The right assets at the right time

Diversification is an important tool for investors in achieving returns over the long term amid a range of different market conditions, but certain types of assets are often more appropriate to particular economic environments. There’s always room to adapt one’s portfolio to the economic weather and new opportunities by changing allocations to different asset classes and sectors – especially in a more volatile market environment.

When building an investment portfolio, certain rules should almost always apply. A diversified balance of economic sectors, geographic regions and asset classes usually helps to deliver consistent returns over time; and staying in the market is generally a better way to expand your wealth than trying to time investment and divestment in response to changing conditions. However, there is still room to adapt your portfolio to the prevailing economic environment, to take advantage of emerging trends or to protect against sudden shocks.

Perhaps the most important decision is the balance between equity investments and fixed-income securities. As a general rule, stock markets do well in a climate of solid economic growth. It is easier for companies to increase their revenue and profit when consumers and businesses have more money to spend. Shares may also offer some protection against inflation because companies can – at least in theory – increase prices to compensate for rising input costs.

Fixed income, in contrast, tends to do well in less favourable economic conditions. In a deflationary environment, the value of the fixed revenue delivered by a bond becomes more valuable. At the same time, investors tend to gravitate away from risky assets such as equities when they are feeling more nervous about economic developments, which puts pressure on stock markets and tends to boost demand for less volatile assets such as bonds.

Some sectors naturally have greater defensive qualities than others, frequently offering more stable revenue and cashflow throughout the market cycle.

Defensive protection or growth ambitions

However, for these two broad asset classes there will always be nuances. Some sectors naturally have greater defensive qualities than others, frequently offering more stable revenue and cashflow throughout the market cycle. One example is healthcare, where demand does not change significantly according to economic conditions; others are defence spending and consumer staples.

There are also areas that are characterised by structural growth. At the moment, a lot of attention is focused on artificial intelligence, which might prove as important as the internet in disrupting the existing economic order, potentially unlocking economic growth and higher productivity, although whether this potential will be fulfilled remains to be seen.

Meanwhile, huge sums are being directed toward renewable energy generation and distribution, boosted by financial incentives offered by legislation such as the US Inflation Reduction Act and the EU’s Fit for 55 programme. These sectors may be less vulnerable to shifts in the economic environment.

Alternative options

Fixed income also consists of different profiles. Government bonds from the biggest developed markets, including the UK, Canada, Germany, France and especially the US, tend to be viewed as safe havens in troubled economic times. Investment-grade corporate bonds issued by the biggest global companies are also generally considered to be low-risk.

However, the high-yield market, which consists of bonds issued by smaller or more indebted companies, possesses different characteristics. These bonds have more equity-like behaviour and can suffer from sell-offs at times of economic weakness, when investors anticipate higher default rates. Bonds issued by emerging market governments and companies tend to have similar characteristics, especially if they are denominated in local currencies that may fluctuate against the US dollar or euro.

Alternative assets may also have a useful role to play at certain times in the market cycle.

Alternative assets may also have a useful role to play at certain times in the market cycle. For example, private equity now owns many of the world’s fastest-growing companies, such as OpenAI (the owner of ChatGPT), online payment processing giant Stripe, social media platform Reddit, and Uber competitor Lyft.

Gold: when investors lose faith

Private equity and venture capital is an option for well-informed investors looking to invest early in emerging technologies, but it can be very cyclical: money tends to pour in at times of economic optimism and exit at times of gloom. Valuations can become inflated at times of exuberance, potentially leaving investors nursing painful losses. It’s also worth remembering that in recent years the market for initial public offerings has slowed, reducing the options for private equity firms looking to cash in their investments.

At the opposite end of the spectrum is gold, the ultimate ‘disaster’ asset class. It tends to rise in value when investors lose faith in traditional investment assets altogether; gold enjoyed a major surge during the 2007-09 global financial crisis, for example, when the world’s financial system appeared to be on the verge of collapse, and again during the early stages of the Covid-19 pandemic.

Gold is also negatively correlated with real interest rates, so it tends to gain in value when inflation and interest rates are low. But since it doesn’t offer income, there could be an opportunity cost to investors if they can obtain a regular return elsewhere on lower-risk assets.

There will be times when no foreseeable combination of asset classes, funds and securities will deliver a positive return.

Tough conditions

There will be times when no foreseeable combination of asset classes, funds and securities will deliver a positive return. During the financial crisis, the only asset worth holding was cash. However, while at that time it might have reduced losses in the short term, it is usually a poor solution for building wealth over a longer perspective.

Another difficult period for investors was 2022 when, unusually, bond and equity markets sold off in tandem. At that point, energy and resources stocks were the only game in town, but it would have taken astonishing foresight to anticipate the war in Ukraine and position a portfolio accordingly.

Investors cannot hope to time shifts in the market perfectly – and should be wary of trying to do so, especially without expert advice. But had they by chance managed to identify the right moment to move into any of the recent hot investment areas – artificial intelligence, Japan or renewable energy – they would have enjoyed impressive returns.

The problem is that investors need to find these ideas when they are still undiscovered, which is extremely difficult without inside knowledge. Humans are hard-wired to follow the herd, and they generally pick up ideas once they’ve been discovered by everyone else – when prices have already risen.

There will always be unpredictable events. Who could have predicted the pandemic bringing economies across the world to a halt, and its longer-term impact, such as the revival of inflation? All investors can do is seek to adjust their portfolio to prevailing market conditions, ensuring they are maximising their opportunities and protecting themselves at least against foreseeable risks. While they cannot predict the direction of markets with any accuracy, it may be possible to make considered judgements on where the economy could be heading and position their investments accordingly.