Since 2013 my firm, Legg Mason, has used a third-party service to conduct an annual global investment survey. We use it to try to measure where investors are allocating their investments and get a clearer sense for their thinking: what do they consider good investments for the coming year — and bad?
We surveyed more than 500 U.S. “affluent investors” with investable assets exceeding $200,000. Their average age is roughly 60.
First, the good news: investors came into 2016 with great optimism about their investments, the U.S. equity markets in particular. On average they told us they expect the Dow Jones Industrial Average to increase 8% this year. In their overall portfolios they expect to achieve an average rate of return of 7%. That's pretty bullish. Note that the survey concluded in early January, so the large market pullback had not yet set in.
In this year's survey, we also tried to measure investors' volatility tolerances. We discovered that most investors were willing to be more patient than panic with their equity investments, even in the face of increased market volatility or outright declines.
Investors reported that it would take a decline an average threshold of 22% before they would consider selling out of their equity holdings. For the most part, I think this is good news.
(More from Thomas Hoops: Power of infrastructure investing in uncertain markets)
With this tolerance band, investors would be able to ride out most market pullbacks, corrections and even a shallow bear market. The S&P 500 has fallen 22% or more from its peaks only four times since 1970 – and clearly recovered each time. Of course, if investors had sold during any of these four events it would have been very unfortunate — and certainly highlights the importance of good advice during very tough times.
That noted, our survey results point to an investor base that is becoming more aware that equity volatility has to be expected — and patience will pay off in the long run.
In addition to seeking their opinions on the markets and related volatility (“what they say”), we also queried their actual asset allocations (“what they do”).
The most shocking number is the 23% held in cash. We've all heard that individual investors are holding larger than usual cash positions, often explained as a reaction to fear and being scarred by the recent financial crisis. However, looking at the data, very different explanations emerge: these investors are not scared; they told us that they are overwhelmingly optimistic!
Thus we must look deeper into their allocations, particularly equities. Keep in mind the average age of survey respondents is 60. They are approaching a point in their lives when they should seek security and income — yet they have 41% in equities. This does not strike me as a “hide under a rock in fear” type of allocation! Something else, outside fear, must be driving this.
Part of the answer may be found in their fixed-income allocations: 15%, the lowest in four years and down sharply from two years ago. This cohort requires income, so it is likely they and their advisers have realized that 2% interest rates — and related interest rate risk — will not satisfy their income needs. Given increasing longevity, this group also still needs to find some growth – but with 41% already invested in equities, it is likely that they are reluctant to increase the volatility of their portfolios by “doubling down” on equity exposure.
Faced with tough choices in these traditional asset classes, indecision and inaction appear to have won the day: with their 23% allocations to cash, investors seem to have decided to do nothing. This is not the safe choice they envision, unfortunately, and all but guarantees that they will not reach their overall portfolio return target of 7%. With 38% of their holdings generating little (bonds) or no (cash) return, the pressure on equity performance is tremendous.
Analysis shows that their equity investments would have to return more than 14% to match the overall 7% portfolio increase investors reported they expect in 2016. That's a tall order.
What the survey highlights most clearly is how much investors need solutions that bridge the gap between equities and traditional fixed income. Investors need to generate income and find lower volatility growth alternatives in markets and asset classes that are less correlated to what they already own.
Moving cash into these strategies is not about taking more risk; it's about taking different risk. It also can help investors achieve real diversification.
Two options that fit squarely between fixed income and equities are core real estate and infrastructure. These real asset strategies provide income that is not tied to traditional bonds and can offer growth that is not strongly correlated with the equity markets.
Investors can also “bridge the gap” by expanding their horizons in fixed income and equities. On the fixed-income side, investors should build global portfolios, particularly with globally unconstrained strategies. For options closer to traditional equities, investors should consider strategies that offer growth with lower volatility and less correlation; things like equity income, managed volatility and hedged equity strategies (market neutral, long/short).
Putting cash to work in a broader array of diversifying growth and income strategies is a good way for investors to improve their chances of achieving their long-term financial goals.
Thomas Hoops is head of business development at Legg Mason.
