by Adam Butler, CEO Resolve Asset Management
This is the second of a three-part series we’re affectionately calling “How to Get Comfortable with Being Uncomfortable.” The series covers the tremendous headwinds investors in traditional portfolios are likely to over the next decade or more, and the steps required to turn a bad situation into a great opportunity. These steps – set realistic expectations, diversify as much as you can handle, and take advantage of others’ mistakes with factor investing – are designed to help investors through whatever the future holds.
Reminder: Valuations are a Problem
In Part 1 of this series, we addressed how valuations on stocks and bonds remain extremely lofty. As a result, it is unrealistic to expect the portfolios that investors have grown comfortable with over the past few decades to produce the returns investors need to achieve financial independence. In fact, after adjusting for inflation and fees, we estimate that investors will be hard-pressed to earn more than 2% per year on traditional portfolios of domestically focused stocks and bonds over the next decade.
Investors who are entrenched in the current investment model face the uncomfortable choice of working longer, saving more, or lowering expectations about their retirement lifestyle.
But investors have other choices if they are willing to think more broadly about their investment options. These choices are no panacea. While they may substantially reduce investors’ savings burden, and provide long-term returns that will support a more substantial retirement lifestyle, they inflict a different type of discomfort.
Global Risk Party and Maximum Diversification
One way investors can make their portfolio more resilient to an uncertain future is to consider more comprehensive diversification strategies. Many investors would be surprised to learn that typical “balanced” portfolios composed of 60% stocks and 40% bonds actually derive over 90% of their risk from equities. This is because equities are so much more volatile than stocks. Even worse, equities only produce positive returns during periods of persistent positive growth shocks, benign inflation and abundant liquidity. While these conditions have prevailed in most years over the past few decades, there have been notable exceptions. In addition to the acute crisis periods like 2000-2002 and 2008, which many investors lived through personally, both equity and bond markets suffered through a 16-year period of low growth and high inflation from 1966 through 1982.
Figure 1 puts the idea of extreme diversification in context, by illustrating how various global asset classes would be expected to react to the economic effects of growth and inflation. Investors who do not feel qualified to forecast future economic environments might be well served by allocating to all of these asset classes so that they have the opportunity to profit however the future evolves. Of course, the asset classes in Figure 1 have very different risks, and complex relationships with one another.
The portfolio that maximizes the opportunity for diversification across these diverse assets is called the Global Risk Parity portfolio.
Figure 1. Asset class responses to the four major economic environments.
Source: ReSolve Asset Management