In the first few days of 2018, markets have surged to all-time highs.
Some gutsy investors are throwing caution to the wind by muscling in on these gains, despite warnings that we could see the end of the bull run in the not-so-distant future.
You’ve also got investment veterans, such as Brewin Dolphin’s Guy Foster, who say 2018 won’t feel anywhere near as benign as last year.
Foster reminds cautious investors of the old Buffettism, to “be fearful when others are greedy, and greedy only when others are fearful”. This contrarian view is particularly useful to remember when stock market levels are scaling fresh highs, because a herd mentality can land you in trouble.
If you want to take a cautious view on your investments, here are some tips to help you capture the upside, and stop you from being hit hard by a market correction.
Own the world
It might sound obvious, but the easiest thing to do is to own all major asset classes in all geographical regions as inexpensively and tax-efficiently as possible. This can save you from suffering severe losses when one region stagnates.
You might think that this approach will mean you end up with indifferent performance, but history shows that this is not the case, says Andrew Craig, founder of Plain English Finance.
Craig quotes US investment writer Harry Browne, who said: “over broad periods of time, the winning investments add more value to the portfolio than the losing investments take away.”
Don’t ignore expensive markets
Cautious investors can find it tempting to ignore expensive markets, because they think slightly toppy valuations means there is more of a risk, which in turn means you could miss out on the gains.
“But when it comes to asset allocation, that’s just not true,” says Ed Smith, head of asset allocation research at Rathbones. In fact, history will tell us that there is absolutely no correlation between price-to-earnings (PE) multiples and the returns achieved over the proceeding 12 months, he says.
“There is a huge misunderstanding between the return and the PE ratio. It’s a good measure for stockpicking – if you want to buy an industrial company, buying a cheaper industrial company rather than an expensive one is a good way to go. But that logic has been extrapolated into asset allocation and that’s not quite right.”
Consider every scenario
It’s also crucial that cautious investors don’t just look at those assets that will simply grow their earnings, but look at those most likely to grow ahead of expectations, according to the asset allocation boss.
Smith says you should consider how assets could cope in a range of different scenarios, and if the asset can only exceed growth expectations in the most optimistic, you should avoid that asset.
Use automation or trend-following data
Another way to avoid worrying about market crashes is to automate your investments by “smoothing” the returns. “This can be very good for your peace of mind, and tends to improve returns because it removes you from the equation,” says Craig.
“Very few professional investors can time markets successfully, and most amateurs are actually hard-wired to buy high and sell low for deeply rooted reasons around human psychology.”
Craig also recommends that cautious investors apply a trend-following overlay to their holdings.
According to financial data, the positive or negative direction of any market is statistically more likely to continue than to reverse. “This means that, if a share or market has been going up steadily, all other things being equal, there is a good chance it will continue to do so – if only because of the herd mentality of human beings.”
Craig suggests using a simple technique that compares the price of your investment today to the 200-day average once a month. “If you’re above the 200-day monthly average, you remain invested. If you're below, you switch out of that asset and into cash.”
Take a look at your bonds
Fixed income is usually the mainstay of cautious portfolios. However, Brian Dennehy of Fund Expert says the 30-year uptrend in bonds is drawing to a close, which has made it even more difficult to construct a cautious portfolio.
Ben Gutteridge, head of fund research at Brewin Dolphin, points to strategic bond funds in particular, which are popular among investors.
“These funds need to be analysed by the cautious investor; you need to make sure they’re not full of negative durations and emerging market debt.”
Leave it to the experts
Of course, you can also let fund managers pick stocks for you, which is useful if you don’t have the time to do lots of research on companies.
However, Dennehy says the problem with a cautious portfolio is that it is, ironically, more difficult to construct than a riskier one.
“It is seldom straightforward when selecting funds from the lower risk sectors,” he says, pointing out that many lower risk sectors, such as targeted absolute return, are confusing.
Dennehy recommends that cautious investors separate their portfolios into three “buckets”. First, invest in three fixed income or absolute return funds, such as Odey Absolute Return, City Financial Absolute Equity, and Threadneedle European High Yield Bond. Second, choose one fund in the Mixed 0-35 per cent Shares sector, such as JP Morgan’s Global Macro Balanced fund. Third, choose a bricks and mortar property fund like L&G UK Property.
While this year might feel uncomfortable to investors, bear in mind that therein lies the opportunity.