Don’t Set It and Forget It—Monitor Your Portfolio

Doctors pockets with medical instruments.

I recently had a terrific experience at my doctor’s office. After my annual physical, the receptionist said, “There’s no charge for today’s visit. Your insurance covered 100% of the cost.” While my insurance is reasonably good, there are usually payments involved for most things. As I pondered why it would fully cover this bill—a preventive exam—I realized that the insurance company is happy to invest in monitoring my health, because ultimately it helps their bottom line.

The same goes for your financial health. It’s important to assess your goals—both the amount of return you need and the risk you can tolerate. But once that exercise is completed, investing should not be a “set it and forget it” exercise. Planning for life’s events can often have us looking far into the future, but markets can change quickly, so it’s important to regularly check in with your own plan. In other words, while it’s important to keep your eye on the horizon, it’s also critical to properly navigate the journey getting there.

Has anything changed?

This is the first question my doctor asks me at every annual physical. Being relatively healthy, I know he’s looking for early signs that my condition may be headed in the wrong direction. While I’m never happy when he points out that I’ve gained weight since last year, I know that this process is critical to my overall health. What I want to hear does not always align with what I need to hear.

Performing a similar exercise on your portfolio is also critical. Reviewing your portfolio when markets are up can be quite fun, while conducting that same review while markets are falling might be painful.

Here are a few questions to ask at least once a year about your portfolio:

  1. Have your objectives changed? Is there something new you are now planning for? Has your time horizon changed? If so, you’ll likely need to adjust your portfolio.
  2. How have your views of the market changed? Different investments come in and out of favor, and your portfolio should reflect that. However, this is not an invitation to bet everything on a hot investment, let a winner run for too long without trimming it, or go to cash if you’re scared. A proper asset allocation will give you the best chances for the success of your long-term plan, so unless your time horizon or required return have changed dramatically, you are best off tweaking around the edges, provided the portfolio was properly constructed.
  3. Is anything you own not working? Monitoring your holdings must always be done with perspective. Some investments should provide growth. Since not everything is meant to increase in price at the same time, some laggards may have justification. However, if none can be found, then it could be time to remove it. Conversely, some investments should help reduce risk. Our expectations for these holdings should be different, but no less important.

What if something happens?

Portfolios should evolve as circumstances change. Through disciplined monitoring and measuring of a portfolio against its benchmark, mismatches can be identified and remedied. In particular, regular portfolio stress-testing can help us learn a lot. Just like my doctor would ask me to run on a treadmill to test for any abnormal reaction in my heart rate, stress testing a portfolio can reveal scenarios that might elicit a dramatic response, helping us prepare for a variety of market events.

Stress testing can also help keep you from making inappropriate moves as market volatility changes. When markets are volatile, investors tend to grow more risk averse. The opposite is also true—when markets are calm, investors tend to take on more risk. In other words, if managing against a large drawdown is the key to keeping you invested at stressful moments, building the portfolio with an intentional awareness of how it would behave should we have a recession (as an example) may be the key to keeping the portfolio invested, and your investment plan on track.

Constant evaluation

More than just a step, monitoring permeates the entire portfolio construction process. It gives you the ability to evaluate results during the journey, ask questions about the portfolio’s recent behavior within context of the markets’ recent returns, and ensure the portfolio’s alignment with the return target you established at the outset.

The process of constructing a portfolio is more complex than ever. Investors need the right tools, technology, resources, products and, most importantly, insights to achieve their investment goals. The portfolio construction process can be time consuming and confusing. In the same way I look to my doctor to help keep me healthy, working with a financial professional can also bring objectivity and expertise to the process, which our research shows can help investors feel more confident and better prepared for their financial future.

While it’s natural to focus on the horizon—your long-term goals—it’s always important to remember that the journey is never a straight line. Regularly monitoring your financial health is essential to your success.

