Diversify your assets to ensure stability during periods of uncertainty

On a recent trip to the cinema I noticed that the old children’s book, Cloudy with a Chance of Meatballs, has now been released as an animated film. Set in the town of Chewandswallow, food takes the place of weather, with soup and mashed potatoes instead of rain and snow. Yet soon things go wrong and hailstorms of meatballs start to fall from the sky.

Like the inhabitants of Chewandswallow, who are forced to leave the town and adapt to life in a new world where the sky doesn’t feed them anymore, investors are also being forced to adapt their investment strategies in order to cope with the uncertainty in the stock market.

The 12-month period to end-September 2009, which included a hailstorm of bank failures around the world, the freezing up of the world’s credits markets and the icy grip of a global economic slow-down, has seen varying returns from different asset classes:

· 11.45% from the 1-3 year Bond Index

· 9.89% from the money market index

· –10.90% from the MSCI global developed-markets equities index (in ZAR). It has been somewhat weakened by a 9.06% strengthening in the value of the ZAR vs the USD.

· 7.70% from the All Share Index

Eminent economists have expended enormous amounts of energy over the past few months in an effort to try to reduce some of the recent uncertainty and determine the likely path of economic recovery. This has gained added impetus as the deep global recession appears to be nearing its end. We’ve heard and read discussions about whether we’re in (or still likely to be in) a L-, U-, V- or W-shaped recession.

The debate reminds me of the alphabet soups I was fed as a child to help me learn my ABCs. But now, the letters refer to the possible shapes that may be traced out on graphs of economic measures such as GDP, employment or industrial output. The U-, V- or W-shapes depict slow, fast or volatile recovery paths. The L-shape is best illustrated by the 1990s-era Japanese economy, which experienced a dramatic decline, followed by stagnant growth for the ensuing decade.

So … which letter is it to be? Frankly, I have little idea. Certainly, manufacturing purchasing managers’ indices have recently bounced back into positive territory – a sign of resuming economic growth. But then, this seems to me more a result of inventory re-stocking than a response to consumer demand.

And what’s more, even if we knew for certain that the economic recovery was definitely going to be U-shaped, that would tell us nothing useful about the consequent path of the world’s financial markets. More than enough research has shown that financial market movements are not closely dependent on short-term economic fortunes, and predicting the one would not help us to usefully predict the other.

You see, the world is not really like a clear alphabet soup from which we can easily extract our choice of letters to make sense and convey meaning. It’s actually much more like the atmosphere above the town of Chewandswallow, which is made of an opaque pea soup fog.

If we can’t predict the future and the world seems much more like a thick pea soup than a clear alphabet soup, then how do you go about managing your portfolio of assets?

Firstly, one needs to take a strategic outlook when constructing portfolios, as one must rely on a long-term perspective of what financial market returns have been and what risks are inherent in capturing these returns. Secondly, decisions must also be hedged, as financial market history show that meatball hailstorms are likely to be unleashed with greater frequency and more intensity than standard financial models predict.

So, keep your portfolios well diversified across a variety of asset classes and managers. Be careful to include wherever possible, elements of protection against unforeseeable negative surprises. I recently interviewed an asset manager in the UK, who spoke of the importance of mixing “investments in greed” and “investments in fear” to protect clients’ investments. For us, the latter may involve anything from simply holding a bit more low-risk cash, to defensive positions which use derivative instruments to reduce equity market risk.

Of course, we’d be happy if the current fog of uncertainty dissipated just a little bit, but we’re not counting on it. Inez Haynes Irwin wrote in a bygone era of the California fogs “not distilled from pea soup like the London fogs; moist air-gauzes rather, pearl-touched and glimmering.” One can always hope.