Even as central bank stimulus drives investors into risky assets, risks are rising. Investors will need to accept, diversify, and hedge to mitigate them.
We have listed 28 risks that could impact markets in 2017. But the biggest single risk individual investors will face is not displayed. That risk is panic.
Panic can lead to inertia, i.e. investors remaining under-allocated to asset classes essential for their long-term portfolios and forever waiting for the “right time to buy.” It can also lead to selling at the worst possible time. Quantitative market research group DALBAR estimates that investors have lost more than 2% annually over the past 20 years from ill-fated attempts to time markets. In a world where a 5% return can be hard to achieve, that is significant.
Creating a long-list of risks to track can help investors accept that many risks exist, keep a long-term mindset and therefore respond in a less emotional manner when risks flare.
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Investors can reduce their exposure to some of the risks listed through diversification across asset classes, regions, and securities.
Many of the risks are region or country-specific, so investors who avoid excessive concentration in any one country or monetary regime can reduce their vulnerability. Even when global risks arise, they do not impact all assets equally.
For instance, higher inflation might be bad for cash but good for real assets and equities. Or higher interest rates might hurt high quality bonds but boost senior loan returns. Effective diversification across bonds, equities, and alternatives can lessen vulnerability. Some risks will also affect individual companies more than entire markets. For instance, disruptive technologies and cyber-attack concerns can exacerbate single-security risk while affecting the overall market in only a minor way. Reducing exposure to individual companies generally helps improve financial returns relative to risk.
Plans are nothing but planning is everything.
Investors can diminish their risk exposure even further through hedging. In an environment of increasing protectionism and monetary policy uncertainty, currency risks are high. This adds to portfolio volatility while providing no clear prospect of return. Currency risks should only be taken on a short-term basis, and should generally be hedged in the long run.
Hedging can also prove attractive to investors hopeful of benefiting from rising equity markets, but particularly fearful of global risks, like a US recession or Chinese hard landing. Our Systematic Hedging approach seeks to regularly buy lower-priced protection in less widely traded markets. While this practice comes at a cost, it can lessen investor vulnerability to major declines in global stock markets.
Similarly, a systematic approach, allocating to equities when the market backdrop is supportive, and reducing equity exposure when conditions worsen, can help protect against large portfolio draw-downs. Risks today are numerous. But by accepting, diversifying, and hedging, investors can reduce their vulnerability to more manageable levels.
Top risks for 2017
We identify at least 28 known risks that could concern markets at some point in 2017. Unforeseen risks will also emerge.
China hard landing
Rapid US rate hikes
Eurozone “taper tantrum“
Financial system worries
Pensions / insurance crisis
European banking crisis
China FX reserve shortfall
Japan debt crisis
Compromised market liquidity
EU political crisis
Escalating Middle East conflict
Rise in global terror
Rising food prices
Oil price spike
Solving the world’s myriad economic problems is about trade-offs, and the choices policymakers make will matter a great deal for your portfolio. The only certainty is that different regions will make different choices. Diversification is the best way to protect and grow your wealth in an increasingly complex world.