Patrick Nolan is the Portfolio Strategist within BlackRock’s Portfolio Solutions group. He is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of October 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

A Song of Ice and Fire: Portfolio Hedging Edition

Mountains 2

With the S&P 500 at another new high and volatility beaten into a state of permanent submission, it seems churlish to discuss preparing for a downturn using hedges and downside protection. That said, while the market rally can continue, it is worth pausing to contemplate how surreal things are getting.

For example, the Sharpe ratio, which measures units of excess return per unity of volatility, is used by professional investors to calculate risk-adjusted returns. Currently, the one-year Sharpe Ratio on the S&P 500 is comfortably above 2, a remarkably high number. Not only is the market producing stellar returns, those returns are coming with virtually no volatility.

With that in mind, and with respect to those who prefer to do their holiday shopping in midsummer, maybe it isn’t too early to start thinking about positioning for the next downturn. The challenge for asset allocators is that when insulating a portfolio, the source of the downturn is as important as the magnitude.

Growth or interest rate shocks

While it is impossible to quantify all the ways things can go wrong, broadly speaking, most corrections fall into one of two broad categories: growth or interest rate shocks. The former describes any event that calls into question economic growth. The latter encompasses periods when investors are facing an unexpected rise in interest rates, either due to an unexpected pickup in inflation or a change in central bank behavior.

Whether an equity market downturn is caused by a growth or rate shock is a crucial distinction. To illustrate, consider a long-term portfolio targeting a 9% risk level. Now assume a shock that causes stocks to underperform bonds by 10%. Consider this the growth shock, as we assume no change in long-term bond returns.

Analysis of this scenario suggests a few conclusions. The obvious changes: Own less stocks, and of the stocks you do own, opt for lower volatility names. You could also theoretically sell credit and raise a bit of cash. The funds from lower equity, credit and cash would be reallocated to long duration bonds, the preferred post-crisis hedge against equity risk.

Now change the scenario. Using the same methodology consider what happens if stocks are selling off because bonds are underperforming, something that has rarely happened in the post crisis environment.

Under this scenario the portfolio rebalance looks very different. To start, you would want to consider lowering your equity allocation even further than in the first example. The reason is that when rates rise, low volatility stocks are often the worst place to hide. Another difference would be raising the allocation to high yield bonds, which are less rate-sensitive than traditional bonds.

The cash factor

However, the big change in the allocation involves cash. In the first instance bonds are the hedge. You even reduce cash to buy more bonds. In the second scenario bonds work against you, so you want to sell both stocks and bonds, using the proceeds to dramatically raise your cash position.

Allocation Scenarios

Both growth and rate shocks can produce stock market corrections; what changes is the prescription. The typical post-crisis correction has been driven by a growth scare. But that is not always the case. If the next correction comes from twitchy central banks, running to bonds is counterproductive.

The bottom line is that nervous investors, assuming there are any left, are faced with two decisions: When will the bull market hit a speed bump and, equally important, why?

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of October 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Putting Risk on a Budget

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Investment risk is one of those things that’s not very easy to describe—no less budget for. This may well be keeping investors from making the most productive use of their assets.

Indeed, findings from BlackRock’s Global Investor Pulse survey reveal that one-third of advised U.S. respondents feel certain they would invest more if they had a better understanding of the risk levels in their portfolios. Another third would possibly invest more with a better understanding of these risks.

Our work with financial advisors reveals that defining and keeping risk on a budget isn’t easy. We generally see two different approaches to portfolio construction aimed at improving the experience of the markets: 1) Achieve a return similar to your benchmark but with less total risk, or 2) generate a higher return than the benchmark, but at the same risk level. Of the first set, only 35% of the portfolios we surveyed met the stated risk goal; in the second set, 53% met their risk target.

Risk Budgeting

Investors are not intentionally building portfolios that miss their risk benchmarks. Many of the products used in building portfolios today have simply become more volatile than the market itself.

Consider that, 10 and 20 years ago, less than half of broad equity funds were riskier than the S&P 500 Index of large-cap U.S. stocks, according to data from Morningstar. Today, the number is 75%—markedly higher than the historical precedent.

