2013 was another fantastic year for the U.S. stock market, with the S&P 500 racking up nearly a 30 percent gain for investors. In fact, it was the best annual gain we’ve seen in the last 16 years. That’s the good news.
Before we do any celebratory end zone touchdown dances, there’s something else we should do first. Buckle up. Yes, fasten your seatbelts, because 2014 could be a very bumpy ride.
Does anyone remember the statistics term called “mean reversion”? Anyone? Anyone? Bueller? For those not familiar with statistics (or “Ferris Bueller’s Day Off”), “mean” is not meant in the context of cruel but in the mathematical context of the “average.” Mean reversion is the well-established theory that investment returns eventually move back towards the mean or average. Simply put, in a coin toss, there is a 50 percent chance of getting heads. Is it possible for someone to get heads two times in a row? Yes. Three times in a row? Also yes, but less likely. Four times in a row? Yes again, but much less likely … and so forth and so on. How does this relate to the market? Since the market correction of 2008, the market has produced a positive total return for five consecutive years. Additionally, the magnitude of those returns has exceeded the market’s long-term averages. These two statistical deviations in one direction may be indicative of mean reversion in which these two things “normalize” by going in the other direction (i.e., a down market).
Statistics aside, there are other factors that may indicate we are in for a bumpy ride in 2014. Earlier in 2013, stocks plunged just on the fear that the Fed may be “tapering” which means beginning to rein in Quantitative Easing (“QE”), the Fed’s bond buying program designed to stimulate the economy. The Fed essentially told everyone to calm down and that tapering would not begin until 2014. Well, it’s 2014 now and tapering could be implemented sooner than later. When the artificial wind that has been blowing into the sails of the economy begins to slow, the effects on the economy and the capital markets could be serious. How serious? In 2013, Dr. John Bogle, founder of Vanguard, predicted not one but two market corrections in the next 10 years that could be as bad as -50 percent. Unless you are in your 20s or early 30s and have a 30-year time horizon, “buy and hold” may not be the most appropriate course of action.
Additionally, there is significant speculation that interest rates will continue to rise as part of the Fed’s efforts to stave off inflation.
If both of these realities materialize, investors could find themselves in a financial “double whammy.” The financial double whammy occurs when stocks decline at the same time interest rates rise, causing both stocks and bonds to decline. This would leave many investors with virtually “no place to hide”.
OK, now that we’ve discussed the risks, here are some of the ways you might consider to diversify your investments to help manage risk.
1.) Introduce bi-directional strategies into your portfolio. Most investment strategies are “long only,” meaning the only way for the strategy to make money is from a rising stock market. If you agree that a forever rising stock market may be unrealistic, then you may want to consider employing a strategy that at least has the ability to switch directions in a down market. If markets begin to show signs of deterioration, the manager of a bi-directional strategy can go short (the short sale will be profitable if the short position is covered at a lower price than the stock was sold short), which means you have the potential to make money when the underlying securities lose value. Of course, there is no guarantee that any manager will definitely be able to successfully shift gears, but all things being equal, I prefer a strategy that at least has the ability to adjust to a deteriorating market. Most investments are unable to go short because their charter prohibits it which can be a severe handicap in a deteriorating market.
2.) Introduce floating rate debt strategies into your portfolio. Traditional bonds typically get hammered when interest rates rise. However, floating rate debt strategies are designed to float up with rising interest rates, so not only do you not get hurt when interest rates rise, but you typically benefit from it.1
3.) Introduce fully registered private securities into your portfolio. The public markets can be extremely volatile and, when things get bumpy, uninformed investors often panic and seek to get out. This can drive up redemptions and force a manager to unwind positions at a loss in order to meet these redemption requests, which can wreak havoc on performance. For example, owning non-traded REITs (Real Estate Investment Trusts) can add another layer of diversification to your portfolio and help insulate you from the whims of the publicly traded markets.2
4.) Introduce tactical management into your portfolio. “Buy and hold” investing works well if you have 30 years or more before retirement. However, as you get closer to retirement, you can’t afford to suffer the kind of losses that a buy and hold investment can potentially expose you to. There is something to be said for “running indoors” when it looks like rain instead of being forced to wait outside for the storm to end, which could take a while.3
Most importantly, these suggestions may or may not be right for your particular situation and require the guidance of a competent planner to help you determine which of these options are right for you.
As they say, “An ounce of prevention is worth a pound of cure.” I can’t tell you how many times people come in and show us the asset allocation their advisor chose for them and it’s deficient in diversification and risk mitigation tactics. Don’t wait until the damage is done to seek out professional advice. Be proactive. We encourage people to do so and provide a free review and second opinion of your current portfolio. We include our specific recommendations regarding what we recommend you do differently, if anything.
Kevin Ross is president and chief investment officer of Innovative Wealth Partners. He is a practicing financial advisor of 21 years and twice has been voted a Five Star Wealth Manager, an award given to only 2 percent of the roughly 40,000 advisors in the Greater Philadelphia Area in 2010. He has been featured in Philadelphia magazine, Suburban Life magazine, Money magazine and Forbes. He sees prospective clients by appointment only.
Kevin Ross
Innovative Wealth Partners LLC
333 E. City Ave., Suite 300
Bala Cynwyd, PA 19004
610-668-1400 | kevinross@iwpweb.com
Securities and advisory services offered through LPL Financial, a Registered Investment Advisor. Member FINRA/SIPC.
¹ Floating rate bonds/bank loans are loans issued by below investment grade companies for short term funding purposes with higher yield than short term debt and involve risk. ² Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained. ³ Tactical allocation may involve more frequent buying and selling of assets and will tend to general higher transaction costs. Investors should consider the tax consequences of moving positions more frequently. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not eliminate market risk. Asset allocation does not ensure a profit or protect against a loss.
Stock investing involves risk including loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
Photograph by Jeff Anderson
