If risky assets had a right to higher returns, then they wouldn’t be risky

By Matthew Brittain, Investment Analyst at Sanlam Private Wealth

As equity markets continue to reward investors, it becomes increasingly challenging to remain disciplined. But there’s little that makes me more nervous than elevated asset prices which are unsupported by underlying data – in some cases exactly the conditions we’re experiencing today.

Since Donald Trump was elected, we’ve seen rising valuations across asset classes, and growing optimism as investors get comfortable forecasting growth further and further into the future. It’s this optimism that has seen risk premiums (the incremental amount of reward you should get for taking extra risk) steadily evaporate, as investors are prepared to pay for these optimistic forecasts. So far, investors have been rewarded for waltzing further along the risk curve in search of yield, but assuming this will continue could be dangerous.

Taking more risk for less reward

In the good times, such as now, when risky assets are producing stellar returns, it is easy to get sucked into the belief that taking risk will lead to a higher return. However, if you look at the graph below you will see that taking more risk means a greater dispersion in expected outcome, i.e. less certainty. On the left we start with a risk-free investment, such as a short-dated, government-backed note. As you progress further out along the black “Capital Markets Line,” investments become more risky, which should, on average, produce an incrementally higher return, but also incrementally less certainty.

It’s up to investors to demand sufficient compensation for shouldering this uncertainty. When a margin of safety is not on offer, history has consistently shown that it’s better to watch from the side-lines, and wait for the risk/ reward balance to recalibrate. Recent conditions have demanded a great deal of patience waiting for this to happen, resulting in investors carrying on regardless. What we are seeing in the market is that investors are giving up on their lower-yielding, safer investments and taking more and more risk at exactly the time when we think one should be considering the opposite. That’s not to say that a long-term investment strategy should be abandoned and we all flee to gold, just that it’s worth bearing in mind that preserving capital is a vital focus, and we think now is a good opportunity to look objectively at one’s portfolio.

When increased risk becomes the new norm

Due to the prolonged period of very low interest rates, other asset classes look relatively attractive by comparison and money has naturally flowed there, pushing up prices. For example, only a few months ago, corporate bonds were trading at an attractive discount to government bonds, so it made sense to buy them. But now, these same bonds are trading at a yield that is much closer to government bonds and we have to question whether we are still happy to hold them. To get the same return as before, an investor would now have to buy something more risky, say a higher-yielding junk bond.

For several years this approach has borne fruit, perhaps resulting in investors becoming a little too comfortable, to the point where it doesn’t actually feel all that risky anymore. That could explain why the market barely blinked at the recent Fed rate hike and guidance that their balance sheet may start to shrink soon. Only a year ago, markets were fixated on when central banks would start to increase interest rates, and such an announcement would almost certainly have precipitated a sharp sell-off.

There’s always a window of opportunity

Of course, a position of caution doesn’t mean we don’t see any opportunity. There are always pockets of value to be found. For example, we have recently benefitted from the high growth rates in Asia where expectations were quite reasonable.

It’s up to investors to insist on proper compensation for taking on uncertainty, i.e. the valuation of investments must not require the realisation of overly optimistic assumptions in order to achieve a satisfactory return. When this compensation is not on offer we must be careful not to fool ourselves into thinking that things are more certain than they really are.