Four pillars for long term growth

How does a serious investor choose which asset classes to invest in for long-term growth?

The chief consideration is that you have to invest in assets whose growth beats inflation. But how does one beat inflation in an investment climate that has significant inherent risk?

The main pillars

The four main building blocks of a portfolio are cash, bonds, equities and property. A well-diversified portfolio would typically be made up of a blend of these asset classes to preserve capital and improve the chances of achieving inflation-beating returns.

Some investors may want to add gold, art, jewellery or vintage cars to their investment portfolio. These collectibles, however, cannot be considered vital asset classes for investment growth. These more niche type of assets can be subject to bubbles and liquidity problems as there may not always be a market for them.

Instead, investors should concentrate on building a portfolio out of the four main asset classes. Deciding how to allocate between the asset classes is determined by the business cycle, or the fluctuations between expansion and contraction in an economy over time.

The skilled specialists

Skilled managers can protect their portfolios when markets are overvalued by adjusting their asset allocations to a more defensive portfolio mix. This may result in the risk of under-performance over the short term, but in the long-term the capital is preserved.

So for example, when the markets are running and share prices appear overvalued, as is happening at the moment, a fund manager might choose to switch some of his portfolio into cash or to the short-term money market. Having cash on hand gives the manager the option to take advantage of lower equity prices when the market adjusts.

While the markets are running, the portfolio would probably underperform. In the longer term, the more conservative returns during the period when the manager switched to cash would be worth it as capital would have been preserved when the market corrected.

Not an inflation beater

However, cash is not an optimal long-term asset class as it does not typically beat inflation. In the situation we are seeing now, where equity valuations are high and the opportunity set is weak for bonds, being in cash is a good short-term solution until the market presents a better opportunity.

Bonds have enjoyed a bull market for the past 30 years. However, this is set to end as inflation levels have now bottomed and are expected to start rising. Bond cycles can play out over a 60 year cycle, highlighting a very long trend. If the cycle continues as expected, and inflation starts to rise, investors would want to switch to equities.

After the extremely low levels of the past few years, equities are expected to benefit as we move into a normalising cycle where interest rates rise, and inflation trends are up. If our currency weakens as inflation rises, having offshore exposure will minimise the impact. The JSE All Share Index has on average delivered returns of 19% every year for the past 40 years. It is unlikely that we will see these kinds of returns in future.

Property performer

Property is well positioned to provide inflation-beating growth, as leases and rentals are directly linked to inflation.

Investing across the four main asset classes is an informed way in which to structure portfolios. Investors do need to realise that returns across all asset classes are expected to be lower than they were over the past 20 years as valuation levels are high relative to history.

While investors can expect to beat inflation with the correct asset allocation, margins will likely be lower. The key to this is to look at the storm that you are facing and riding it out as there is a rainbow at the end of it.