12/03/2015

A temptation for investors to resist when the outlook for investment returns is subdued is to abandon a carefully-constructed and appropriately-diversified portfolio in an effort to boost, or at least maintain, returns.

Vanguard’s economic and investment outlook 2015, Australian edition encourages investors to “evaluate carefully” the risk/return trade-off involved before shifting into higher-risk asset classes in their pursuit of returns.

In short, higher potential returns mean higher risks. It’s as straightforward as that.

As Vanguard’s report discusses, a shift to higher-risk assets may include “tilting a bond portfolio towards corporates [bonds] or a wholesale move from bonds into equities”.

The report’s authors are economic and investment specialists with Vanguard: global chief economist, Joseph Davis; Hong Kong-based senior economist for Asia-Pacific, Qian Wang; Australian-based economist, Alexis Gray; and US-based investment analyst, Harshdeep Ahluwalia.

They suggest that investors with investment objectives based either on set spending requirements or on performance targets may need to consciously assess whether they can tolerate the extra risk involved to still meet their goals.

The report concludes that a balanced approach would be for investors to consider adjusting their investment objectives given the outlook for lower returns. In other words, adopting a realistic approach to likely returns rather than taking greater risks.

Significantly, the global investment and economic outlook is discussed from the perspective of an investor with an Australian-denominated portfolio. (Read the report to learn more about its findings and the basis for its investment and economic outlook.)

Some of the key points made in Vanguard’s economic and investment outlook include:

  • Global economic growth is likely to remain “frustrating fragile for some time”
  • The investment environment is likely to be “more challenging and volatile in the years ahead”.
  • Vanguard outlook for global stocks and bonds while not bearish is the “most guarded since 2006 given compressed risk premiums and the low-rate environment”.
  • Modelling suggests that balanced portfolio returns over the next decade are likely to be below their long-term historical averages. “Even so, Vanguard still firmly believes that the principles of portfolio construction remain unchanged, given the expected risk – return trade-off between stocks and bonds.”
  • Investors should have realistic expectations for investment returns and understand the implications of the prevailing market for their portfolios.
  • A disciplined approach to investing should be maintained to achieve long-term investment success.

To treat the future with the deference it deserves, Vanguard believes that market forecasts are best viewed in a “probabilistic framework”. A primary objective of the report is to assist investors in making all-important strategic asset allocation decisions for their portfolios.

A critical take-away message is that investors should not readily surrender a carefully-constructed portfolio and move beyond their personal tolerance to risk in an attempt to lift performance in a lower-return environment.

No doubt, many astute investors will look at making some adjustments to their spending and their saving patterns, among other things, rather than taking on higher investment risks.

This may include if possible: taking a tighter control of spending, reducing investment management costs with lower-cost managed funds, considering postponing retirement (of course, not everyone can), and trying to save more to build-up investment capital.

It is also worth thinking again about the role of bonds in a diversified portfolio. In their role as a diversifier, bonds counterbalance the volatility of shares and other growth assets to reduce the variability of portfolio returns. The primary role of bonds is provide diversification to growth assets, income and capital stability.