Is Your Retirement Portfolio All-Weather?
Checking up on these five risk factors can help ensure you're not casting your lot with a single outcome.
Our early summer weather in Chicago has been running to extremes. We've had stretches of what feels like August--hot and muggy, punctuated by periods of monsoon-like rain. But there have also been spells of below-average temperatures that have had everyone griping, "Summer? What summer?"
The market environment has felt even more changeable than usual, too: While stocks started 2018 on a strong note, they limped through the early spring, recovered in May, then flatlined again last month due to trade-related worries.
Market sentiment seems to be teetering between major--and basically opposing--scenarios. If economic growth remains robust, that could spark inflation and/or prompt the Federal Reserve to take an even more aggressive tack on interest rates than it has already outlined. Such a scenario would continue to weigh on bond prices and could have a negative effect on stocks, too.
Lately, however, it seems that market participants are contemplating the opposite possibility--slowing economic growth and perhaps even a recession. The yield curve is currently flat, meaning that long-term bonds are yielding no more than shorter-term ones. The fact that investors aren't demanding any extra recompense for owning long-term bonds indicates they believe inflation--and in turn interest rates--will remain low. Historically, an inverted yield curve (a step beyond today's flat yield curve)--when investors are demanding a higher yield from short-term bonds than they are from long-term--has been a harbinger of economic weakness to come.
Of course, no one knows which of those two scenarios will play out. It's also entirely possible that neither will, exactly; there's always the risk of some type of heretofore-uncontemplated market shock. That underscores the case for building an all-weather portfolio--one that can withstand rising interest rates and inflation, as well as slack economic growth and even recession. The downside of taking a diversified tack is that it will be a rare market environment when your portfolio is firing on all cylinders; you'll inevitably own some laggard holdings at any given point in time. But nor will you run the risk that all of your holdings will fall simultaneously.
As you think about weather-proofing your retirement portfolio, here are some of the key risks to guard against.
Interest-rate jitters have been top of mind for investors for almost a decade. As the Fed's zero interest-rate policy lifted the economy and, in turn, riskier assets, investors assumed that higher rates would soon follow. It took a while, but higher rates have begun to materialize: The Fed has raised rates twice so far in 2018, and has indicated that two additional rate hikes are in the offing. Those rate increases have put pressure on bond prices: The typical intermediate-term bond fund has lost 1.6% for the year to date through the end of June, and long-term bond funds have lost nearly 4%.
If you're concerned about your bond holdings experiencing losses in a period of sustained rising rates, run them through this duration stress test; make sure that you're not taking more risk than you can afford to. Also be sure to match your bond holdings to your spending horizon. If you have a very near-term spending horizon, cash is your best option, and yields are starting to look much more attractive. If you have a long time horizon until you'll need to crack into your bond holding--say, 10 years--you can afford to take a lot of risk, venturing into lower-quality and more specialized bond types, such as emerging markets bonds. If your time horizon falls somewhere in between, high-quality short- and intermediate-term bond funds will likely provide higher returns than cash over your holding period without the extreme volatility that accompanies long-term or lower-quality bonds.
As you assess your portfolio's interest-rate sensitivity today, also take a look at your equity holdings. Equity investments that are prized in large part for their yields, such as REITs and utilities, can experience price drops in periods of rising interest rates. Even if you're an income-centric equity-investor, that risk factor argues for holding a complement of nondividend payers, too.
This risk factor goes hand-in-hand with concerns over interest rates. Inflation isn't generally a big deal for portfolios with high equity weightings; over long periods of time, stocks will usually deliver a return that's comfortably above inflation, and when inflation is on the move, stocks are often trending up, too. But inflation risk looms large for portfolios with sizable allocations to bonds. Because bonds' income is what it is, regardless of inflation, it will buy less and less if the costs of goods and services trend up. Thus, bond-heavy investors should work hard to ensure that their portfolios include ample exposure to investments with the ability to keep up with, if not out-earn inflation, including stocks and Treasury Inflation-Protected Securities, which have a built-in hedge against inflation. This article details some of Morningstar's favorite inflation-fighting investments for retirees.
This risk factor has only recently been getting attention, thanks to the aforementioned flattening of the yield curve. Under such a scenario, economically sensitive equities such as basic materials, energy, retailing, and industrial stocks often struggle. Morningstar's X-Ray tool can help you see how your equity portfolio is arrayed across various sectors, and you can also check your exposure to the three major "supersectors"--cyclical, economically sensitive, and defensive--relative to the S&P 500. Your sector and supersector exposures don't have to be in lockstep with the index's, but make sure you're not making any big, inadvertent bets.
High-quality bonds would typically perform pretty well in a weakening economy or recessionary environment, as interest rates would be likely to remain low. Indeed, such an environment is one of the main reasons to carve out fixed income exposure in your retirement portfolio. Lower-quality bonds, on the other hand, tend to be more in tune with the economy and the equity market; they're often issued by fragile companies whose fortunes dim when the economy softens.
Despite the long-running equity-market rally, stocks don't look terribly expensive to Morningstar's analysts today. But trees don't grow to the sky, so if you haven't checked your portfolio's asset allocation relative to your targets recently, it's a good time to do so. While you're poking around in Morningstar's X-Ray tool, also take a look at your portfolio's style exposures. Not only have equities had a tremendous run, but growth equities, in particular, have soared. Over the past five years, Morningstar's U.S. Growth Index has lapped its value counterpart, returning 17% on an annualized basis versus 11% for Morningstar's U.S. Value Index.
Rebalancing appreciated positions--like lightening up on growth equities right now--can achieve multiple goals in retirement. Not only can it reduce the risk in your portfolio, but it can also help you source your cash flows for the years ahead and achieve other goals, as discussed here.
Here's a risk factor that doesn't get discussed enough: The risk that you'll up-end your plan at an inopportune time. Perhaps you'll undermine your results by falling into the fear-greed cycle, for example. Such mistimed buying and selling can exact an even bigger toll than investment fees over time.
We're all wired differently as investors, so unfortunately there's no one-size-fits-all way to short-circuit behavioral risk factors. However, a few simple steps can help. First, follow Jack Bogle's advice and "don’t peek" at your portfolio or its value; assuming the plan you started with was reasonable, a policy of benign neglect will tend to beat one that's overly busy. In addition, creating an investment policy statement and a retirement policy statement to document your strategies can serve as additional safeguards against impulsive decision-making.