurate weather forecasts are, yet many of us check the weather prediction on our phones every morning. Knowing that a weather forecast, especially in Cape Town, can be as unreliable as a coin flip, we still rely on the weather app.
If you live in Cape Town, a rational approach is to be prepared for wind, rain, sun and clouds every day. While you won’t know exactly what each day will bring, you can have the right gear to handle most weather conditions. I call this an “average strategy”: you won’t be perfectly prepared on any given day, but you’ll be fine on most days.
I share the same view on investment forecasts; they are not very reliable. I prefer to base investment recommendations for clients on factors such as age, risk capacity, volatility appetite and needed growth to meet their goals. I only consider market conditions like currency or equity valuations when deciding if clients’ lump sums should be phased in.
This approach allows my advice to be reasonably accurate most of the time without the pressure of being precisely correct in predictions. While straightforward, maintaining this strategy is difficult when clients want action amid rapid market changes. Therefore, I spend time setting expectations before investing. I emphasise my inability to predict currency or market fluctuations and clarify that I won’t change a long-term plan based on short-term market movements that could alter their strategy quickly.
What to do when market valuations are high
There are times when the stock market experiences prolonged periods of strong growth. During these times, people’s reactions vary. Some clients become concerned about a potential crash and ask whether they should sell their shares and move the proceeds into cash, gold or cryptocurrencies. I explain that markets can continue to grow for years, even when valuations seem stretched.
Holding large cash reserves during such periods can cause capital to fall behind inflation. To secure inflation-beating returns over a decade or more, a more strategic approach than simply switching between cash and equities is required.
Some options include buying an index that allocates an equal amount of money to each share within the index. This strategy results in being underinvested in shares that are growing strongly and overinvested in less popular shares. In most cases, it will also mean that the portfolio has a lower valuation than the index.
Alternatively, we can keep part of their money in the index and allocate some to value funds. This maintains the overall equity allocation but offers diversification away from fashionable or expensive sectors. Historically, it has been a wise decision to buy shares at low valuations and hold them for the long term, whereas purchasing shares at high valuations has been less rewarding.
Finally, we can reduce their allocation to shares in favour of bonds, property companies and some commodities. It is important to remember that clients should still maintain a balance across all asset classes; however, we can limit their exposure to shares.
My preferred way of managing assets when valuations are high is to establish a fixed asset allocation and ensure portfolios are rebalanced annually. For example, if a client has a target equity allocation of 75%, we review their overall asset allocation in the same month each year. If their allocation to shares exceeds 75%, I will reduce it; if the equity allocation is only 65%, I will increase their equity holdings.
This approach enforces a disciplined method of asset allocation that isn’t based on predictions or my judgement of valuations. It often results in buying equities when stock markets are falling. It’s not easy to convince clients to buy equities when most people are selling, but it often means they buy well-priced shares, which benefits long-term growth.
Can you ignore the weather app and other forecasts?
While I remain sceptical of all predictions, I still find myself checking the weather app on my phone; it is a deeply ingrained habit. It turns out I am also a sucker for incorrect weather predictions! To protect myself against this flaw, I keep a jacket in the boot of my car; if the forecast for a sunny day proves wrong, I will have some protection against wind, rain or cold.
Owning a diversified portfolio of local and international investments spread across different asset classes is my financial equivalent of a jacket in the boot. I find that most clients are comfortable with this approach, provided we spend enough time managing their expectations about market behaviour in both rising and falling markets.
