One of the dangers of our modern world is the over-analysis and belief that we can somehow predict and control complex systems. Just because we have more computing and analytical power than ever, it doesn’t necessarily improve our ability to predict real-world results.

We’re reminded of the notorious SAGE modelling that was relied on semi-religiously by our overlords, sorry, we mean our government. We were “guided by the science” which actually should have read we were “guided by a statistical model which contains a large number of assumptions, most of which will be incorrect” because that is exactly what predictive models are. This is not a political comment by the way; this is just pointing out facts.

Investing is exactly the same.

Modern Portfolio Theory, which started in the 1950s and still rather bizarrely has acolytes today, works on the belief that you can use historical data to build the ultimate portfolio of assets based on their returns and volatility.

Like all science, it assumes there are certain basic laws that are infallible, just like in physics and chemistry. The problem with investing is that simply is not true, because investing is not a science.

Within global markets, there are no basic laws that just exist; like economics, it is a social science that relies on the most unpredictable of all inputs – human behaviour. Markets are inherently complex and variable, and just because something has acted a particular way for a long time, doesn’t mean it will continue to do so.

Which brings us back to the traditional (and accepted across the finance industry and pushed by our regulator) measure for ‘risk’ which is volatility.

The idea is that the adviser and client discuss risk, and the client completes a relatively straightforward questionnaire, which then defines what risk and therefore what portfolio the client should have.

Very simple, very measurable, and easy for compliance and the regulator to manage. But it’s completely not fit for purpose!

There are many things wrong with that approach, which within our processes we have changed and will continue to change. However we don’t have the space to explain it all here, so we will stick with the main one, and this is the key point:

The biggest issue we have now is that the historical tools to reduce portfolio volatility, such as bonds and cash, are virtually guaranteed to lose value (in real terms) in an interest rate rising environment where we are coming up off a 0% level.

And, remembering the risk profile questionnaire mentioned above, the more cautious the investor you are, the higher proportion of these assets you have in your portfolio.

Let’s ignore cash for the moment as that’s just deadweight in a portfolio anyway, but put simply as interest rates rise, the value of bonds fall. Aha, we hear you saying, but you said before markets have no rules. We did say that, but on this occasion we’re happy to stand on the side of mathematics.

You can hopefully see how this is a real problem. The most cautious of investors, the investors who want either a stable income or to keep the value of their assets intact, are actually the ones most disadvantaged out of this situation.

How come this is happening?

Welcome to the unintended consequences of 0% interest rates. As advisers, where it is our job to find solutions for our clients most pressing financial needs, how can we justify keeping an asset in a portfolio where we know virtually for sure it will lose money?

Answer: There are a number of different ways, and we will explain one option we look at below.

If we reframe the word ‘risk’ to not mean volatility, but actually to mean risk of not achieving the intended goals, which in our mind should be the correct definition all along, then it becomes quite straightforward.

Next step is to remove bonds from the portfolio, but to keep roughly 20% in cash. This is just a rough number and will be different for each client.

The balance of the portfolio we then complete with equities: 40% into a global equity index to give us a US and global growth exposure and the other 40% into a FTSE 100 index fund.

We use the FTSE 100 because it tends to have lower volatility than the US index, is much cheaper in terms of valuation and has a higher dividend rate. Plus the older-economy stocks contained in the FTSE 100 should do better in a rate-rising environment – think oil companies and banks.

So let’s call this the PWP Modern Cautious Portfolio:

• 20% Cash
• 40% Global Equity Index
• 40% FTSE 100

For reference, the traditional cautious portfolio we’ve used to compare is 50% global equities and 50% global bonds.

So how does it compare on a performance basis?

Now remember on the comparison, we have been in a rate falling environment, where bonds have done very well AND the UK has struggled with Brexit amongst other issues.

Even so, over the last five years, performance has been virtually identical:

The PWP Modern Cautious Portfolio (in blue) has been more volatile, but you would expect that. Given the headwinds mentioned above, it seems to have held up very well.

So let’s see how it performed in the last rate rising cycle we had, which was between 2016-2018 where US interest rates went up from 0.5% to 2.5%.

The PWP Modern Cautious portfolio outperformed here, albeit again with a little more volatility.

Then finally, let’s look at how this portfolio has worked over the most recent year, which is most relevant to the current situation today:

Big outperformance with virtually no difference in volatility. And remember, interest rates haven’t even moved higher yet.

Every client situation is different, so the above will not be appropriate for all clients.

We continue to look to make these adjustments based on each client’s individual situation and goals, as well as our knowledge and experience of markets. At the end of the day, it’s about maximising the value of our clients’ assets.

We hope you enjoyed this brief insight into our thinking process. If you have any questions on this, or other aspects of our thinking, please feel free to get in touch.

Adam Walkom, Adrian Johnson and Dalip Mahara.