Rationalizing risk

What’s an investor to do in this environment? We recommend keeping a few things in mind as you seek to understand and budget risk:

Keep it real

The framing of risk can make all the difference. Consider that a $100,000 investment in an asset with an annualized level of volatility of 10% could easily undergo a drawdown of $10,000 in any given year. The question isn’t whether 10% volatility feels OK to you. It’s: “Can I bear a loss of $10,000 in value at any moment in time?” If the answer is no, you likely need to consider more conservative options or balancing that asset with a less volatile investment.

Diversify risks, not just asset classes

Just because we call a security a stock or a bond doesn’t mean it will always act like one. Case in point: High-yielding stocks can sometimes serve as bond proxies, and lose value when rates rise. It’s important to look beyond the labels to understand the risk drivers behind each asset you’re choosing. The goal, for example, is to understand the amount of equity risk you have—not simply the amount of equities you own. Only then can you truly diversify your portfolio.

Don’t assume recent history will repeat

Measuring the risk associated with past returns will not always paint a complete and accurate picture. The S&P 500 Index has demonstrated annual volatility below 11% in four of the past five years. The historical norm observed over the prior four decades was 15%. So which is right? There are no crystal balls in investing, but working with an experienced advisor and an investment manager with expertise in the strategy you’re pursuing can bestow valuable perspective.

Know the risks you’re taking

And the more risks you understand, the better. BlackRock has identified over 2,200 unique risk factors, and has a powerful system to measure any given portfolio’s sensitivities to different types of stress scenarios. Our risk-management technology analyzes the ongoing relationships between millions of tradable securities around the globe, giving our investors access to a vast amount of risk intelligence.

Contemplating risk on these dimensions can help ensure the risks you’re taking are deliberate, diversified and appropriately scaled. And putting your portfolio on a risk budget can not only help you stay away from danger zones along the journey toward your long-term investing goals, but can also help you to better navigate the emotions that go along with investing—no matter how you define “risk.”

Patrick Nolan is the Portfolio Strategist within BlackRock’s Portfolio Solutions group. He is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of July 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Should You Be Afraid of a Stock Market Crash?

Bear Markets

US stocks have been on a tear over the past 6 years, with the S&P 500 index of large US stocks returning over 200% since its nadir in March 2009. Such a lengthy bull market can lead to concern about when it will inevitably end; after all, stock markets tend not to rise forever. But if such fear leads you to hoard cash rather than invest it, you’re likely making a mistake, particularly if you have a long time horizon for your portfolio.

To see why such fear is mistaken, let’s take an example where you invested $1,000 in the S&P 500 index at the start of each calendar year. Even in an extreme situation where your timing was abysmal and you began making these investments near the starts of the worst stock market downturns in history, after suffering some sizable early losses you’d still be in positive territory within a few years.

The worst of these downturns was during the Great Depression. Even if you began in 1929—the beginning of an epically nasty bear market where US stocks lost 2/3 of their value of from the start of 1929 through the end of 1932—you’d have more money than you put in within 7 years. In less prolonged slumps the recovery would take far less time: if you started in 2008, you’d be back in the black by the end of 2009.

These results suggest that for investors with a long time horizon, the downside of even a worst-case scenario isn’t that dire. Having a more diversified portfolio containing other asset classes in addition to US stocks could reduce risk even more.

By contrast, there’s plenty of peril in holding too much cash. The “what goes up must eventually come down” logic can be applied at almost any point during any bull market, so using it will almost certainly cause you to miss extended periods when markets perform well. In fact, stock markets reaching new highs are generally a sign of a protracted bull market rather than an imminent collapse. Unless you’re able to time the market with far more precision than financial professionals can, keeping your money in cash rather than investing it is likely to result in a smaller portfolio over time.

