By GRAHAM FROST 21/04/2006
The last three years have been an exceptionally satisfying period for investors. Low interest rates and rapid emerging markets growth have led to vast amounts of cash flowing around global economies ('high liquidity') and soaring commodity prices respectively. Just about every asset class has enjoyed strong performance as a result.
As the chart below highlights, higher risk sectors including commodities/natural resources, emerging markets and medium/smaller companies have delivered especially strong returns.
The rapid ascension of emerging market economies, notably China, has been one of the key drivers of the recent boom. China's almost insatiable demand for commodities, to build its infrastructure and fuel manufacturing output, has helped propel commodity prices sky high. Furthermore, its ability to flood the global marketplace with cheap manufactured goods, thanks to low labour costs and an artificially low exchange rate, has led to rapid economic growth. While the long term prospects remain attractive, it is unrealistic to expect the recent rate of growth to continue. China is under increasing pressure from the US to revalue its currency (as the US desperately seeks to reduce its $13.8 billion trade deficit with China) and it would certainly feel the pinch if the feared slowdown in global demand materialises.
Medium and smaller companies might also struggle to continue outperforming larger companies by such an extent over the next few years. With many large companies currently on far lower P/E (Price/Earnings) ratios than medium/smaller, we could see large caps fall back into favour through offering better value. We may also see more mergers and acquisitions amongst large companies, as many corporate balance sheets remain cash rich.
Those Bestinvest clients who actively use our portfolio asset allocation models will have reaped the benefits of these strong sector performances, but are now likely overweight in these areas as a result.
| "Re-balancing is a vital part of good investment management." |
If this is the case (Bestinvest clients can view their portfolio breakdown in 'Client Centre' or call their adviser) you might be taking more risk than is appropriate to your objectives. While it can be tempting to remain overweight in light of such exciting recent performance, this could lead to disappointment. Now might be an opportune time to take some profits and re-balance your portfolio.
Re-balancing is a vital part of good investment management. As well as keeping excessive risk at bay, it can also enhance portfolio returns, as the below example shows:
| Asset |
Year 1 |
Year 2 |
Cumulative |
| A |
+20.00% |
-10.00% |
+8.00% |
| B |
-10.00% |
+20.00 |
+8.00% |
|
50/50 Portfolio |
| without re-balancing |
+5.00% |
+2.86% |
+8.00% |
| with re-balancing |
+5.00% |
+5.00% |
+10.25% |
History suggests that if you do not regularly re-balance your portfolio, the market may well do it for you!