It will also be important to pay close attention to valuation, reducing downside risk by avoiding over-valued assets that are priced to generate lower returns, no matter how popular they are.
The recent experience of sky-high expectations in 2021 for leading technology companies followed by large falls in share prices in 2022 illustrates that returns can be poor for any investment, even high-quality businesses, when they become over-valued.
The upside is that poor economic conditions – high inflation, recessions – are fertile environments for bargain hunting. This opportunity exists because of well-documented behavioural biases that reduce our ability to make good decisions, in the face of uncertainty.
When thinking about future scenarios, we over-emphasise highly memorable recent experiences, good or bad. In booms it is hard to imagine busts; in the depths of recession, it is hard to imagine a boom.
Even though we know that booms and busts do come to an end, the longer they go on the more accustomed we become to that environment and we adjust our expectations about the future accordingly.
In a nutshell, assets are often at their cheapest and most under-valued in a recession. Buying assets that are priced for very bad scenarios leads to higher than usual returns because on balance most scenarios will turn out to be better.
As easy as this sounds to do, it is not. You need rigorous fundamental research to assess fair value, a systematic decision-making process to deal with behavioural biases and the patience to wait long enough for the payback.
It might take several years or just a few months. Our own experience bears this out – the payoff took several years when we bought energy stocks in March and April of 2020, but less than 12 months when we bought high yield that same year.
In the end, sound diversification and playing close attention to valuation are in our view the most reliable ways to deal with higher inflation and the wider than usual range of scenarios investors face today.
Mike Coop is chief investment officer for EMEA at Morningstar Investment Management
