Early in my career, I had the good fortune to meet an industrialist whose avocation was investing. He managed his company’s pension plan and personal assets with impressive results. He attributed his success to three basic principles:
- Never own too much of any one investment
- Keep only those investments that offer the prospect of a reasonable return
- Accept the fact that the financial markets will behave in a way that confounds the majority of people
From our perspective, these are first principles of preserving and growing capital in an uncertain world. They speak to the importance of portfolio diversification, maintaining reasonable expectations and avoiding the latest fads. All of which deserve special attention at this juncture in the financial markets.
Speaking of the markets, we believe the dramatic rise in bond prices, since the depths of the financial crisis, has left this asset category fairly valued. Consequently, we expect that future returns from these investments will come primarily from their coupons, or the interest rates they pay. Furthermore, in an effort to safeguard portfolios against the eventual rise in interest rates and inflation, our recent bond investments have favored short-to-intermediate maturities, as well as inflation-protected securities.
Turning to the stock markets, we believe additional gains from current levels will require that corporate profitability catch-up to investors’ expectations. Judging by the earnings announcements of the past few weeks, there is good reason to believe this process is under way. The pace of this improvement is likely to be quicker in developing markets where economic conditions are strong and slower in developed markets where conditions are fragile.
In the meantime, we have used the rebound in stock prices as an opportunity to encourage clients to prune concentrated stock or stock option positions. This activity should not be construed as a market call, but rather our belief in the wisdom of the first two principles mentioned above. In fact, in those instances where a larger allocation to stocks is justified, it’s worth remembering that even after the markets’ recent gains, many developed stock markets are still trading at levels first reached a decade ago.
With regard to real-return assets, we continue to favor commodities and inflation-protected bonds over commercial real estate. Our short-term expectations for commodities are modest given a global economy that still has significant excess capacity. However, once this capacity is absorbed, the prices of most commodities should move higher.
Our allocation to commercial real estate has been achieved through a handful of investments made by several of our international managers. Considering the headwinds still facing this asset class, we deem this level of exposure sufficient for most of our clients. However, we are actively monitoring several real estate specific strategies in anticipation of future allocation decisions.
(c) Chess Financial