“Will this wind be so mighty as to lay low the mountains of the eeaaarth?” intoned Rowan Atkinson’s character in a sketch from The Secret Policeman’s Ball, the 1979 Amnesty International fund-raiser. (The sketch itself was an extended homage to a 1961 Beyond the Fringe skit, and both featured the incomparable Peter Cook). When the predicted apocalypse fails to materialise, the group disbands, making plans to return at the same time the following day on the basis that “we must get a winner one day”. Investment strategists don’t spend their days at the top of a mountain with their jumpers pulled over their heads, but there does seem to be a lot of predicting of the end of the bull market, if not the world. In the end, of course, the bears will be right, at least about the bull market! 

As equity markets continue to break all sorts of records, the most frequent question I am asked is “when will it end?” And invariably I have to answer: “I don’t know”. There is no law that places a time limit on market cycles, nor on the economic cycles that tend to drive markets. I have commented previously that investors have been faced in recent times with innumerable banana skins on which they might have slipped, but they have been successfully dodged, allowing shares to continue their advance, backed by a recovering global economy and strong profits growth. This is the phenomenon known as “climbing the wall of worry”.

Of course, we are profoundly aware of the threats, and that has been reflected in the risk appetite expressed in the votes of our Global Investment Strategy Group. GISG has recommended a neutral risk position all this year, having been resolutely overweight risk for the previous few years. This position reflects valuations that are no better than fair value at a time when global monetary policy is being slowly tightened. There is also no end of geopolitical uncertainty to contend with – Trump, North Korea, the Middle East, and so on, none of which have managed to derail markets so far, but which remain “live”. 

The position of more cautious investors is made more challenging by the fact that it is very difficult to generate a return on safer assets. Cash yields next to nothing; 10-year UK government bonds still only offer an annual return of 1.31%, which is a lot less than the current rate of inflation; high quality corporate bonds also fail to keep up with inflation. This lack of “safe” return has been reflected in a recent reassessment of our Strategic Asset Allocation benchmarks, where we are placing greater emphasis on uncorrelated assets (ie those that tend not to perform exactly the same as equities or bonds, particularly in more stressful times).

It is worth reiterating at this point how risk is measured in these circumstances. In financial theory, risk is measured in terms of “volatility”. In layman’s terms that is how much the price of a financial asset moves up and down over a certain period of time, either in absolute terms or relative to another security or index. There are other elements of risk, such as permanent loss of capital or running out of retirement funds, for example, and we take these into account when advising clients, but volatility is the key indicator. And it’s very important that investors understand the relationship between volatility and investment returns.

Financial theory, notably Modern Portfolio Theory and the Capital Asset Pricing Model rely very heavily on the assertion that there is a linear relationship between risk and return – the more risk you take (i.e. the more volatile the asset), the greater return you will make in the long term. And there’s the rub. Investors have to be patient in accumulating those returns, and be prepared to endure unrealised capital losses on the journey. Our new SAAs incorporate a wealth of historical data (because, whether we like it or not, we can only look at history to establish the possible future outcomes). In the drawdown analysis (that’s a fall in value in layman’s terms), we have looked at the worst 3-year returns over the last thirty-five years for all the asset classes that we use as the building blocks for portfolios and then built those into five thousand simulations. The lowest risk mandate that we offer still has a theoretical double-digit maximum drawdown. The highest risk mandate could suffer a loss greater than 40%, although that must be put in the context of equity markets halving in 2008/09. 

These are most definitely NOT predictions. They are a guide to what the worst outcomes could be. Unfortunately, by publishing them, our industry is in danger of creating a state of mind where people begin to focus on the worst outcome, an attitude exacerbated by the experiences of the Tech Bust and the Great Financial Crisis. But these are worst case scenarios, and not currently in our range of expectations for the foreseeable future. However, they should serve to remind all of us that temporary negative portfolio returns are a fact of life for any balanced portfolio investor who intends to be invested for a reasonable period. That may or may not happen over the next year or so, but we should all be mentally prepared for the possibility. And when (not if) it eventually happens we might have to invoke the words of another 1960s and ‘70s comedy stalwart, Corporal Jones from Dad’s Army: “Don’t panic!”

Finally, the Qing dynasty was the last Imperial dynasty of China. This week, the national airline of Indonesia takes its name from what type of mythological creature?