Asset Allocation: Pandemic Protection?

​This week we revisit an old favourite of ours, asset allocation. Specifically, we begin this article by saying that ýou live and you learn, and the past couple of months have certainly taught us a lot.

As previously mentioned, one of the most interesting occurrences (for us at least) in recent weeks has been the tendency for asset classes to appear correlated. The classic case right now being bonds and equities with sales of even safe-haven assets such as gold. Trends that we would’ve thought impossible, such as a negative price on oil, have now become a reality, so where to next? Could we potentially live in a world where even mortgage rates go negative (something that has been done in Europe)? And, if so, how do we protect ourselves in this environment? 

Starting Point

Before we dive into the notion of protecting ourselves, it is perhaps important to take a step back and understand how it is we are protecting ourselves. Here I would like to bring in the thought processes of the esteemed “Duchess of Poker”, Annie Duke (for those of you unaware of who she is, look up a book called Thinking in Bets). Her fundamental argument is that decisions are always made in an uncertain environment, with a trade off between time vs certainty. Furthermore, there are diminishing returns to information seeing as the more information you might have may lead to greater confidence but not necessarily a better decision. The example she uses is a business owner that wishes to know whether having cookies might or might not increase customer satisfaction, one can sit and think through it as well as process data on market environment and consumer behavior but the best thing is often just to put a jar of cookies out and see the result. The point being that procrastinating when it comes to markets isn’t necessarily the best idea. 

Don’t get us wrong, procrastination is not the same as waiting. You would certainly have been better off in cash during the recent sell-off, the difference is to be proactive and understand what it is you’re waiting for. Having a view on metrics around valuations or a particular trend is markedly different from not knowing what to watch for in the first place. One is intentional and the other is not. 

The second point we would like to make, and this was somewhat of an epiphany for us, is that uncertainty is a constant and has always been so. This seems somewhat obvious when you think about it but it often isn’t considered so. Too often we are prone to think probabilistically, take that as certainty and try to make the world fit our models. Something like a global pandemic, a statistical anomaly in any given year, is required for us to realise that this is not the case. The fact of the matter is, uncertainty is always present. If it weren’t a pandemic then it might be a meteorite or, to a lesser extent, a war or anything else. When we think about making decisions we have to start with the premise that we will never have the full spectrum of information available to us but inertia in making decisions could be more harmful than good.  

Take the example of buying a house and taking out fire insurance. You might have bought a house in a uniquely temperate climate and you don’t expect to have a bushfire anytime, but it might be more reasonable to take out insurance when the premiums are rather cheap than after the event when the premiums might be more expensive. You don’t expect or want the house to burn down but better to be safe than sorry. Same thing can be said about markets, having an allocation to long-volatility or options to hedge the downside might’ve been the most reasonable thing to do when it was cheap (i.e. not now). You don’t expect your baseline case to be a market sell-off but you work on the premise that you are constantly uncertain. We certainly wish we had done so and, going forward, it is one lesson we intend to keep with us. 

So there you have it, our first points are:

1 - Decision is better than no decision 

• This decision might be to hold cash but understand that it is an asset class and ask yourself the question of why it makes sense to do so and it cannot be because your neighbour is doing so, unless of course it happens to be Warren Buffett (i.e. you have actively made the informed decision to not take action);

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2 - Allocate within the notion of uncertainty 

• That means having the ability to be less aggressive with returns on the upside with some certainty that it is in return for protection, an example of which could be put options

Protecting Ourselves

What is it that we are protecting? Put simply it is this, it is the ability to sustain ourselves and our capital over a long-term horizon, over different market conditions. The primary goal is to always minimize the amount of market risk (the risk of losing wealth permanently) taken. In order to do this we have to first understand how markets and people react to uncertainty. We constantly tell ourselves that past experiences are an indicator of what is likely to happen in the future, such as buying the dip. But let us pose a question to you: how many currently active investors have experience investing through the Great Depression or even through the 70s? We certainly don’t. And even if we did, on top of that, the world has changed a lot in a short space of time. Buffett has famously said that investing was much easier in decades past as it was much easier to come across an information advantage in a less interconnected and information-saturated world.

