Should You Rethink Your Investment Strategy?

Despite noise and speculation in the media about what the future holds, the downturn in US tech stocks in July turned out to be quite a non-event.

On the surface, despite some stocks losing multiple billions in one day, everything recovered in a blink.

We all know that market fluctuations and volatility are a part of investing and when you have a long-term investment outlook, these types of events aren’t usually a topic for discussion.

However, when you dig a little deeper, this seemingly minor blip in US tech stocks did uncover some interesting insights and may have signalled a warning to individuals to rethink their investment strategy.

Read on to find out what we learned and how we can better protect ourselves as investors in future.

What Happened & Why?

Anyone who is invested in a fund, either in cash or within a pension, is highly likely to own a bit of each of the ‘magnificent seven’ – Alphabet (Google), Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla.

That means pretty much everyone – you and me – anyone who has any investment anywhere, is likely to hold these stocks to some degree, whether through a fund or in direct stocks.

After steady and significant growth over the last two decades, back in July, these US tech stocks had a downturn.

Drops in these values appeared to wipe years of growth out overnight and set about a frenzy in the financial media.

The stocks recovered quickly and for now, are still the best performers in the market, but question are now being raised about how long this outstanding performance can last and how long we can depend on these magnificent seven to generate remarkable returns.

Why did this happen?

The downturn was due to a sell off of US technology companies for some of the following reasons:

• Although huge investments have already been made, the initial excitement around AI is starting to cool off. Investors are now questioning whether AI going to be as profitable as initially thought and whether they will see a significant ROI as quickly as hoped. Nvidia lost in excess of €200 billion in market value in one day in July, although it has since bounced back and is still being touted as the best stock to buy and watch.
• Reported earnings from Q2 fell sharply. Tesla was the biggest casualty here with a reported 45% drop in profit in spring 24.
• The ‘great rotation’. The economy moves in cycles, based on interest rate movement and inflation. More recently, the release of lower inflation data saw investors shifting from expensive large cap tech stocks to cheaper small and mid-cap stocks.
• Concerns about overexposure to tech stocks and investors seeking diversification. The over reliance on tech stocks for performance in recent years could be a ticking time bomb in portfolios that are over weighted in US tech.

What Impact did this have?

On the surface not much.

At Everlake, we don’t normally react or comment on isolated events such as this. Our investment philosophy is always to take a long-term outlook and ride out the peaks and troughs of the day to day.

As John Bogle, founder of The Vanguard Group, said ‘the stock market is a giant distraction from the business of investing’ so we generally recommend filtering out all the noise and leaving the market to do its work.

However, this event did uncover a significant area of vulnerability for some funds in the Irish investment market.

Before we dig into what we discovered, we need to understand how investment strategies are generally chosen and the level of risk that investors take with their money.

What is the right investment approach?

Many clients expect us to pull out a glossy brochure from a pension/investment company showing that they have the ‘best performance’ over the last 20 minutes.

Remember regulators all around the world require investment literature and advice letters to state that “past performance is no guarantee of future returns”.

Past performance of a fund, and even to extent the associated charges, are much less important than how your money is invested. Or in investment terms, your asset allocation.

In other words, investors should pay much less attention to the provider of the investment and much more attention to the mix of stocks, bonds, property etc. within the fund.

Risk Appetite v Risk Capacity

Effective investing considers your risks profile, which includes both your risk tolerance and risk capacity. Ideally, when working with an adviser, your investment strategy should balance less strongly your emotional comfort with risk (risk tolerance) and more strongly your financial ability to take risk (risk capacity).

For example, you might have a good appetite for risk and be willing to take a good deal of risk with your funds. But if your pension pot is relatively small and you are close to retirement, your capacity for risk is lower because you can’t actually afford any great dips in value in the near future. Therefore, a more conservative investment approach is recommended.

On the other hand, you may be quite generally risk averse with a tendency to be more cautious about how your money is investment. But if you’re 25 and investing into your pension fund regularly over the next four decades, you have a much greater capacity for risk. You can therefore afford, and benefit from, taking more risk.

What is a risk rating?

Each investment fund is given a ‘risk rating’ which in theory should match up with a client’s tolerance and capacity for risk.

In practice, these risk ratings are rarely very accurate. While there are several ways to allocate a risk rating to an investment fund, there is no one single benchmark or method for rating and comparing all funds in the world, or even all funds in Ireland.

The majority of investors with life companies in Ireland are lumped into moderate risk profiled funds, without much thought for balancing both their tolerance and capacity for risk or the accuracy of the risk rating that has been assigned to the fund.

Why does this matter?

Due to the structure and wrapping of Life Company offerings like pensions, investments and savings plans, it’s often difficult to truly see how your money is invested and understand important things like diversification and asset allocation.

How your chosen investment fund performs is almost impossible to work out due to the complex fee structures and lack of transparency given by life assurance companies.

