Uncertainty in the market is creating anxiety but investors who are contemplating changing investment strategies to combat potential interest rate volatility should seriously reconsider. While it might feel natural to chase high-performing stocks and shift asset allocations at the first indication of economic turmoil, it's actually one of the biggest mistakes investors can make.
That tactic flies in the face of the financial maxim about buying low and selling high. The key to surviving volatility is not to fight the tide, but to hold a portfolio through multiple market environments. That means diversifying across asset classes and investment strategies, and resisting the urge to let emotions dictate decisions.
VOLATILITY: THERE'S NO CRYSTAL BALL
With the big shift out of bond and into equity funds that catalyzed the S&P 500's extraordinarily strong showing last year and some of its best five-year numbers on record, many investors reacted by riding that wave. But it's impossible to predict which asset class will lead the others from year to year.
Investors should bear in mind that there is little consistency in market leadership, as today's top performing asset classes may be the bottom performers tomorrow. Equities were the market leaders in 2013, with the Dow Jones Industrial Average hitting 52 all-time highs — the most since 1996. In general, when equities are performing well, fixed income tends to have lower relative returns. Conversely, when equities experience negative returns, fixed income tends to see better relative returns.
Significant volatility has been present since 2000 in the U.S. equity market and even more so in international markets. International equities not only lost more than U.S. equities during that time, but hadn't fully recovered their losses by the end of 2013.
This wasn't the case, however, for fixed income, which benefited from the declining interest rate environment. But last year, as the tide started to turn, a 100-basis-point increase in rates resulted in a negative return. The increasing pressure on rates to rise could mean serious head winds for fixed income.
Nevertheless, the power of fixed income as a portfolio diversifier remains critical. This is best illustrated by the example of a 60/40 portfolio, with 40% U.S. equities, 20% international equities and 40% U.S. fixed income. Since 2000, the biggest loss on that portfolio was approximately 35%, compared with -54.6% for global equities. By adding the fixed-income allocation, the portfolio was able to reduce the biggest loss and the time it took to recover.
SEEK STRATEGY DIVERSIFICATION
But investors shouldn't stop there. They should also seek strategy diversification within the asset class allocations mentioned above. This type of enhancement can further help contain damage caused by market volatility, and some platforms give advisers access to managers and products that diversify the equity portions of client portfolios. A tactical unconstrained approach to asset allocation, for example, removes limits on the extent and frequency of allocation shifts in an equity portfolio, allowing for a more aggressive response to changes in outlook or the market.
While a tactical unconstrained approach can help diversify some of the equity risk, an absolute return approach can help diversify some of the fixed-income risk. An absolute return strategy seeks to keep volatility in line with the long-term volatility of bonds but uses a much broader tool kit in seeking to provide a positive return over a full market cycle.
Alternative investments can help diversify both equity and fixed income risk as they use strategies that may be convergent or divergent with traditional markets. The idea is that half of the portfolio would remain in the traditional 60/40 strategy, and the other half would go into a combination of unconstrained, absolute return and diversified alternatives. The objective is to reduce the losses on the portfolio even further, as well as the time it takes to recover those losses.
Investors should be diversified across asset classes but also seek to improve their portfolio by including holdings across additional risk diversifiers that use more flexible strategies. When markets are rising or falling, diversifying away from any one single strategy can work to an investor's advantage, and a combination of strategies representing multiple asset allocation approaches has been shown to experience less volatility historically.
The goal, in the end, is to be balanced across strategies that do well in rising markets and strategies that also do well in falling markets, and to get the best return for the risk taken. Nearly every quarter, investors should be dissatisfied with one part of their portfolios. If they're not, they're not diversified. Those who do it successfully will find they can concentrate on building wealth instead of worrying about taking on risk to make up losses.
Zoë Brunson is director of investment strategies for AssetMark Inc.