3 things to know about investment cycles
To make the most of market opportunities, investors should stick to a long-term strategy while adjusting medium-term allocations.
During periods of low growth and volatility, relative exposure to different asset classes is more critical to investment returns than active security selection or choice of investment manager. In this article, we discuss the benefits and philosophy behind a dynamic asset allocation investment strategy.
What is dynamic asset allocation?
Dynamic asset allocation is used to actively adjust the split of investments across asset classes in response to expected market changes. In doing so, it provides diversification benefits in a portfolio but it also provides the ability to adjust allocations to help enhance performance.
This approach seeks to target real outcomes that generate long-term growth. It enables investors to find opportunities that capitalise on the ebbs and flows of the market cycle and offers the flexibility to shift investments in and out of asset classes to seek mispriced opportunities, free of the rigid constraints of static allocation portfolios.
Dynamic asset allocation helps investors make the most of two investment fundamentals:
- The power of compound interest: the concept of earning interest on interest or, more broadly, getting a return on past returns;
- Market cycles: encompass normal business cycles that result in three to five year cyclical swings in share markets.
How to navigate markets
Markets are cyclical and volatility can last as long as a decade before subsiding. Cycles can throw investors off a well thought out investment strategy that aims to take advantage of long-term returns and they can cause problems for investors when they are in or close to retirement. Rather than stick to their strategy of investing in higher return assets over the long term, investors can be spooked by volatility, as we have seen recently, and reallocate to ‘safer’ asset classes such as cash, thereby missing out on the long-term benefits of compound interest.
To reap maximum benefits from compound interest, investors need to ensure they have an adequate exposure to growth assets, that they contribute early and often to their investment portfolio and find a way to avoid being thrown off by investment cycles.
There are essentially three ways to manage cycles:
- Ignore them and adopt a ‘set and forget’ approach to asset allocation – this may be suitable for long-term investors but not for those who are older or have a short-term focus;
- Forecast them using economic forecasts – but this is difficult as the track record of economists’ point forecasts show;
- Use rhyming elements to manage them – while investment cycles don’t repeat precisely, they do rhyme. Each cycle has common elements, e.g. downswings in equities are usually preceded by overvaluation, tight monetary conditions and investor euphoria. These rhyming elements can be captured and combined to provide warnings of swings in the cycles and hence are a solid foundation for an active asset allocation process – this is the dynamic asset allocation approach.
In the absence of rigid growth and defensive constraints, a dynamic asset allocation approach can drive investment across a range of asset classes to exploit periodic mispricing between asset classes through the market cycle. These pricing disparities are common and it is within this inefficiency that real investment value lies, where the ebbs and flows of the market cycle present significant opportunities to generate performance returns. This flexibility, along with the risk management capabilities of this approach, may make it attractive to investors in the accumulation phase who are looking for growth and to those who are nearing retirement and have the ability to withstand the potential for short-term volatility.
Top tips for SMSF investors
- Focus on investments offering sustainable cash flow: Don’t’ be misled by promises of high returns and low risk. If it is hard to understand or looks too good to be true then it’s best to stay away.
- Invest for the long term, ignore the short term noise: This is the best way to benefit from compound interest. Investors can develop a long-term plan to suit an investor’s level of wealth, risk criterion, tolerance to volatility and age. It’s important not to get distracted by short-term volatility or trends.
- Diversify: Investors are best placed to spread their investments across a mix of asset classes that best suit their long-term investment strategy and goals.
Remember that asset allocation is paramount
It’s easy to worry about an individual share investment or whether the fund manager is picking the right shares but the reality is, the key drivers of returns are the assets (shares, bonds, cash, property, infrastructure, listed/unlisted, onshore/offshore, hedged/unhedged) that an investor is exposed to. Managers using active asset allocation should stick to an investor’s long-term strategy while adjusting medium-term allocations to make the most of market opportunities.
About the author
Nader Naeimi, Head of Dynamic Markets at AMP Capital. He is also the portfolio manager of the Dynamic Markets Fund.