The downturn in the tech stocks further highlighted how opaque the funds offered by life companies in Ireland can be.

One of the most popular funds in Ireland, offered by a big Life Company, has shown outstanding performance in the past 15 years and has over €4.37 Billion invested in it. 

The provider of the fund describes it as being actively managed with a diversified range of equities, bonds, property, commodities, cash and alternative assets. It also states that fund managers aim to generate long term capital growth while targeting a volatility range of 5%-10% over a rolling 5-year period.

The last line is the most important part. The fund is targeting a volatility range of 5% to 10%. Based on the European Regulator (ESMAs) definition of risk this fund is a risk level 4 out of 7 on the risk scale.

During the recent downturn in tech stock value, the performance of this fund dipped at an alarming rate, so we took a closer look.

US tech stocks make up around 20% of the overall investment market. When we looked under the bonnet of this fund, we found that US tech stocks make up 30% of this fund.

In other words, this fund has been relying on the performance of a handful of stocks to produce its fantastic results. While the tech stocks have rallied, it’s highlighted the precarious nature of relying on one industry (tech) and one region (US) to continue to deliver great results. How long is this winning streak likely to run for?

And the most alarming thing is that the risk rating of this fund is only at a level of four, which means that it’s likely the most standard and popular fund to place an average investor into.

So, has the risk taken by investors been worth it?

A Case Study

Jane is a 30-year-old self-employed Solicitor with a salary of around €150,000 per annum and savings of €100,000 in her pension plan to date.

Based on her age and the earnings cap of €115,000, she is contributing the maximum possible based on her age which is currently €23,000 per annum.

Jane met with a broker and was asked to describe her risk tolerance through a standard risk questionnaire. Like MOST people by definition, she came out with an average 4 out of 7. Based on this, her broker suggested that she invest in the fund discussed above.

According to the provider, the Annualised Performance of this fund over the last 10 years (Aug 2014 to Aug 2024) has been 6.66% pa. Adding on the 40% tax relief to contributions upfront Jane is delighted to hear this. It’s certainly around six times what she is making on her savings in the Bank.

Let’s look a little more closely.

What if Jane had started in October 2013 with her €100,000 and added €23,000 annually? Looking at the graph below, we can compare six different risk rated options and see how they performed.

While the back test doesn’t reflect the performance of an actual client’s investment account, it does show whether the risk that was taken was worth it.

We can see that there is a huge difference between the performance of the various investment strategies. The fund recommended by Jane’s broker is the prominent purple line right in the middle of the pack. Exactly where we would expect it to be.

Source: FE

So, if Jane had taken this advice ten years ago, her pension would have increased to a healthy €544,705 over this period based on these contributions and investment performance.

However, based on our assessment of her risk capacity we would never recommend that a 30-year-old professional invest in a mid-risk multi-asset fund like this. It’s far too conservative for the likely 30 year plus time horizon.

All things being equal, Jane should invest her currently modest pension savings into the market, 100% equity, globally diversified, in a low-cost index-based portfolio.

Basically, she should just track the market and not attempt to try and ‘beat the market’ through active management.

Firstly, because there is virtually no evidence in academic literature that anyone can consistently beat the market. And, more importantly, Jane doesn’t need to beat the market to have a comfortable retirement, she just needs to earn a market rate of return.

Let’s compare the highest risk fund available from the same provider as our fund above, with a low-cost passive index portfolio. Over the last decade we can see, as we would predict, that the more broadly diversified market portfolio has outperformed the more concentrated actively managed portfolio.

Source: FE

In other words, over this period, the market has delivered an additional 0.55% annually for less volatility than the highest risk offering.

Projecting this into the future, to state pension age of 66, if Jane invests in the market as we would suggest and continues to contribute €23,000 per annum, we project a total pension fund of circa €2 million. Ignoring tax free lump sums, from age 66 Jane can expect an annual income of around €6,690 per month from this.

Source: PortfolioMetrix

Whereas if she takes her current broker’s advice, as illustrated below, her expected pension pot at retirement is €1.2 million on average producing a significantly lower income to her during retirement.

Source: PortfolioMetrix

Are US Tech Stocks ‘Bad’?

Absolutely not. On the other side of this, if we looked at funds or client portfolios that hold little or no US tech stocks then we would see a marked underperformance compared to the overall market.

US tech companies have been great at driving growth in recent history and have been very beneficial to investors to date. And as no one has a crystal ball, they may well continue to be.

The message here is balance. Diversification is the key to balancing risk and return.

Conclusion

Don’t believe the hype. Just because a fund is popular or has performed well recently doesn’t necessarily mean that it is the best investment for you.

Avoid letting the system drive you into “investing by numbers” with a risk profile questionnaire most likely throwing you into the mid risk ESMA 4 or 5 bucket. You could be taking significantly more risk than you realise, without the pay off in the end.