It will soon be the 10-year anniversary of when, in early October 2007, the S&P 500 Index hit what was its highest point before losing more than half its value over the next year and a half during the global financial crisis.
Over the coming weeks and months, as other anniversaries of major crisis-related events pass (for example, 10 years since the bank run on Northern Rock or 10 years since the collapse of Lehman Brothers), there will likely be a steady stream of retrospectives on what happened as well as opinions on how the environment today may be similar or different from the period leading up to the crisis. It is difficult to draw useful conclusions based on such observations; financial markets have a habit of behaving unpredictably in the short run. There are, however, important lessons that investors might be well-served to remember: Capital markets have rewarded investors over the long term, and having an investment approach you can stick with—especially during tough times—may better prepare you for the next crisis and its aftermath.
BENEFITS OF HINDSIGHT
In 2008, the stock market dropped in value by almost half. Being a decade removed from the crisis may make it easier to take the past in stride. The eventual rebound and subsequent years of double-digit gains have also likely helped in this regard. While the events of the crisis were unfolding, however, a future of this sort looked anything but certain. Headlines such as “Worst Crisis Since ’30s, With No End Yet in Sight,”, “Markets in Disarray as Lending Locks Up,”, and “For Stocks, Worst Single-Day Drop in Two Decades”, were common front page news. Reading the news, opening up quarterly statements, or going online to check an account balance were, for many, stomach-churning experiences.
While being an investor today (or during any period, for that matter), is by no means a worry-free experience, the feelings of panic and dread felt by many during the financial crisis were distinctly acute. Many investors reacted emotionally to these developments. In the heat of the moment, some decided it was more than they could stomach, so they sold out of stocks. On the other hand, many who were able to stay the course and stick to their approach recovered from the crisis and benefited from the subsequent rebound in markets.
It is important to remember that this crisis and the subsequent recovery in financial markets was not the first time in history that periods of substantial volatility have occurred. Exhibit 1 helps illustrate this point. The exhibit shows the performance of a balanced investment strategy following several crises, including the bankruptcy of Lehman Brothers in September of 2008, which took place in the middle of the financial crisis. Each event is labeled with the month and year that it occurred or peaked.
The Market’s Response to Crisis
Performance of a Balanced Strategy: 60% Stocks, 40% Bonds (Cumulative Total Return)
Although a globally diversified balanced investment strategy invested at the time of each event would have suffered losses immediately following most of these events, financial markets did recover, as can be seen by the three- and five-year cumulative returns shown in the exhibit. In advance of such periods of discomfort, having a long-term perspective, appropriate diversification, and an asset allocation that aligns with their risk tolerance and goals can help investors remain disciplined enough to ride out the storm. A financial advisor can play a critical role in helping to work through these issues and in counseling investors when things look their darkest.
BUT THIS TIME ITS DIFFERENT
Given today's market environment, there is a lot of discussion that "this time its different" and that investors should move "towards the exits". It seems even Warren Buffett is playing defense, too as Berkshire Hathaway Inc. is holding 15 percent of its assets in cash. Whether this is true or not, many investors continue to discuss and debate much of the following:
Bond yields remain in unexplained territory as interest rates continue to hover near all-time lows.
Continued lower yields may suggest lower expected returns in the future for bonds.
With lower rates, retirees will have trouble creating sustainable lifetime income solutions.
Shouldn't I be concerned about sequence of returns risk?
Private alternative investments can provide higher income given the lower yield environment.
Interest rates can only go up which could be bad for equity and bond markets.
Pubic U.S. equity and bond markets are at all-time highs.
Current valuation levels indicate stocks are significantly overvalued.
Expected return in public equity markets will be lower in the future.
Private alternative investments can offer diversification and help preserve wealth.
Bonds no longer serve as an effective asset allocation tool.
All of these comments seem reasonable at face value. If true, several of these points could have a significant impact or should be considered for investors' asset allocation decisions in the near-term, in particular recent or soon-to-be retirees.
CAN BONDS STILL HELP DIVERSIFY A PORTFOLIO FOR SAFETY IN A LOW-YIELD ENVIRONMENT?
While it may be hard to believe, it is a possibility that bond yields could move up or down even from these low levels. However, yield levels are not as relevant for asset allocation as one might think. First, its important to understand how the investment returns for bonds work:
Total Return = Risk-Free Rate + Excess Return
The risk free rate is basic compensation merely for saving (rather than consuming), but it does not include the return for taking risk. Excess return is the return for taking risk associated with investing (and also potentially the return on investment insight or acumen). Its also important to keep in mind that investors can only earn the risk free rate in their home currency.
With regards to an investor's asset allocation, this decision only affects excess returns. The long-term excess positive returns for bonds (generally their risk premiums in corporate fixed income) are based on the shape of the yield curve. The positive return derives from the average upward slope of yield curves (positive w/ term premium) not the level of actual bond yields. A structurally flat or inverted yield curve over the long-term would reduce expected excess returns.
Investors should also keep in mind that bonds are not a "hedging asset". Or to get technical, this suggests one should not expect bonds to exhibit negative correlation with other asset classes to add value as a diversifier (although in recent years they have been negatively correlated and indeed acted as valuable safe havens to equity markets). Instead, we should expect the correlation between bonds and other asset classes to average about zero which serves its purpose and is consistent with long-term historical averages. In Exhibit 2, we can see the average correlations between bonds and both stocks and commodities have been close to zero over the past 70 years.
Asset Class Correlations in Different Environments 1946-2016
In the mind of some investors, there is always a “crisis of the day” or potential major event looming that could mean the beginning of the next drop in markets. Some investors may feel the market environment of 2016 was unusual, and that it continues to persist in 2017. However, this should not contradict the need to maintain a diversified asset allocation. As we know, predicting future events correctly, or how the market will react to future events, is a difficult exercise. It is important to understand, however, that market volatility is a part of investing. But also understanding the difference between short-term market movements and the risk of permanent loss is vital to one's success. To enjoy the benefit of higher potential returns, investors must be willing to accept increased uncertainty. A key part of a good long-term investment experience is being able to stay with your investment philosophy, even during tough times.
We are also aware that sequence of returns risk is a big concern for many investors who are about to retire or already in early retirement drawing income. Because of this, your asset allocation may be structured based on the most efficient way to create sustainable lifetime income for the future. As a result, diversifying beyond just traditional stocks and bonds may be necessary not only to achieve income needs but also to protect one's principal.
Therefore, this highlights the continued need for investors to diversify across both traditional and alternative return sources and to appropriately size those return sources so they matter in their portfolio. A well‑thought‑out, transparent investment approach can help people be better prepared to face uncertainty and may improve their ability to stick with their plan and ultimately capture the long-term returns of capital markets.
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