There has been a lot of uncertainty in the economy and a lot of volatility in the financial markets. Recently, that has been good; the bump after the fiscal cliff deal took us to a five-year high. Clearly, the expectation in the stock market is that uncertainty has been reduced, problems have been solved, and we have clear sailing ahead.
Many people, though, are not convinced. Although there are good arguments for stocks to continue to rise—with Jeremy Siegel being one of the most convincing proponents—others with equally impressive credentials are calling for a market decline. What is an investor to do?
Personally, although I do think there is potential for continued appreciation in the stock market, I also recognize that there are significant downside risks. In my judgment, the downside risk is at least as great as the potential for appreciation, and any portfolio has to take that into account. I believe that this also applies to the bond market. With interest rates still at historic lows, at some point they have to rise, which will result in lower bond values. Rates don’t have to rise this year, or next year, but every month they stay down brings us one month closer to the inevitable rise.
With that said, when you design your portfolio, there are things you can do to try to participate in any growth while potentially limiting your risk.
Fixed income. With rates probably at current low levels at least for a while, but with the potential to increase, it makes sense to limit duration. Holding shorter-term bonds will, first of all, limit the price damage from increases in rates; second of all, it will allow reinvestment sooner after rates do rise. Yes, the short-term income will be less, but so will the risk.
With the shorter duration, take a look at corporate bonds rather than government bonds or mortgages. The latter markets are affected by Federal Reserve buying right now, and credit seems to be a better option in general. Not only that, at this point blue-chip companies may be a better risk than Uncle Sam.
Also worth a look are foreign bonds, which may benefit from currency effects, as well as in many cases from having a superior fiscal situation for the sovereigns. Finally, municipal bonds are always worth a look depending on your tax situation, although a proper credit evaluation is becoming more important.
Stocks. Returns from stocks come from two things: price appreciation and dividends. With the potential for price appreciation constrained by the potential for price depreciation, dividends are literally money in the bank. Not only that, but there is evidence that dividend-paying companies have outperformed over time, even in price appreciation. Dividend payers are worth a look. Another way to look at this is to consider stocks that vary in price less than the market, or that have low volatility. In difficult market environments, such low-volatility stocks—many of which are dividend payers—have often shown superior performance.
Finally, it might be worth investigating strategies that are not just buy and hold, which might include long-short, tactical, or market neutral. Although these strategies have often underperformed in strong markets, they are designed to hold up better in difficult markets.
All of these strategies seek to limit downside risk while still allowing you to participate if the market takes off. No strategy is perfect by itself, nor will it work all the time, and the last piece of the puzzle is to put together these strategies in a way that gives you the highest probability of meeting your goals. Diversification really is the only free lunch in investing—and pretty much in anything else as well.
Diversification does not assure a profit or protect against losses in declining markets and diversification cannot guarantee that any objective or goal will be achieved.