Investment returns have been weak since the start of the year

Over the past couple of years, we have become acquainted with change and uncertainty in many aspects of our lives, over and above the usual ups-and-downs that are typically thrown at us. Financial markets, no strangers to change and uncertainty, have reflected this, with wild shifts in sentiment and precipitous movements in asset prices.

The table below shows the weak performance of shares and bonds since the start of 2022, driven by fears that authorities will struggle to control sky-rocketing inflation, the Russian invasion of Ukraine, and severe lockdowns across China.

Asset class Return (year-to-date)
International Shares -14.5%
Australasian Shares -14.1%
International Bonds -7.7%
New Zealand Bonds -4.9%

Source: Bloomberg®*. Returns shown are for the following benchmarks, from 1 January 2022 to 13 May
2022: International Shares: MSCI All-Country World Index (100% hedged to NZD), Australasian Shares:
S&P/NZX 50 Index (including imputation credits), International Bonds: Bloomberg Global Aggregate
Bond Index (100% hedged to NZD), New Zealand Bonds: Bloomberg NZBond Composite 0+ Years Index.

Many influences drive markets but trying to predict them is fraught with difficulties

Many influences drive markets at a particular point in time. These influences, which could be economic, geopolitical, environmental, or technical, shift like sands in the Sahara-, seemingly chaotic and dependent on the way that the wind is blowing. While making sense of these influences is an important part of investing, trying to predict and react to them is fraught with difficulties.

Instead, by formulating a clear and consistent long-term investment approach based on sound principles and risk management, we can look past short-term sentiment and avoid costly investment mistakes. Even though the pace of change – the shifting of the sands – has increased over recent years, what hasn’t changed is the fundamental approach we follow when making investment decisions.

There are three important factors that we consider when managing investment portfolios:

1) Diversification across different countries, sectors, asset classes, styles of investment, and securities

Diversification means holding a range of investments that tend to react differently to the various influences that drive markets at a particular point in time. The aim of diversification is to reduce risk by avoiding having too much money in investments which may be negatively impacted by the same market influences. Over the long-term the reduction in risk from diversification leads to higher investment returns, and a smoother investment experience.

However, there are certain times, typically quite short-lived and often during periods of turbulence, when the benefits of diversification appear weak, and there is nowhere for investors to hide. As the returns data above show, we are living through such a period at the moment. Despite this, remaining well-diversified imposes investment discipline by ensuring that we look past short-term volatility and remain focused on long-term return generation.

2) Ensuring that portfolios are maintained with an appropriate level of liquidity

Maintaining liquidity means investing in assets that are easy to convert to cash without having significant impact on their value. How easily assets can be converted to cash can vary significantly, with cash instruments, government bonds, and large-cap shares sitting at the most liquid end of the spectrum, and with real estate, private equity, and private debt at the other end.

While investing in less liquid assets can increase returns, it also increases the risk that investors are unable to get their money back in a timely manner or at all. This scenario is more likely during market turbulence, which is often the time that more liquidity is desired by investors.

3) Ensuring that portfolios are invested in higher quality assets

Like most things in life, financial assets come with varying levels of quality. Investing in higher quality assets, while avoiding those that are lower quality, has proved to be a sound strategy over time. It can be particularly effective during periods of market uncertainty.

Our bond portfolios only invest in investment-grade securities, which tend to be issued by companies and countries that have a stable outlook and are financially sound. We avoid sub-investment grade bonds, which tend to be issued by less stable companies and countries and have a higher risk of underperforming or defaulting (not paying back the debt owed on the bond).

Our share portfolios are primarily invested in larger, financially stable, and established companies, many of which are household names. Domestically this includes companies such as Fisher & Paykel Healthcare, Auckland International Airport, and Spark. Internationally, this includes Apple, Microsoft, Alphabet (Google’s parent), and Nestle. While the former three have underperformed during the recent downturn, as technology-related companies have been hit particularly hard, this needs to be viewed in context. These types of companies, which have produced stellar investment returns over the past decade, remain dominant in their sectors and highly profitable. Conversely, our portfolios avoid investing in unprofitable, less established companies in the technology sector. These types of companies have, in many cases, lost half of their market value, or more, over the past six months. Similarly, our portfolios do not invest in cryptocurrencies such as bitcoin and Ethereum, which exhibit significant volatility and are unregulated.

Sticking to the long-term plan

The influences driving markets at a particular point in time will continue to shift. Understanding these influences and adapting to them, when appropriate, is an important part of investing. That said, avoiding being influenced by the way that the wind is currently blowing, and sticking to the long-term plan of constructing well-diversified portfolios invested into liquid and high-quality assets, allows us to avoid costly investment mistakes.

Disclaimer:

* Bloomberg® is the service mark of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and has been licensed for use for certain purposes by BNZ Investment Services Limited (BNZISL). Bloomberg is not affiliated with BNZISL, and Bloomberg does not approve, endorse, review, or recommend, nor guarantee the timeliness, accurateness, or completeness of any data or information relating to, this article.

Any views expressed in this article are the personal views of the author and do not necessarily represent the views of BNZ, or its related entities. This article is solely for information purposes and is not intended to be financial advice. If you need help, please contact BNZ or your financial adviser.

Neither Bank of New Zealand nor any person involved in this article accepts any liability for any loss or damage whatsoever which may directly or indirectly result from any, information, representation or omission, whether negligent or otherwise, contained in this article.