How to Think Like a Long-Term Investor

Road

For investors concerned about what will affect the long-term growth of their portfolio, it can be difficult to focus on the right issues. Most financial news stories are produced for traders and others in the financial industry who are interested in daily market movements. After all, their paychecks can depend on what goes up and what goes down. But for long-term investors, the implications of what’s happening can be very different. Here are a few interesting—and perhaps counter-intuitive—ideas for long-term investors to keep in mind amid the din of financial markets:

1) Low valuations can be good. It’s nice to have a bigger portfolio, so it feels good when the values of your investments go up. But if you’re building up your nest egg, you actually want prices to be cheap so your money goes farther. You’ll end up getting the best outcome if valuations are low during the “accumulation phase” of your life when you’re buying investments and high during the “spending” phase of your life when you’re selling investments.

2) Volatility isn’t necessarily bad. The up and down movements of financial markets can be gut-wrenching. But if you’re making periodic investments over time, such as putting a portion of each paycheck into a retirement account, there can sometimes be a bright side to volatility. Since your money buys more shares when the market is lower than when the market is higher, the ups and downs may result in a larger portfolio over time than if the market had been flat. This phenomenon is similar to the idea behind dollar-cost averaging.

3) Standard deviation may be the wrong measure of risk. The riskiness of investments (or even entire portfolios) is often described using “annualized standard deviations,” which are statistical measures that can be used to estimate the range of possible outcomes for a 1-year period. But even assuming that these estimates are accurate, using them to estimate potential outcomes over longer periods of time typically means assuming that what happens in one year doesn’t affect what happens in subsequent years. In the real world this assumption isn’t true, so these kinds of estimates may overstate or understate how much risk you’re actually taking.

Reacting to a Stock Market Decline

S&P 500 Index Declines

The last month has been a rough one for the stock market. The S&P 500 index of large US stocks has fallen by more than 7% in the last four weeks (as of the end of the day on October 16th), and many international stock markets have fared even worse. Such a sizable decline can be painful, especially since stocks in general have done so well since the end of the global financial crisis in 2009. But sticking to your long-term strategy, rather than panicking and trying to change things up in response, is (as usual) probably the right way to react.

Put in a broader historical context, it’s clear that the recent market decline isn’t too unusual. In fact it’s rare when there’s a year when the stock market doesn’t fall at least 7% in a four-week period. Such a decline occurred for the S&P 500 index in 2012, multiple times in 2011 (remember the debt ceiling crisis?), multiple times in 2010, and multiple times in 2009.

Panicking during any of these declines may have seemed reasonable at the time, but reducing your exposure to the stock market would have resulted in missing out on some of the gains during the bull market that’s lasted more than 5 years. Even after its recent decline the S&P 500 index is more than 170% above its March 2009 low.

That’s not to say that markets always surge following a moderate decline: in 2007 (shortly before the worst of the financial crisis) and in the late 1990’s (shortly before the bursting of the tech bubble), stocks continued to fall for an extended period of time rather than bouncing back up. But the overall historical record suggests that a moderate drop in the stock market is not a good reason to panic.

How to Determine the Right Amount of Risk

Risk Level

We recently discussed the importance of sticking to a set risk level. But what should that risk level be? Since more risk can result in larger potential gains but also larger potential losses, correctly answering this question is one of the most important parts of successfully managing your wealth.

There are two key factors that should determine your risk level. The first is how much risk you are able to take. The second is how much risk you are comfortable taking. While these two ideas sound similar, they can often be very different.

How much risk you are able to take depends the details of your financial goal. You can take a lot more risk if you don’t need the money for 40 years than if you need the money in the next few years. You can take a lot more risk if the amount of money you need for your goal is somewhat flexible rather than a fixed amount. And you can take a lot more risk if your goal is something that would be “nice to have” (like a nice yacht) rather than something you consider absolutely necessary (perhaps a child’s education).

How much risk you are comfortable taking depends on how you react to the ups and downs of financial markets. If you can handle sizable drops in your wealth without losing sleep, you can take on more risk than if every market dip caused you to panic.

So when these two factors don’t align, which one should determine your risk level? The answer is whichever one suggests a lower amount of risk. If you’re not comfortable taking much risk for one of your goals, for example, it doesn’t really matter how much risk you’re potentially able to take: you shouldn’t lose sleep over your investments just because you “can”. Conversely even if you’re comfortable with a high amount of risk, if you need the money in the near future your risk level should probably be fairly low.

