In the final instalment of our holiday mini-series Shares looks at the final pair of our top 10 golden rules of investment
Academic theory shows that a maximum of 12 to 15 company shares, bonds or funds provide ample portfolio diversification, assuming they cover a range of different industries and potentially geographies. This number is also practical in terms of dealing costs, newsflow management and performance measurement. This should cover most eventualities and keep something trickling into your savings pot almost whatever the weather.
As the US Federal Reserve steps back from its own Quantitative Easing (QE) drive, last month (30 Apr) reducing its monthly asset purchases another $10 billion to $45 billion, it is still unclear whether the net result of huge central bank intervention around the word will be inflation, deflation or stagflation. Each scenario remains possible but would have profound implications for investors’ portfolios and the optimal mix of asset classes within them.
Deflation is thankfully rare but it is no friend to equities. Japan’s experiences are proof of this. The Nikkei 225 peaked at 38,957 on 31 December 1989 and despite six substantial rallies since has only made it to 14,458 some 25 years later. Falling prices have a pernicious effect on corporations’ and consumers’ behaviour if they have too much debt, as the value of the liabilities grows in real, inflation-adjusted terms. Deflation is horrid for debtors but good for savers as the value of their cash and coupons clipped from bonds rises in real terms.
Stagflation is rarer still. The UK in the 1970s provides a historic example here and it is not a good one. After the Barber boom of 1971-72 the economy overheated, the Heath government jacked up interest rates and then came the 1973 oil shock. Squeezed by inflation on one side, high borrowing costs on the other and an inability to properly plan investment, firms and consumers alike decided to take the high nominal returns available from the bank. UK equities collapsed and only bottomed on a forward price/earnings of less than five. Names which outperformed at the time were pricing power stocks, such as food producers, food retailers, drinks firms and providers of household goods. Bonds were dreadful performers owing to inflation and the best asset to own at this time was gold, which went bananas, rising from $35 an ounce to over $500.
Inflation is the most usual state of affairs, although equities did best in the 1980s and 1990s during an era of disinflation and progressively milder increases in the cost of living. During this ‘Goldilocks’ period, economic growth was neither too hot to force central banks to hike interest rates and make cash more attractive than equities or bonds or too cold so as to jeopardise corporate profits or even threaten a recession. Share prices won out either way, while bonds began a 30-year bull run in the very late 1970s as the US Federal Reserve and Bank of England led a crusade to tame inflation. Share prices went on a tear and even the 1987 Black Monday crash now looks like a blip. Only the bear markets of 2000 to 2003 and 2007 to 2009 have stopped equities in their tracks and let bonds take the lead during the great moderation of inflation.