The risks of not taking enough risk

I was in Marbella seeing clients a couple of weeks ago and had the dubious pleasure of flying home with EasyJet. It was an overnight trip, so I only brought a small piece of hand baggage to ensure a speedy departure from Gatwick for home on the return journey. An early Friday evening to start the weekend on time was just the ticket.

Of course, being EasyJet, there was the obligatory race to get your cabin bag in the cabin … and I lost. Instead of taking my bag to the hold, however, I decided to make a break for it as the luggage handler wasn’t around. I got away with it too, stowing my bag easily under the seat in front of me.

So this was a risk worth taking. I got home at a reasonable hour and I won a small victory for travellers everywhere. Of course, there was a small chance that I might have been arrested and left in a Spanish cell for the weekend…

I’m making light of the situation, but I was genuinely worried, given the power airlines have over us these days. The same powerlessness could really be said of most investors these days too, given the valuation of equity and bond markets. What do we do? Invest more in low volatility alternative investments? Hold more cash? Or hold the line on equities?

I believe we should persevere with “risk” (or equities, in the jargon). It is always very easy to justify reducing risk, but for long-term investors it usually doesn’t pay. Trying to time markets is typically fruitless and relies more on luck than judgement. How long do you take risk off for? One year? Two years? Longer? What if equity markets rise 8% each year for the next three years? Investors would miss out on more than 25% of upside.

Right now, for a balanced investment strategy, I think equities remain the best asset class to reward you for the risk you are taking, particularly if you look globally rather than domestically. Yes, there will likely be more volatility, given current valuations, so keep cash in reserve to take advantage of this.

But holding illiquid alternatives with no or negative real returns makes little sense and may well not reduce your portfolio risk either. For example, remember how commercial property funds dived last year and quickly gated funds?

When valuing income-producing asset classes, whether it’s aircraft leasing, peer-to-peer lending or infrastructure, gilt yields are always the benchmark. I know it seems unthinkable right now, but imagine 10-year gilts yielding 4%. What yield would you expect for investing in these alternatives if that were the case? In my view, the number should be at least 7%, and in many cases double-digit, assuming inflation would likely be 3% in this scenario. Impossible?

I find it strange that many people are concerned about bond investing and the potential illiquidity of that market, yet they are happy to invest in highly illiquid alternative investment vehicles, which are typically long duration. Would you buy a 30-year high yield bond yielding 5%? If the answer is no, then I would question the logic of holding alternatives that display just as much – if not more – sensitivity to changes in interest rates and yields.

We believe a long-term strategy should be taking some risk at the moment, despite the stock market highs. In fact, the global economy looks pretty buoyant. We are keeping my bond holdings in short maturity assets, accepting lower yields in doing so. This is to lessen the risk of capital erosion from faster than expected interest rate rises. We have retained a decent level of cash, but we raised this from expensive alternatives and long-dated bonds – not equities.

Because otherwise, we may end up in the worst possible world: taking no risk but losing money.