Sticking to a Set Risk Level

Money Tightrope

When the stock market is rising—as it has been for much of the past 5 years—it’s common to think that you should be taking more risk with your investments. When the stock market goes down, it’s common to think the opposite. But constantly shifting around the amount of risk you’re taking in response to how financial markets are doing is a recipe for poor long term performance. A better idea is to take a longer-term view of the risk you want for your portfolio and stick to that risk level.

There are two main problems with constantly shifting around how much risk you’re taking. One is that it’s very difficult to do successfully. It’s natural after markets have rallied to regret not having taken more risk. But the better time to take more risk would have been before the market went up, not after. Increasing the risk of your portfolio after markets have gone up simply puts you in a position for larger losses when the markets reverse course.

A second problem with shifting your portfolio’s risk in response to what markets are doing is that your portfolio can easily become disconnected from your real-world financial goals. If you’re investing money that you plan to use in the near future, it may be a good idea to take less risk to ensure that your portfolio won’t lose a large amount of its value shortly before you need the money. Remembering this may be more difficult when you’re constantly shifting around your portfolio’s risk level. If your financial goal has a short time horizon and you happen to take on more risk right before markets decline, you put yourself in danger of not being able to reach your goal.

Understanding Diversification

Pie Chart

Having a diversified portfolio is one of the keys to successfully managing your wealth. But while the idea of diversification may seem simple—putting all your eggs in one basket generally isn’t a good idea—it’s often misunderstood.

Simply having a lot of different investments doesn’t necessarily mean you have a diversified portfolio. Having a large number of stocks that are all in the same sector of the market—a lot of technology stocks, for example—doesn’t offer much diversification: if something happens to that sector, all of the stocks could decline at the same time.

Even having a large number of funds (which offer more diversification than individual stocks or bonds) doesn’t guarantee you’ll have a well-diversified portfolio. If all the funds have similar characteristics, they’re likely to all rise and fall at the same time. In other words, even if your eggs are in different baskets, it won’t do you much good if the baskets are all tied together.

So if the raw number of different investments doesn’t matter, what does? The goal of diversification is to lower the overall risk of a portfolio by putting together different investments that don’t all go up or down at the same time. A well-diversified portfolio will therefore have a mix of different asset classes, different stock sectors, different bond sectors, and different regions of the world. A portfolio that’s too concentrated along any one of these dimensions is not well-diversified, no matter how many individual investments in contains.

Avoiding the Low Volatility Trap

Stock market volatility—how much the market goes up and down on a daily basis—has recently been unusually low. Since July of last year the S&P 500 index of large US stocks has gone either up or down by more than 1% on only about 12% of trading days, compared to a historical average of more than 20%.

Stock Market Volatility

Such low volatility isn’t necessarily good or bad, although most investors probably appreciate not having the value of their wealth swing wildly on a day-to-day basis. But low volatility can also trick investors into making bad decisions that damage their long-term performance.

One cause of these bad decisions is regret. Low volatility typically occurs as markets rise: the recent tranquility has occurred in the middle of an almost 40% rise in the S&P 500 index since the start of 2013. When these kinds of bull markets occur, a natural tendency is to wish you had allocated more of your portfolio to stocks.

The effect of regret is compounded by recency bias, the tendency for people to predict what’s going to happen in the future based on what’s happened in the recent past. During periods of low stock market volatility, it can be easy to forget that stocks often move up and down quite a bit (at the nadir of the financial crisis in late 2008 US stocks rose or fell by more than 5% in a single day numerous times).

Regret and recency bias are normal, so it’s not always easy to fight them off. The result can be a low-volatility trap, where calm markets lull you into taking too much risk. The key to avoiding this fate is to honestly assess your willingness and ability to take risk, and then stick to a long-term strategy aligned with that risk tolerance. Sticking to your strategy may not always be easy, but it will increase your chances of achieving your long-term financial goals.