Deleveraging has become an ongoing theme; central banks have played a significant role in guiding the economy and extreme swings in investor sentiment have all contributed to market volatility. All this will likely continue to impact the reliability of future investment returns. 

Investment cycles prevail

The fundamental principle underpinning a dynamic asset allocation approach to investing is that just about everything in financial markets is cyclical. The pendulum-like swings in investor sentiment is one thing that investment markets can depend on. Financial success increasingly depends on a better understanding of market and economic cycles, with the ebb and flow of stock markets presenting enormous opportunities to generate wealth if market cycles are accurately understood. 

Market cycles range from multi-year periods called ‘secular’ cycles to multi-month periods called ‘cyclical’ cycles. The key to understanding what drives stock market cycles is to recognise that there are concurrent cycles at play during any given time. While the secular cycle determines the primary trend in the share market, the cyclical cycles also have a great capacity to impact investors’ financial goals. The key point to recognise is that while secular cycles are driven by valuations, cyclical moves are driven by investor sentiment and central bank actions. 

Better than the toss of a coin

Given ongoing deleveraging, ominous demographic trends and high starting-point valuations for both bonds and equities, it would be a safe assumption to expect low returns on the basis of secular market cycles. In this environment, the shorter-term business cycles are of critical importance. Capturing opportunities during market upswings while protecting returns during downswings is the obvious path to success. Of course, this is much easier said than done. 

Four investment principles for dynamic asset allocation

While making investment decisions objectively is critical to success, these decisions still need to pass the test of time – this is where investment takes shape as an art form. 

For the investment process to pass the test of time, it must be underpinned by a set of fundamental investment principles. The following principles are engraved within our dynamic asset allocation investment process and we believe should be taken into consideration by all investors:

1. Risk is not the same as volatility – risk is the potential to lose money and not recover; volatility is a backward-looking measure at how variable an asset is. Therefore, price risk should be a stronger focus than backward-looking analysis.
    
2. Risk and return are different sides of the same coin – there is often more downside to investing in high performing companies with low volatility than the apparent low performing companies with high volatility. This is due to the critical role ‘investor expectation’ plays, where the expectations on high performing companies become increasingly hard to meet.Similarly, expectations on the low performing companies are low and hence become easy to beat.
    
3. Diversification based on historical correlation is destructive – correlations can change; typically increasing during economic instability. Overcrowding and the typical high pricing of popular investments leads to high correlation when the economy turns and investors decide to sell at the same time. Therefore, the diversification benefits that are crucial during these times aren’t received. Smarter diversification can be based on how assets are valued and how crowded the positioning is, rather than relying on historical correlations.
    
4. The market cycle leads the economic cycle – if you aim to buy assets when the economic cycle is strong and sell them when it’s weak, you will inevitably miss out on opportunities and be exposed to risks. History has shown us that weak economic conditions don’t always lead to weak future share market returns. It would be unreasonable to assume that the macroeconomics and earnings impact on future market returns is insignificant. Indeed, a sustained and durable move higher in shares requires strong support from earnings growth and a healthy macro backdrop.

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Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.