How liquid should you be?

This may be the wrong question to ask in the current environment. The more appropriate question to ask before investing is: am I being adequately rewarded to take risk at this point in time? Once this question has been answered the asset allocation decision becomes easier.

The ‘traditional portfolio approach’ to asset allocation is shown below.

By using this traditional or conventional approach to allocating capital, you are exposed to riding the rollercoaster of market ups and downs. But this approach does not focus enough on downside (capital loss) risk. For example, a typical balanced investor lost more than 30 per cent of their capital during the global financial crisis in 2008–2009, and it took more than five years for their portfolio to recover.

Most investors want all of the market upside, but with no market downside. They are comfortable taking risk, that is, up until they actually get it! This is what the traditional approach delivers.

The current environment is not suited to the traditional asset allocation approach. We have record low interest rates, low inflation, record debt levels, and asset valuations that look expensive relative to historical measures. Returns will be harder to achieve going forward and investor expectations need to be reset if they are going to follow the traditional asset allocation approach. Accordingly, investors need to rethink the way they invest. For example, a balanced portfolio with 40 per cent defensive assets and 60 per cent growth assets may provide the following returns:

This portfolio return assumes no fees, yields on defensive assets remain at two per cent and do not fall further, and risk assets (property and shares) return 10 per cent per year growth. These assumptions are a big ask. If risk assets return five per cent instead of 10 per cent per year over the next few years, the annual expected total return would reduce to only 3.8 per cent.

Most people cannot live off a return of 3.8 per cent per annum and will need to eat into their capital.  Record low interest rates make cash, term deposits, and government bonds very unattractive from a return perspective. Today, a $1 million one-year term deposit would provide interest income of approximately $24,000. Back in 2008 this same term deposit provided interest income of approximately $64,000 – this is a big reduction in purchasing power for investors holding cash.

But this is the environment we live in, and we need to be smarter when making investment decisions and constructing portfolios, taking into consideration the following challenges:

• record low interest rates are punishing savers and low risk investors
• Government Bond yields are at record lows
• share prices are expensive relative to historical measures
• property prices are at or near record highs in Australia
• excessive leverage and speculation has ‘brought forward’ future returns
• returns may disappoint in the coming years.

Most investors are not prepared for this potential outcome. Cash will not provide enough return to cover living expenses; bonds face a high risk of capital loss when interest rates eventually rise; and shares and property markets are susceptible to large falls should any adverse risks materialise.

Maintaining high cash liquidity comes at the expense of potential future returns. This is a balancing act, which requires investors to have clear risk and return objectives. With low-interest rates, investors need to have their money working as hard as possible, which means sacrificing some liquidity. And if taking risk in shares and property is not an option, then investors need to look at alternative asset strategies that have the potential to provide strong risk adjusted returns.

Alternative assets and absolute return strategies typically display low correlation to traditional assets such as bonds, shares, and property, which increases the diversification benefit within the portfolio. The risk and return profile for these assets sits in between cash/bonds and shares/property, with the aim being to provide positive returns in all market environments.

Many alternative and absolute return strategies have daily liquidity and are easily accessible. As with any type of investment, the skill is in picking the high quality alternative strategies and avoiding the ‘losers’.

So to the question of what is the appropriate asset allocation mix, the answer depends on your risk and return objectives.

• Defensive and risk averse investors will need to accept that their returns will be very low over the coming years and may even be negative after adjusting for inflation.
• Higher risk investors will need to accept a high degree of volatility and risk of capital loss to achieve their return objectives.
• Those investors who are prepared to invest into non-traditional alternatives assets and absolute return strategies should be well positioned to achieve the best returns for the amount of risk they are prepared to take.

An ‘objectives-based approach’ to investing aims to tailor an asset allocation and portfolio strategy to suit an investor’s return and risk objectives, and unlike the ‘traditional approach’ it has significantly less reliance on markets to rise in order to achieve these objectives.

By maintaining enough cash and short dated term deposits to cover living expenses for up to one year, the remaining portfolio can be invested in a combination of alternative assets and growth assets which provide both income and capital returns over the long term. The income produced from these assets can be used to ‘top-up’ the cash balance (to cover living expenses) and any shortfall can then be funded by ‘locking in gains’ from the growth assets.

This effectively turns growth into income, and focuses on total portfolio return as opposed to ‘chasing’ higher yielding income returns which may require more risk to be taken.

Ultimately, a combination of defensive cash, higher risk shares and property, and alternative absolute return assets will be required to achieve return objectives going forward.  The weightings to each will be dependent on each investor’s specific risk and return objectives.

Chris Malloy is Chief Investment Officer Morrows Private Wealth. He specialises in providing sophisticated investment and portfolio construction advice, and is responsible for overseeing portfolio construction and implementation processes for the Morrows Private Wealth Investment Committee.

This information is general in nature and has been prepared without taking into account your objectives, financial situation or needs. It has been prepared with due care but no guarantees are provided for the ongoing accuracy or relevance. Before making a decision based on this advice you should consider its appropriateness having regard to your own circumstances. You should seek professional advice from a financial planner, lawyer or tax agent in relation to any aspects that impact your financial and legal circumstances.

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