An ill wind

What Investment, June, 2007 by Keiron Root

'Another month, another rate rise. Interest rates show no sign of receding--indeed, there was another base rate rise at the beginning of May--and inflation continues to hold the Bank of England's Monetary Policy Committee in its thrall. The Consumer Price Index is at its highest ever level, above three per cent, and, should we need reminding, the Retail Prices Index, which includes politically inconvenient things like housing costs, is more than a percentage point higher.

A growing number of market commentators have been going to great lengths to remind investors that inflation has its merits as well as its drawbacks. Experienced investors will realise that circumstances change and that 'putting all your eggs in one basket', even if it is an equity basket, is rarely a good idea.

The point is that investment portfolios need to adapt to reflect changing market conditions. If interest rates continue to rise--and some commentators are suggesting that six per cent before the end of the year is a real possibility--while this would certainly put pressure on borrowers and could well have an adverse effect on the stock market, cash deposits would certainly become more attractive and bond returns would see a dramatic improvement.

I spoke recently to a bond fund manager who confessed that base rates at six per cent 'would be like going to heaven'. The bond markets have had a very rough time during the prolonged period of low interest rates and you can understand why those people whose job it is to invest in the fixed-interest markets are looking forward to better times ahead.

The simple truth is that no one form of investment will outperform all other forms of investment in all circumstances, and there will be times when it is sensible to move away from equities and into something better suited to the prevailing conditions. This is the principle behind portfolio diversification and one that increasing numbers of private investors have embraced over the past decade, at least in terms of investing in property.

However, there are now fears that the move into property has been overdone, especially if investors have borrowed heavily to do so. Far too often, the investing public gets carried away with the latest fad or latches onto a particular asset class at a positive point in its cycle, and piles too much money into it too quickly. This is not diversification, it is simply exchanging one overexposed position in one asset class, say equities, for an overexposed position in another, say property.

A well-balanced portfolio should have exposure to both equities and property, as well as other asset classes such as cash and bonds. For those with longer time horizons and a greater appetite for risk, there is also scope to consider areas such as commodities and "alternative investments" (by which fund managers usually mean hedge funds).

The important thing to remember is that investment is not a static process. Not only is there a need to keep an eye on individual holdings, take profits from time to time and get rid of underperforming elements where necessary, but you also need to keep the bigger picture in mind.

Asset allocation is a core element of many fund management houses' approach to investment, yet it is something that the private investor has been relatively slow to latch on to. Yet adjusting the overall profile of your portfolio to meet both your own changing circumstances and the movement in markets over time is an essential part of building a successful investment strategy. And it will be particularly important if the bond fund manager gets his wish and base rates really do hit six per cent.'

Keiron Root

Editor