Q3 In Focus

Article 1: Is the investor glass half full?

The siren calls to disinvest remain legion. From intimidating valuations to messy geopolitics, the worry list for investors is perhaps particularly long and various at the moment. This week we take another quick tour around the most common concerns.

US elections and geopolitics

As we’ve noted before, there can be no slam dunk rebuttals to make everyone feel more relaxed. This is a dangerous and tragic moment for the world. However, there are a couple of things for investors to bear in mind.

Plotting the highs and lows of measured geopolitical risk¹ against ensuing returns for stocks and other risky assets points to it being an unreliable tool for investors. One good qualitative example is the rolling strife of the 1950s and 60s.² This turbulent period, with fresh memories of far worse, coincided with an economic boom in much of the developed world and soaring stock markets.

This example is perhaps useful for today, given that it was the messy birth of multiple new technologies (some of which had been gestating in one form or another for decades) that were the prime drivers of the economy, not the horror that justifiably filled the news of the time. In turn, it was these changes in the real economy that spurred investment returns higher.³

The message from history is that an investor’s time is most profitably spent assessing the outlook for productivity growth, not the convulsing geopolitical backdrop.

The same goes for politics in the national sphere for the most part. What is newsworthy in the 24/7 battle for our flitting attention barely overlaps with what is useful for us as long-term investors.

However, outside of our bizarre preference for a diet of outrage and negativity, there is one fact that investors should remind themselves of this year of all years – it is the real economy that is the driving force behind investments. That real US, or other, economy answers to no individual. The US economy in particular is too big, complex and various for that to be the case.⁴

The forces at work here often move too slowly and unmeasurably to be of much interest to our newsfeeds. Outside of the blockbuster technological breakthroughs, the most important part of the story surrounds the tinkering by the world’s entrepreneurs as these leaps forward are commercialised.

This process is thought to lean on all sorts of unsexy stuff, from the setting of institutions to the freedom of the individual. Nothing that would knock the battle for the Oval Office off the front pages anyway.

Investment conclusion

The anchoring point in amongst all of these uncertainties is that productivity is both central to long-term investment returns and unpredictable in terms of both the when and the where. The implication of this is that you should always have some exposure to the world of investments (subject, of course, to your personal circumstances).

Right now, the excitement is justifiably surrounding large language models in particular. There are of course many ways in which this new technology and its proliferating progeny could disappoint. However, for those looking for a reason to invest, there are also many futures where it doesn’t.

We are at a moment of plausible excitement about the changing technological paradigm. There are multiple breakthroughs on a range of fronts promising to transform our lives. One way to express an optimistic view on where these technologies could ultimately take us is to own a globally diversified batch of capital markets assets.

Article 2: Why not just 60/40?

Stocks and bonds tend to be bedrock asset classes in many investors’ portfolios. Proponents of the so-called 60/40 portfolio – comprised of 60% stocks and 40% bonds – take this to the extreme. Drawing on lessons from recent years, we discuss why this portfolio isn’t fool-proof, and how investors can potentially achieve better diversification.

A brief hiatus?

The 60/40 portfolio is a simple one that, for the most part, has performed well since the turn of the millennium. (Note that past performance is not a reliable guide to future performance). Investors still had to endure gut-wrenching drawdowns during the unwinding of the dotcom bubble and the Great Financial Crisis (GFC), but bonds helped cushion those blows. There was smaller need for other, less traditional, asset classes.

However, 20 years of this dynamic stifled investors’ imaginations that the future could hold anything different. ‘Alternative’ asset classes, such as commodities and alternative trading strategies⁵, regressed into line-item risks within portfolios.

But, as investors discovered in recent years, past performance cannot be relied upon for future performance, and economic regimes can switch unpredictably. It raises the question as to whether the 60/40 concept is too rigid for today’s fast-changing world.

60/40 pitfalls

As long-term investors, evaluating a portfolio on one year’s performance isn’t appropriate. That said, 2022 serves as an explicit reminder of the shortfalls the 60/40 portfolio, elements of which we discuss below:

1. Most of the risk comes from equities

While a 60/40 portfolio might appear balanced, when analysed through a risk lens, it’s not. Figure 1 shows a decomposition of the contribution of risk to a 60/40 portfolio from stocks and bonds⁶. The nominal weights are obviously 60% and 40%, but the weights in risk terms are closer to 90% and 10%. This means the 60/40 portfolio isn’t as diversified as meets the eye.

Figure 1: Equities dominate the risk in a traditional 60/40 portfolio

Source: Bloomberg, Barclays calculations, July 2024.

2. Reliance on a negative correlation between stocks and bonds

Bonds being a good diversifier to stocks is contingent on a low (or ideally negative) correlation between the two asset classes. In other words, as one moves up the other moves down, and vice versa.

The stock-bond correlation being negative is actually a relatively recent phenomenon, only beginning in the early 2000s after a few decades of mildly positive correlation (Figure 2). Understanding why this relationship changes is important in determining its persistence.

Figure 2: Stock-bond correlations wax and wane

Source: Bloomberg, Barclays calculations, July 2024.

Thinking about how macroeconomic factors influence returns is a good starting point. For example, if investors become more risk-averse, you would expect stocks to fall and bonds to rise as investors ‘fly to quality’.

