By their very nature a market collapse or economic crises are unpredictable, if they were predictable, then they would be avoided and severe effects mitigated. What we do know, is that the next market downturn is coming, it is not a question of if, but when and how. This is not to fear monger, but merely stating the obvious. The bigger question is how to plan and manage downturns and severe adjustments.

Over the past 90 years, investors had a ~40% chance of a market collapse in any 10-year period and a ~10% chance of two collapses, as happened in the first decade of this century. Investors that entered the US market between November-1999 and August-2000 generated negative returns over the next 10-years, in what was known as the “lost decade”!

Market collapses are recurring, intermittent and uncorrelated from past performance. The only way to manage investment risk is through diversification across asset classes that can deliver positive returns when equity markets fall. The most important of these other asset classes for long-term investors is Interest Bearing Securities (also referred to as Fixed Income or Bonds).

A well-diversified Interest-Bearing portfolio that spreads credit risk across different industries and has a majority weight to floating-rate securities can remove the extreme tail risk in the distribution above; focusing returns in the middle and top thirds of the distribution.

The image below demonstrates improved return distribution with the incorporation of an Interest-Bearing allocation of 50%, with the remaining allocation to equities. We see that this effectively removes the outcomes in the first third of the distribution with only a small reduction at the top of the curve, providing more stable returns suited to long-term, retirement investors.

For many reasons, the development of high quality diversified Interest-Bearing portfolio can be problematic for Australian based investors; the listed market is dominated by banks, the size of issuances is decreasing, and yields are low. For these reasons (and more) investors should look to access the wholesale over-the-counter market for more significant opportunities.

It is not all doom and gloom for investors. Yes, the current recovery has been longer than most, and this has given rise to concerns that we have now entered a late-cycle phase. However, the rate of economic growth in this recovery has been unusually slow, and the current climate more closely resembles where we expected to be after five years. The slow recovery coupled with the fact that there was two market collapses in the prior decade give weight to the argument that this recovery has some ‘catching-up’ to do and will continue for the immediate future. Investors should, however, be mindful of the substantial risk of being undiversified.

Cameron Harrison’s partners have been delivering specialist advice to business owners and families for over 50 years. Through our defined planning methodology, our clients gain access and receive a careful and properly integrated wealth framework.