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Strategic directions - Investment recommendations in an uncertain market

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Strategic directions - Investment recommendations in an uncertain market

 Investment returns can often deviate from their long-term averages. Figure 1 shows that while average annual IPD UK capital returns were 4.2% between 1973 and 2013, there was a 7% probability of values falling by more than 10% in a year. Such left tail events – typically defined as returns beyond two standard deviations – are undesirable to investors. Conversely, right tails are sought after.

Minimising left tail occurrences presents a formidable challenge to investors and they often moot diversification as a solution. Nevertheless, diversification strategies have three limitations. First, naïve diversification often results in a spreading of investments. While this could help reducing downside risk (a major assumption), it almost certainly reduces reward by diluting outperformance.
Second, periods of financial stress have appeared more often than what might be traditionally anticipated (Figure 3). Portfolio strategies often assume that future returns and volatility are normally distributed. However, this assumption has consistently underestimated the probability of extreme negative returns. Figure 2 provides evidence supporting how the normal distribution underestimates extreme left tail events for UK all property capital returns. For example, the normal distribution indicates that the probability of achieving a capital return of -16% is roughly a one in 35-year event (probability of 2.82%). However, the data indicates that this is a one in 20-year event. While the above analysis applies to ‘All Property' returns, similar findings have been reported for the individual IPD segments in the UK, in the listed property market and across other countries.
Source : AXA Real Estate

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