The same inverse relationship would likely hold for stronger-than-expected growth, since earnings would increase (supporting equities), as would the trajectory for monetary policy rates (weighing on bond prices).

A little inflation is generally a good thing. However, if it becomes exceptionally high, this can be damaging to bonds and equities. This is exactly what we saw in 2022; bonds didn’t provide diversification to stocks, and the 60/40 portfolio struggled.

3. Limited asset universe

Narrowing your investable universe to stocks and bonds is an unnecessary limitation. It’s exceptionally difficult to consistently predict how economic environments will wax and wane, so you ideally want a range of assets in your portfolio that can perform well in different economic environments.

Adding more (unique) assets or exposures improves the diversification benefit you get. As an example, commodities and alternative trading strategies proved to be helpful additions to investors’ portfolios in 2022. We cannot easily predict how either will perform in the short term, but that’s not the point.

The focus should be on whether they bring something different to the portfolio. We’re not trying to choose the best-performing asset class each year. We’re trying to build a diversified portfolio that’s resilient to a range of future outcomes.

Investment conclusion

When considering a 60/40 portfolio, there are three key takeaways to remember:

• A 60/40 portfolio isn’t as diversified as meets the eye. Around 90% of the portfolio’s risk comes from equities.
• Different economic environments can cause correlations between asset classes to change. This can have a large impact on portfolio construction. 
• Investors should look beyond just stocks and bonds. ‘Alternative’ asset classes, such as commodities and alternative trading strategies, can provide diversification in certain economic environments.

Article 3: Hindsight bias

The importance of reflection

As many investors begin to take a summer break, it’s a good time for reflection on business and investment decisions, performance, and thinking about positioning for the rest of the year.

As well as reflecting on the impact of past events, it’s also important to think about one’s reactions to them. This means both decisions taken and not taken, and their impact. Individuals are typically better at reflecting on actions taken than those they may have considered but ultimately didn’t go through with.

The importance of this reflection is due to the role that psychology has in driving markets. Superior investment returns can potentially come from understanding the difference between how things are supposed to work and how they actually work in the real world, and a key input is psychology.

If understanding investor psychology can help make sense of, and capitalise on opportunities at the market level, analysing decision-making at the individual level should also lead to better outcomes for the individual investor.

This is because of the use of heuristics – in other words, mental rules of thumb – and the resulting behavioural biases that can come from them, which can impact judgement and decision-making.

Reducing the impact of behavioural biases

Due to the way that human beings are wired, we all experience behavioural biases – essentially, systematic deviations from rationality – to varying degrees.

Unfortunately, it’s very difficult to ‘de-bias’ ourselves completely. What we can do is have an awareness of our own biases, and put things in place to try and limit their impact, such as decision-making rules or frameworks.

By agreeing a plan ahead of time, for example agreeing to phase in investments over a defined period (rather than all at once), investors can attempt to limit the derailing impact of short-term news flow, which can in many cases serve as distracting noise for the long-term investor.

One bias to be aware of is hindsight bias.

Hindsight bias and overconfidence

Hindsight bias is a person’s tendency to perceive past events as having been more predictable than they actually were. Once an event has occurred, people tend to believe they could have foreseen the outcome. They can also claim to have ‘known all along’ what the outcome would be, despite having had no basis for such confidence beforehand.

This bias can lead to overconfidence in one's predictive abilities and poor decision-making, as it distorts the true uncertainty and complexity of events.

How does this affect investing? There is a risk of exacerbating overconfidence, which is when one’s subjective confidence in their own judgement is typically greater than the objective accuracy of that judgement.

Hindsight bias can compromise the ability of investors to confuse prior expectations with new information. This can lead to overconfidence from believing that one is a better forecaster than they objectively are.

To help bring this to life, consider an investor tracking the stock of a technology company. Before an earnings report, they might be uncertain about the company's prospects. However, once the report shows higher-than-expected profits and the stock price jumps, the investor convinces themselves that they had predicted this outcome all along.

This false sense of certainty can lead this investor to trade more aggressively in the future, mistakenly believing in their own predictive abilities driven by overconfidence and hindsight bias.

What are the investment implications?

Overly confident investors have been shown to have higher investment turnover, i.e. they trade more, which has been shown to reduce investment returns over time. These investors are also more likely to attempt to time the market and, as we have discussed many times before, it is our belief that time in the market is more important than market timing.

Figure 1: Portfolios with higher turnover tend to have lower returns

Source: Barber and Odean, Barclays Private Bank and Wealth Management, July 2024.

So, what can investors do about it?

Asset allocation

Long-term investing success is never guaranteed but more often than not, it involves having the right foundations and following the right behaviours. The former typically supports the latter.

By right foundations, we usually refer to asset allocation, namely holding a well-diversified portfolio. Owning a mix of asset classes, sectors, and regions provides one of the few ways to both protect from, and capitalise on, unexpected events.

A core satellite investing approach provides the base to stay invested through market cycles, whilst providing the headroom to mitigate risks and capitalise on short-term opportunities by tweaking that core base allocation.

Diversification can help minimise overall fluctuations in the value of your portfolio. This stabilising effect reduces the emotional stress associated with sharp market swings and encourages clearer, more rational decision-making.

With less concern about immediate market changes, investors are better equipped to focus on their long-term financial goals and avoid the pitfalls of biased or emotional decision-making.