The current market environment presents investors with a set of asset allocation dilemmas: portfolio choices that range from bad to sub-optimal to merely OK. The cocktail of low rates, elevated valuations, and risk aversion has made building a durable portfolio more difficult than at any time in recent memory. Blame it on central banks, deflationary fears, or slow growth – the primary culprit is low/negative interest rates. Most of today’s portfolio dilemmas stem either directly or indirectly from this factor.
Portfolio Dilemma #1: If today’s low yields remain stable or rise, high-quality bond returns will be somewhere between poor and bad – nowhere near a typical pension’s discount rate of 7% or even a retiree’s 4% annual withdrawal rate.
Portfolio Dilemma #2: Low/negative yields could move even lower, resulting in price gains for bonds. However, gains will be on top of low starting yields, and the associated deflationary environment would be terrible for global equity markets. If you “win” on bonds, you probably lose on stocks.
Portfolio Dilemma #3: Many investors want a more defensive portfolio. But this shift comes with a high price: low yields and significant rate risk for bonds, and the loss of purchasing power as cash under-yields inflation. Like Uber’s surge pricing, lowering volatility has become more costly just when investors want it most.
Portfolio Dilemma #4: Low yields are not a new problem for asset allocators. Central banks have been ripping the floor out of rates since 2008. However, low yields combined with stretched equity valuations is a relatively new phenomenon, starting in late 2014 when P/Es ran through and above their longer-term averages.
Portfolio Dilemma #5: A common refrain is that stocks aren’t actually overvalued because interest rates are so low. This however still places the asset allocator in the awkward position of justifying the relative value of equities by comparing them to the extreme overvaluation of sovereign bonds.
Unfortunately, there’s not one comprehensive solution to these dilemmas. The opportunities and risks in today’s financial markets and the macro economy are what they are – we can’t change that. The best we can do is to offer some modest coping mechanisms to aid the asset allocator.
- Stick to your targets – Other than high-quality bonds at super-low yields, few assets are significantly overpriced or underpriced. This argues for maintaining allocations that are close to their long-term target weights. In the absence of over- or undervaluation, there is little rationale for significant over- or underweights.
- Have a plan for volatility – If you’re keeping cash on the sidelines, have a plan for using it. If a market sell-off comes to fruition, know which falling knife you’ll choose and how you’ll catch it. Having a plan in place should reduce the emotional predilection to sell low.
- A cheaper defense – Portfolio ballast of high-quality bonds and cash is expensive, due to interest rate and inflation risk. Don’t simply surrender and accept more volatility than you can tolerate. Investors should look for other sources of safety which could include a modest allocation to other “risk off” assets like gold.
- Brexit Schmexit – Don’t become paralyzed by the news. The world is full of risks, but trying to handicap geopolitical outcomes is a fool’s game. The biggest risk is in owning overpriced assets, which results in high volatility and lower future returns.
- Lower your expectations – Returns for stocks (due to elevated valuations) and bonds (due to low yields) will be sub-par. Better to under-promise and over-deliver on portfolio return assumptions. Avoid the temptation to get more aggressive or chase yield. Setting realistic expectations helps combat the emotional response that can undermine long-term portfolio success.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
Understanding current market conditions and what might be expected in the near term.
Understanding potential market trends in early 2017 requires a look at the market’s recent optimism.
During periods of market optimism, remaining mindful of risk is still important.