The financial markets, which experienced so much volatility from 2008 to 2011, have been remarkably stable during the first four months of 2012. Daily price swings on the Dow Jones Industrial Average of 100 points or more have been much less frequent this year. In 2011, there were 102 days where prices closed more than 100 points up or down. There have been only 15 such days in the first four months of this year. The combination of price stability and a rising stock market has made the experience of investing in stocks quite pleasant for most investors. Everyone understands that these cheerful times are not going to last forever. Volatility has begun to show itself within the last few weeks and many believe that more violent short-term moves are just around the corner.
There are many factors that contribute to market volatility. Investors are routinely advised to “tune out” many of those factors on the theory that making investment decisions on the strength of day- to-day economic or geopolitical news is not prudent. One consideration that should not be ignored, however, is the general direction of the economy. After all, the ultimate objective in buying stocks is to invest in companies, or mutual funds and exchange traded funds (ETFs) that hold baskets of companies, that are undervalued. In a weakening economy, however, finding undervalued companies becomes more difficult.
The economy in this country has been slowly, but steadily, improving since early 2009. Unfortunately, the recovery has been, by just about every measure, sluggish and unimpressive. Predicting what will happen next is especially tricky. The problems in the Euro zone are very well publicized. The growth in once booming emerging markets such as China and India is slowing. This country is facing an unprecedented debt problem at a time when neither of our two political parties can even remotely agree on a solution. Certainly, neither higher tax rates nor significantly reduced government spending is going to boost the economy in the short run. Despite the efforts of the Federal Reserve, the struggle between the forces of inflation and deflation remains unresolved. All of this points to future volatility in the economy, which means volatility in the financial markets.
Conventional wisdom is that the way to protect one’s portfolio, particularly in volatile times, is through appropriate investment diversification. Unless someone is lucky enough to glimpse a future copy of the Wall Street Journal, the direction of the financial markets is an unknown. Even in one of those unusual cycles where the direction of the economy somehow seems obvious, surprises, both good and bad, are always a possibility. Of course, one’s decision to make an allocation between asset groups should not be based strictly on predictions about the direction of the economy. An investor’s age, time horizon, future income prospects and tolerance for risk are all critical factors in devising an appropriate investment model. Presently, allocating assets is even more difficult because of the condition of the bond market. Simply put, interest rates will not remain this low forever. Once rates begin to rise, bond prices will fall. Chasing higher interest rates today by extending maturity dates is a dangerous proposition. Bonds are a necessary ingredient in all portfolios, but in today’s environment any allocation to fixed income needs to be very mindful of the maturity dates and the types of bond (i.e., government, corporate, high yield, etc.).
In the attempt to protect one’s portfolio, stocks and bonds are not the only option. Examples of alternative investments include commodities, hedged products and real estate investment trusts (REITS). The easiest way to get exposure to these asset classes is through mutual funds or ETFs. One of the attractions of these alternative investments is that they often are non-correlated to the broader market indices. In other words, they act as contra assets. Alternatives, hedged investments specifically, are designed to limit volatility within the overall portfolio. These investments have grown in popularity over the last 10 years. Prior to this, they were only accessible in large institutional accounts. In some cases, even cash is an alternative option. While cash presently earns nominal rates of interest or no interest at all, it will come in handy in a number of scenarios. For instance, in a market selloff, if bargain prices for stocks emerge, cash will provide an investor with buying power.
For most investors, the decision of how to allocate investments becomes more important as retirement age approaches. Much has been written about the decision by many of the baby boomer generation to extend its target date of retirement. A substantial portion of that phenomenon can be attributed to bad behavior during volatile markets. Those investors who did not spend the time to fully understand their investment portfolio allocation were especially vulnerable in the last market crash, in 2008 and early 2009. Many who believed they had the fortitude to avoid panic in a major selloff learned the hard way that they were out of touch. The result? The classic mistake of buying high and selling low. That is why it is so important to be appropriately diversified. What happened in 2008-2009 will occur over and over again. It happened on a smaller scale as recently as last summer when the S&P 500 index lost 17 percent in just 11 trading days. For those who are invested in the stock market, either individually or through retirement plans, those periods of vicious volatility can be extremely stressful. And that’s when decisions are made that prove harmful to one’s financial health. It doesn’t have to happen if an investor is appropriately diversified and adequately monitors his or her portfolio.
Alan Mandeloff, CPA/PFS, CFP is president of Citrin Cooperman Wealth Management, a registered investment adviser that provides personal financial planning, investment management and insurance design and brokerage. Citrin Cooperman Wealth Management is an affiliate of accounting, tax and business consulting firm Citrin Cooperman. Alan can be reached at 215-545-4800 or email@example.com