Flagstaff Business News – In Challenging, low-return market environments, investors should capitalize on the benefits of diversification.
Investing – Challenging Times – July 10, 2013
Investors today face a number of challenges as they look to position their portfolios to accomplish their goals. Those looking for income are being forced into increasingly riskier asset classes, including high-yield bonds, with the hopes of generating income greater than what they are earning in money market funds, CDs and savings accounts. With this increased yield, of course, comes increased risk, and those same investors have to decide if they can handle the volatility, or potential capital losses, that could result. Those who are focused on total return have increasingly moved into equities, an outstanding asset class during the last 12 months, but the ride has been far from smooth. In June alone, equities as measured by the S&P 500 moved more than 0.5 percent (up or down) on 16 of 20 trading days (80 percent). Finally, even those investors focused primarily on capital preservation have been disappointed with low returns and capital losses as the yield on the 10-year Treasury bond moved from a low of 1.66 percent on May 1 to a high of 2.60 percent on June 25 (a 56 percent increase in less than two months).
In light of these challenges, many investors are wondering how to position their portfolios for the future. The short answer lies in diversification. Diversification is investing in different types of investments with the goal of reducing risk, but not returns. While some investments are decreasing in value, others should be increasing in value. The end result is a combination of investments that creates more stable, consistent returns, allowing investors to build wealth more consistently and feel more comfortable with the day-to-day movements in their portfolios.
So how should investors diversify their portfolios? What types of investments provide diversification and will do well in the current economic environment? What is the best method for accessing these types of investments efficiently and at a low cost?
The Four Peaks Wealth Management forecast is for a continued period of slow economic growth, low inflation and ongoing employment challenges. In this type of environment, the Federal Reserve should continue to maintain low short-term rates while investors drive modest increases in long-term rates as they look for higher yielding alternatives for investment. Looking at historical asset class performance during these types of time periods, intermediate to long-term bonds perform poorly and stocks have more modest returns accompanied by increased volatility. For most investors who have only stocks and bonds in their portfolios, this leaves a limited set of choices. Investors can either move into short-term bonds to minimize losses, at the expense of accepting yields near zero on their money, and slowly losing their purchasing power to inflation. Conversely, they can increase the risk of their portfolios by increasing the allocation to stocks and high yield bonds. Unfortunately, under this economic scenario, past market performance has shown that many investors do not get compensated for this increased risk through commensurately higher returns.
A third alternative is to broaden the types of investments that are part of an investor’s portfolio. A recent article by James Debevec II, CFA, a founder and principal for Absolute Value Capital Management, analyzed the performance of various types of investments during rising rate environments going back to 1981. He found that commodities, specifically oil and copper, perform exceptionally well, and in fact earn the majority of their returns during such environments. Stocks also perform well. Bond prices and utility sector stocks tend to be two of the worst performing investments.
An effective way to access these different types of investments is through the use of Exchange Traded Funds (ETFs). An ETF is a fund made up of different securities. ETFs provide an efficient, low-cost way to diversify a portfolio. They are purchased when the goal is to own a basket of investments and are traded on exchanges throughout the day in the same manner as stocks so they provide intra-day liquidity.
In challenging, low-return market environments, it is important that investors capitalize on the benefits of diversification and move beyond the traditional asset classes of stocks and bonds as they look to improve returns without taking additional undue risk. Exposing your portfolio to a wider selection of kinds of investments, acquired through low-cost ETFs, will increase portfolio efficiency, lead to more stable returns and help investors sleep better at night. FBN