￼When I first came into the Financial Services business nearly 20 years ago, I was taught what one could call “traditional diversification” or asset allocation. The premise behind the concept is by diversifying investor’s assets between equities (stocks) and bonds (fixed income) you can adjust the portfolios risk by leaning one way or another.
For example, an investor with a more conservative appetite would have a higher weighting of fixed income in their portfolio. The reasoning for this has been the fact that stocks and government bonds tend to have a negative or opposite correlation. Usually when the stock market declines, government related bonds (Treasuries) rise as investors reduce their exposure to stocks by shifting assets over to the more conservative category of government bonds. Conceptually an investor with a mix of 60% stocks and 40% fixed income or vice versa, would be considered to have a “balanced” portfolio. I imagine most of you reading this missive have a similar design within your portfolio and the good news is that history has shown this works.
Today I’d like to challenge history a bit. After all, the history we are talking about is most likely the last 30 years which is a time frame when interest rates have been declining steadily. And as you may or may not know, declining interest rates cause the government bond portion of a portfolio to have a nice tail wind as rates decline and government bond prices typically rise. The last 30 years has been a good environment to have a portfolio split 60- 40 or even 40-60 as described above. The challenge comes if/when this was to change.
￼What would you do, or better yet, what would your advisor do if this dynamic changed and we went into a period of time when interest rates rise and stocks decline? Now I know this sounds a bit like a Unicorn, something you have heard about but never seen (except for that one time in college) and I acknowledge that times of rising interest rates and declining stock prices have been few and far between in the past and that when it has happened the duration of the move was short lived. However, for some uncanny reason I feel it’s important to bring this to investors’ attention and encourage all investors to think about what plan B would be if we entered a time when interest rates rose and stock prices fell for more than a week or two. As you can imagine the damage of having both sides of a portfolio decline for an extended period of time could really put a wrench in your income planning. In fact, if you would like see an example of the potential pain a scenario like this could cause then take a closer look at your August 2015 statements, assuming you have a portfolio diversified as described earlier.
￼August 2015 was a funky month for those with a “traditional” diversified portfolio. The stock market took a nice hit compliment of global turmoil coming from our friends in China and Treasuries or Gov. Bonds also took a nice hit leaving all with “traditional” diversification wondering why their portfolio declined so much when they are “diversified”. August was a good example of how the fixed income part of the diversification not only failed to provide a hedge but it helped the decline look worse. Recently we have had questions from investors that we have provided portfolio stress tests for as to why this took place and while I could invest another hour and many more paragraphs answering that question, the short version is that August was the first time we got a glimpse of what can happen when a foreign government gets in trouble and they have to sell their US Treasury holdings to shore up the damn.
In my opinion, this should be a warning shot to advisors and investors that they better get their plan B together. For us at Quiver Financial this has been a topic of conversation between us and our clients for quite some time. So much so we even invented a new word for the way we think retired investors should diversify their portfolios- “Quivercation”. If you would like to learn more about Quivercation and how it may be able to help improve the diversification of your portfolio then join us on October 16th 2015 in Irvine, CA for some lunch and learning. We look forward to seeing you and until next time we wish you lots of health and wealth.