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 DIVERSIFICATION AT EVERY LEVEL
But investors shouldn't stop there. They should also seek strategy diversification within the asset class allocations mentioned above. For instance, within your equity allocation or within your fixed-income allocation, you should be diversified across individual investments.
The goal, in the end, is 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.
Zo� Brunson is director of investment strategies for AssetMark Inc.