Are the rules of thumb, that we currently take for granted, legitimate?  One of the most interesting thought processes we came across recently was a gentleman by the name Christopher Cole who posits (with research) that the period of 1984 to 2007 is an outlier compared to any other period in economic history, though you wouldn’t think it given the amount of managers and investors that use this period as the norm. Consider this, if you had bought on market declines from 1929 to 1970, you would’ve gone bankrupt three times through those periods. The inverse correlation between bonds and equities was a recent phenomena as well. 

Why was this period an outlier? 

For one thing the end of two World Wars, an expansion of credit growth, historically low interest rates, demographic shifts (Baby Boomers entering the workforce) and productivity growth. Combine this with the biggest deflationary force in recent history in the form of China and you have what is essentially a two-decade Goldilocks scenario. In fact, from peak to trough, during the 1930s the markets lost approximately 88% of their real value and US treasuries declined 25% through the 1970’s. 

We are not saying this to create fear and we are by no means prophesying the end of the world. However, we want to reiterate the point that we must always question our assumptions or, as Kuhn would have it, our paradigm. 

So what can we expect going forward? For one thing, we will continue to initially see deflationary pressures as Baby Boomers head to retirement and asset valuations potentially go lower after hitting a critical mass as said generation draws upon their wealth to fund their retirement. However, given the sheer amount of debt and, quite frankly, debt monetisation around the world, this should quickly turn into inflationary pressure. This is something that most investors have seemingly forgotten about since we have not seen anything like it since the 70s. 

Ask yourselves questions about the future of globalisation and what that means for your portfolio? What about stagflation (i.e. persistent high unemployment and high inflation)? And what asset classes are likely to perform in that environment? 

On the flipside, before you make the decision to go very pessimistic, what about upside risk? Do you want to miss out entirely on an unexpected v-shaped or the more likely U-shaped recovery? 

Again, as we have said previously, the most important thing is to constantly stress-test your portfolio to see how it would react under differing market conditions.

So, How Do You Allocate? 

For one, the greatest lesson we have taken through this period is that protection is powerful. We have previously mentioned our rather bearish outlook on bonds but it’s little consolation to say ‘we told you so’ when we have been impacted by recent phenomena just the same as the rest of the market. 

Going forward, we would like to go back to the notion that having a truly diversified portfolio is not about having an even spread of assets across sectors but understanding how asset classes behave in different environments and putting them together accordingly. So, an investment like long-vol would’ve been rather painful for the past three years but would’ve been exceptional as a hedge through the current period. Similarly, an inverse or a bear hedge would’ve been painful over the past ten years but would’ve been exceptional over the past few months. One would not necessarily have to have all the eggs in one basket but having an appropriate percentage allocated towards hedges (or the “uncertainty insurance bucket”) should be helpful, the proportionality increasing in line with our uncertainty. This is not a ‘set and forget’ strategy, it must be actively managed and adjusted in accordance with the information one has available.

We fundamentally believe that active management can achieve outsized returns. But it might be pertinent to take on optionality whether in the form of covered calls, put options and asset allocations towards bond proxies, such as infrastructure, or deals similar to our Fairfield Heights property asset (long-duration, safe anchor tennant and inflation resistant since rental increases are built in). From a geographic perspective, we will allocate to countries that have significantly different factors at play than those of our own local economy. The composition of the ASX, for example, is primarily financials and materials, hence it might make sense to allocate to indices where there is greater diversity. 

Furthermore, it might be pertinent to ask yourselves questions about the logic behind having the vast majority of your exposures to a market that makes up cumulatively 1.6% of global GDP? That’s not to say that there isn’t value in investing in a market you understand but the fact remains, most companies and the general economy, as recent events have shown, are exposed to the vagaries of global markets anyway. The easiest analogy for investing from this perspective is taking a dinghy to sail out a hurricane.

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