It’s been exactly 3,020 days since the financial markets bottomed out in the wake of the financial crisis that literally wiped away trillions of dollars in assets. Panic struck everyday investors, who ran for the hills thinking that the unrest would never end. We learned in hindsight that the best thing to do was batten down the hatches and ride out the storm, but unfortunately we as humans can’t live that way. Sure, the traditional scientific method is always 20-20 hindsight at its best, which allows you to see where you’ve been. It allows us to formulate a certainty of what we think we know, a validation of sorts. But unfortunately, hindsight doesn’t tell us where we should go moving forward, so we need to ask ourselves if it’s time to break the mold.
March 9, 2009 is the date that I was referring to in the above paragraph, and since then the S&P 500 Index has grown a whopping 260.36% (note: the S&P 500 Index is an unmanaged index and cannot be directly invested in). While that certainly sounds great, the fact of the matter is a lot of investors were left behind, still stricken by fear of another crisis. With the current economic expansion at 96 months and counting, what factors should you be thinking about as you ponder the “new normal”?
First of all, correlations are on the rise. What is correlation? According to Investopedia, “Correlation, in the finance and investment industries, is a statistic that measures the degree to which two securities move in relation to each other. Correlations are used in advanced portfolio management. Correlation is computed into what is known as the correlation coefficient, which has value that must fall between -1 and 1.” In today’s post-crisis environment, emerging markets, U.S. Treasuries, emerging market bonds, government bonds and U.S. high yield bonds have all moved in lockstep with equities. Pre-crisis, many investors subscribed to the Modern Portfolio Theory (MPT), which essentially states that it’s not enough to look at the risk and return of one individual stock, but rather one should diversify by having a mix of stocks and bonds, thus reducing overall risk. When stocks and bonds weren’t positively correlated, that theory was sound financial advice. However, it has become challenging to build a diversified portfolio that contains assets that behave differently. Globalization and central bank intervention across the globe have resulted in growing correlations among even the most traditional investments, especially during times of stress within the markets.
Drastic increases in volatility is another factor to consider when evaluating how to approach a “new normal”. Financial markets are more volatile than ever, and looking at the last 60 years proves it. Between 1996 and 2015, there were 422 days when the S&P 500 Index moved 2% or more. Consider that from 1956 to 1996 there were just 254 days of 2% or more price movements in the index. So in a span of just nine years, this event occurred 1.67 times more than it did over a 40 year time frame. It’s not just stocks that have experienced magnified volatility, as bonds have seen some huge price movements as well. Typically known as safe havens and instruments of low volatility, government bonds experienced volatility that rose over 40% in 2013, and 40% in early 2015 (data from Merrill Lynch’s MOVE Index, which measures bond market volatility). Central banks have flooded the financial markets with easy monetary policies, while the U.S. Federal Reserve has embarked on a tightening policy, which could cause volatility to persist as markets adjust to a rate tightening cycle.
The final component to consider that has been a direct byproduct of the financial crisis is low yields. For the most part, interest rates have been declining for the better part of 30 years. Low inflation and monetary policies that are accommodating have pushed yields on the 10-year U.S. Treasury note to a low of 1.61% in 2012, down from a rate of over 15% in 1981. Although the U.S. Federal Reserve has slowly begun to emerge from a zero interest rate policy, central banks throughout the rest of the world remain ultra accommodating, which could lead to interest rates around the globe that stay low. As you look back at the historical yield of the 10-year U.S. Treasure note, bonds may not be able to provide adequate income in the low interest rate environment that we face for the foreseeable future. Here’s the double whammy. What happens when interest rates actually start to rise? Traditional fixed income investments may suffer losses as rates rise, which diminishes the short term value of fixed holdings.
The Modern Portfolio Theory was created in an environment that had a limited range pf choices, where expected return and risk was based on a mix of stocks and bonds. In those times, an investor seeking to lower risk in their portfolio would simply tilt their portfolio weighting towards more bonds, whereas investors looking for maximum returns would seek out more stock allocations. But as I’ve laid out above, today’s environment forces us to look at the investment landscape through a different lens. There are ways to create a more diverse portfolio through the addition of alternative investments, which tend to not be correlated with stocks or bonds. A common mistake that I see or hear is when others treat alternative investments as a single asset class. Alternatives cover a wide spectrum of assets and strategies, and should not be looked at as a replacement for a class in your portfolio, but rather a complement to your portfolio. Investors should always consider alternatives while keeping in mind their goals, objectives, risk tolerance, liquidity needs and time horizon. Only then can an investor begin to review how alternatives might serve as a complement to their traditional portfolio. Although alternative investments have varying degrees of risk and return, they may be able to contribute to improved overall returns on a portfolio due to their lower correlation to traditional investments.
Investing in the “new normal” requires investors to rethink their approach to portfolio construction. Now more than ever, individuals need to develop tailor-made solutions that address today’s financial challenges. There is no one-size-fits-all approach solution to investing and how it relates to alternatives. If you’re worried about how the future looks in regards to the overall financial landscape, maybe it’s time to look at the “new normal” with a new lens.
Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.
Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.
***Alternative Investment Disclosure: Diversification does not assure a profit or protect against loss in a declining market. Portfolios that have a greater percentage of alternatives may have greater risks, and this additional risk can offset the benefit of diversification. Alternative investment strategies such as leveraging, arbitrage and commodities investing are subject to greater risks and volatility than more traditional investment offerings. Although asset allocation among different asset categories generally limits risk and exposure to any one category, the risk remains that an asset category could perform poorly relative to the other asset categories. Some of those risks include general economic risk, geopolitical risk, commodity-price volatility, counter party and settlement risk, currency risk, industry concentration risk, leveraging risk, market risk, liquidity risk, real estate investment risk, and sector risk.***