It’s the heart of hurricane season, and here on the coast, every tropical weather system brings with it a flood of speculation: Will this turn into a major storm? When will it make landfall? Where will it hit?
The answers to those questions may prompt me to take some small steps: Trips to the grocery store for bottled water, and to the gas station to make sure my car is filled. But when it comes to the big things — like renewing my flood and wind-damage insurance — forecasts have nothing to do with my decision. I’m always insured, rain or shine. The financial cost of being unprepared for a hurricane is simply too large to risk.
Rain or shine — be prepared …
I believe the same approach applies to portfolio construction. Market and economic forecasts might prompt investors to make tactical adjustments — for example, to capitalize on opportunities presented by certain sectors, regions and companies, or to play defense against volatility by leaning toward higher-quality, less risky securities. But forecasts shouldn’t cause you to move all-in or all-out of stocks, bonds, cash and other major asset classes, in my view. Maintaining a well-diversified portfolio is like renewing your flood insurance — it helps you stay prepared for events you aren’t expecting.
Take for example, investor attitudes in 2007. After years of a bull market, there was speculation about whether the US would experience a recession in 2008. But plenty of observers doubted it would happen. Articles debated: Is the chance of recession 10%, 25% or more?
In that environment, many investors left their financial house unprotected. They avoided assets, such as long-term government bonds and cash, that have historically held up during recessions. Instead, they positioned their portfolios for continued economic growth through stocks and other equity-like investments. And their portfolios were severely damaged when the economy slipped into recession and the markets plunged. (And for those who reacted by pulling out of the stock market completely, many missed the eventual upturn in the markets, hurting their portfolio as well.)
The problem is that many investors disconnected the probability of a recession from the impact of one. And while you may think that investors won’t make that same mistake again, I’ve recently seen articles reassuring investors that the odds of a recession today are unlikely — and some may interpret this as a reason not to prepare. But for those of you familiar with actuarial science, you know that you should always insure a high magnitude event, such as a hurricane, even if it has a low expected probability. Many investors unfortunately take on an “all in” or “all out” perspective on their investments. They don’t want to “miss out” on the current environment, so they don’t prepare for what’s to come.
… by staying diversified
Of course that leaves us with the question — how do you prepare a portfolio for various economic environments?
If you’ve read my previous blogs, then my answer won’t come as a surprise. A well-diversified portfolio should include a mix of assets that perform differently in various economic environments. Stocks provide growth potential, but also make sure you’re prepared for two major risks that can derail that growth: inflation and deflation.
- To stay ready for inflationary environments, talk to your financial advisor about commodities, direct real estate or Treasury inflation-protected securities (TIPS).
- To be prepared for deflationary and recessionary environments, talk to your advisor about bonds.
Here on the coast, we circle Nov. 30 on our calendars – that’s the end of “hurricane season.” But market volatility has no season. Year-round preparation is key.
Important information
Diversification does not guarantee profit or eliminate the risk of loss.
Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.
Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.
While Treasury inflation-protected securities (TIPS) provide substantial protection against credit risk, they do not protect investors against the price changes resulting from changing interest rates.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating. Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.