We have been stating, on a number of our publications in recent months, that markets, particularly credit, can be considered expensive. Not only in terms of valuations but also when viewed in the greater scheme of things, particularly the rally the share class has had in recent years, as a result of accommodative central banks, in addition to the realisation and acknowledgement that investment and economic cycles are shorter than they have been in the past.

What should an investor do when the asset classes s/he is familiar with appear overpriced? The 10-year US Treasury bond currently yields about 2.9 per cent, significantly lower than the 5 per cent historical average and only slightly higher than the Federal Reserve’s 2 per cent inflation target.

Currently, investors are not compensated (insufficient risk premium) in terms of yield when going for lower-quality bonds when compared with on a like-for-like basis with those of traditionally safe Treasuries or Bunds.

Investors generally put their money to work with a long investment horizon and thus can benefit from market upswings and downswings. Scholars suggest that no one can consistently time the market, but entry points ultimately determine the return an investor makes on an investment. Proper market-timing involves making two decisions - when to get out and when to get back in. Timing both correctly is practically impossible; not even the most sophisticated algorithmic trading platform or experienced investor will get both correct in a consistent manner. Investors who try to outsmart the market more often than not get it wrong.

The two strategies that work in keeping their investment risks in check and attempt to reduce the dependency on market timing are broad diversification and rebalancing.

Broad diversification is commonly referred to as the most simplistic (yet effective) of ways of reducing market risk. By holding a wide variety of asset classes, investors have in the past historically enjoyed smoother gains during bull markets and dampened losses during bear markets. In a diversified portfolio, asset allocation decisions are key, and, more importantly, understanding asset correlation on returns will aid asset managers ascertain that optimal risky portfolio which maximises the return potential for a given unit of portfolio risk.

Diversification is necessary not only in terms of asset class but also geographical. Many investors fail to realise the long term benefits of broad international diversification. True, the world we live in is enjoying widespread expansion on a global scale, but economic conditions and asset performance are not perfectly correlated across different countries. Internationally diversified portfolios tend to see less volatile returns over time and better risk-adjusted performance.

Portfolio rebalancing is another technique asset managers use to manage risk. Investors would do well to examine their portfolio periodically to ensure the asset allocation has not deviated (through market movements) from desired levels. If, for example, the strong emerging market credit performance in 2017 resulted in a higher proportion that is riskier than desired, it would be appropriate for the excess exposure to be trimmed for a preferred allocation to that asset class which, as a natural consequence of market movements, has an allocation below the desired levels.

Global asset allocation funds are those funds managed by investment professionals whose task it is on a daily basis to continuously challenge their strategic asset allocation decisions whilst striving to achieve that optimal asset allocation through the use of diversification and rebalancing techniques.

Disclaimer:
This article was issued by Mark Vella, investment manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.

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