Revisiting Core Investment Principles in Times of Uncertainty

Investors hoping to earn outsized returns commit vast amounts of money, time, and effort attempting to forecast economic growth, inflation, interest rates, corporate profits, and other variables that influence the performance of financial securities. But capital markets are also affected by events and crises that originate from outside the economic system. Escalating conflict between Russia and Ukraine is an important reminder that geopolitical risk is a part of investing in global markets. 

With the U.S. stock market officially entering correction territory—defined as a decline of more than 10 percent from a recent high—it seems to be a good time to revisit a few of the core principles underlying our investment strategy.

We Prepare for What We Cannot Predict

Our portfolio construction process revolves around the idea that it is impossible to predict with any degree of precision the catalyst of the next global downturn—it could be a war, a pandemic, an earthquake, a recession, an inflation shock, a policy mistake, a terrorist attack, anything. If we cannot predict the arrival or impact of certain types of events that affect capital markets, we must prepare for market volatility—whenever it might occur—through prudent portfolio construction.

This entails diversifying among and within a wide range of asset types whose returns are driven by different economic variables and outcomes, while establishing an asset allocation policy that enables us to weather the storms we are sure to encounter in our pursuit of investment returns.

Liability-Driven Investing Establishes a Strong Foundation

Few ideas in the investment world are as widely accepted as the notion that risk and return are positively related—that without accepting higher risk, the possibility of higher return is not available. But it is only when we invest over a sufficiently long period that we begin to see higher risk investments dominate lower-risk investments.

Hence, the key to assuming risk responsibly in pursuit of investment returns is to give each market segment an adequate amount of time to achieve its long-term performance target. This requires two key elements:

1. We know the timing and amounts of anticipated cash needs for each client, and
2. We determine a minimum holding period for each asset class, understanding that more volatile market segments should be given more time to perform according to expectations.

Putting these two concepts together, our Cash Needs Analysis computes a running total of annual withdrawal needs for each client portfolio, and our Investment Committee sets guidance for how capital is allocated among our Capital Preservation, High Income, and Global Equity portfolios based on optimal holding periods for each category.

As we detailed in a recent paper “How we are positioning portfolios, and why,” we entered 2022 aiming to protect the first eight years of anticipated cash needs in Capital Preservation and the next six years in High Income, giving our Global Equity holdings a 15+ year time horizon. In cases where our clients do not have any anticipated cash needs for the foreseeable future, our model calls for a minimum allocation of 10 percent to Capital Preservation and 20 percent to High Income—meaning our most aggressive portfolios currently have 30 percent allocated to fixed-income securities.

In assigning holding period targets, we want to give each bucket enough time to endure a pullback, recover temporary losses, and then provide a positive return commensurate with our expectations for the asset class. It is a proven process that has enabled us to successfully navigate through the most challenging market environments in the modern era. 

Knowledge of what doesn’t work is powerful

Much of the scientific enterprise can be construed as the use of formal procedures for determining when to throw out bad ideas. Investors can establish a strong foundation for superior long-term performance by emphasizing the avoidance of mistakes and errors—by throwing out bad ideas.

While the ongoing conflict in Ukraine is a serious matter, history shows that equity market sell-offs resulting from geopolitical flare-ups tend to be short-lived and markets are often higher six and twelve months after the onset of similarly troubling events. When faced with a specific crisis, we understand the urge to move to a cash position and wait for a resolution. The problem is that it’s not a reliable way to improve performance—history suggests it’s a bad idea. If timing markets on the basis of event-driven risks was a reliable way to increase returns, we would see a much higher success rate of active managers who beat benchmarks indexes given the frequency with which these types of events occur around the world.

Conclusion

During periods of heightened equity market volatility, financial experts often quip, “Don’t just do something, stand there!” To some, this advice may come across as dismissive of prevailing or potential risks. But, in our case, we are confident advising our clients to stay the course.

1. We are equipped with a mindset that we must prepare in advance for what we knowingly cannot predict.
2. Our liability-driven investment framework ensures that we have the appropriate time horizon for each investment.
3. We have a proven process for effectively managing client portfolios through periods of volatility—in part because we know what we shouldn’t do.

We will continue to monitor this situation and provide updates as it unfolds. In the meantime, please do not hesitate to contact your planning team with any questions.