Off and on

8th March 2012 by The Value Perspective

By Nick Kirrage.

Markets may now be polarising risk but basic investment tenets have not changed

Recent years have seen markets become obsessed with the idea of ‘risk-on’ and ‘risk-off’. When investors are risk-on or bearish they buy only perceived safe-haven assets, such as UK gilts or US treasuries, and when they turn risk-off or bullish, areas such as emerging markets start receiving more attention. A less polite name for such an investment strategy would be ‘fear and greed’ – but, then, can it really count as an investment strategy at all?

One of the fundamental tenets we believe as value investors is an investment approach that relies on market timing is inherently unsound – and yet risk-on/risk-off appears to be solely based on an ability to time the market. How is that different from gambling or speculation? The crucial point of an investment strategy is it should be repeatable and correctly guessing risk-on and risk-off does not appear very repeatable.

Of course, we may be being overgenerous here in suggesting markets are investing on the basis of anything like trying to time the market. It could well be that many people are simple reacting to the latest market indicator or piece of data and, since these are particularly volatile at present, this is accentuating and shortening the whole cycle of fear and greed.

Either way, it is creating difficulties – once you filter everything into risk-on and risk-off, the question then becomes how to play that. Taking equities as an example, all those perceived as ‘risky’ get placed in one column and all those perceived as ‘not risky’ in another.

In theory at least that is bad news because, as value investors, we want a diversified portfolio but risk-on, say, should lead to all risky equities becoming cheap and all less risky ones becoming expensive. Thus, to create a diversified portfolio, you would have to buy expensive companies to ensure you had a lower-risk component to your fund.

Fortunately – because the market is not that clever at working out what does and does not constitute a risk asset – this does not happen in practice. As such, there are ways to construct a diversified portfolio by buying assets that are cheap but are not actually that risky – pharmaceutical businesses being the classic example and, to a lesser extent because they are not quite so cheap, telecoms.

It is a good job the market does get it wrong because otherwise a complete polarisation of assets would make life very difficult indeed for value investors. To our minds, every portfolio needs both risk-on and risk-off – from your higher-risk assets you intend to make higher returns while your lower-risk assets will still make returns but as a part of a diversified portfolio.

If you have a 30-year investment horizon, you should have a more high-risk, high-return slant to your portfolio but, if it is five years, it should be more balanced. That is the nature of what we do and it has not changed just because the market has decided to turn life into a choice between risk-on and risk-off. Most people – in fact, almost everyone – will, in different amounts, need a bit of both.

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