Risk is unusually high these days. Investors can either be paralyzed by uncertainty…or seize the long-term opportunities that volatility creates. We believe the key to choosing the latter path is updating five long-standing investing precepts for today’s tough times.
Add a dynamic edge to your strategic asset allocation. Tailoring your strategic allocation—the long-term mix of stocks, bonds, and other investments—to your objectives remains the most important determinant of your long-run investment success. But that doesn’t mean you should adhere rigidly to your strategic allocation when markets become excessively volatile. At such times, it makes sense to benefit from a dynamic process geared to adjust your exposure to risky assets. Calibrating your portfolio’s risk level to the prevailing market conditions in the short run can mitigate extreme outcomes and keep you closer to the portfolio risk level you chose, all without sacrificing return potential. That will help keep you on track to achieving your long-term plan.
Bonds are still the traditional counterweight against equity risk—but they’re poised to post lower returns in the period ahead. High-quality intermediate-term bonds are still your portfolio’s anchor to windward: your best insulation against stock volatility. But with interest rates near historical lows, it’s likely that rates will rise in time, cutting into bond values. And so after a decades-long bull bond market, this is a time to adjust expectations and anticipate lower returns. Indeed, we project only a one-in-three chance of bonds beating inflation over the next 10 years. Nonetheless, most investors are adding to their bond and cash portfolios. Our advice is, don’t follow the herd. Instead, determine the stock/bond allocation that gives you the return you require at a risk level that you can withstand.
Diversify your stock strategies by time horizon. We’ve all been schooled in the virtues of stock diversification by investment style, geography, and capitalization size. Important as those dimensions are, there’s a fourth dimension that is especially important today: time horizon. Some equity strategies, such as deep value and aggressive growth, tend to pay off in the long term. Other strategies, such as high-dividend or low-volatility stocks, pay off when short-term uncertainty in the markets makes investors uneasy. When the market is focused on the here and now, as it is currently, your portfolio should complement its longer-horizon holdings with exposure to shorter-horizon strategies. Don’t give up on those longer-horizon strategies, though: They will thrive when the market again takes account of future earnings potential.
Add an alternative source of return. With bond return potential muted and stock-market volatility elevated, it’s tempting to seek out an alternative asset class that can generate attractive returns but isn’t as dependent on the equity markets. We believe that for most investors a strategic allocation to a well-diversified portfolio of hedge funds can help meet that objective. When added to a stock/bond balanced portfolio, hedge funds can reduce the likelihood of experiencing large losses without sacrificing expected return. In sum, alternative investments diversified by manager and by strategy can complement a traditional portfolio.
Don’t forget about inflation risk. In the current low-rate, modest-CPI environment, it’s easy to forget that inflation hasn’t disappeared and may surface again—probably when you least expect it. Consider the possibility of adding traditionally inflation-resistant assets such as inflation-protected bonds, commodities, and real estate to your strategic allocation. If you’re retired and will be dependent on fixed and/or investment income, you’ll need more of these assets; if you’re still working, you’ll need less because your earnings provide an inflation hedge. Either way, don’t take inflation out of your planning just because we’re not facing the threat imminently.
These new rules of the road are easy to articulate but take work to implement, and none is a magic bullet that will eliminate volatility in all markets. But acting on them can help you stay on a smoother investment course with a higher probability of meeting your financial goals.
The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Seth J. Masters is Chief Investment Officer of Asset Allocation and Bernstein Global Wealth Management at AllianceBernstein.