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The Risky Business of Stability

Andrew Dickens

The Risky Business of Stability

» Article by Andrew Dickens Director of Pension Services and Wealth Advisor | May 5, 2018

We’ve had a remarkable recovery since the Great Recession of 2008 and 2009. The markets have been on a bull run for over nine years now.

The Dow Jones has had it’s longest and most significant recovery since World War II. The S&P 500 is likewise having its second longest and largest recovery since the technology rally of the nineties.

The equities market is only half of the equation when it comes to most investor portfolios. The fixed income (or bond) market saw yields bottom out during the recession and early recovery, This benefited clients’ fixed income portfolios as equities markets were declining or just beginning to recover.

A recent tightening of the monetary policy from the Federal Reserve has led to a flattening of the yield curve. Investors are likely to see a drag on their fixed income performance because bond prices move inversely with yields, and yields are expected to continue to climb in the near future.

While equities are known to be “riskier” investments, with better return potential than comparable investments, the fixed income allocation of a portfolio is considered the “safe” portion.

Investment Risk

However, this is not always the case and sometimes prevailing economic conditions give rise to situations where the fixed income side of the portfolio will suffer from price drag until prevailing interest rates stabilize.

At Summit, we manage risk in the fixed income portfolio in many ways, including using shorter duration income and non-correlated instruments.

While these strategies are effective in overcoming these shorter-term risks, they introduce longer-term risks if subsequent market cycles take abnormally long to develop.

Investors who are in the distribution phase, or “distributors,” are especially susceptible to volatility in both equity and fixed income allocations.

The distribution phase refers to investors who are taking periodic withdrawals from a portfolio to supplement income in retirement. Due to this fact, distributors must periodically sell investments to produce the cash needed to distribute.

Selling investments that have produced gains are desirable to capitalize on those gains and, when reinvesting, to rebalance the portfolio. However, selling investments at a loss are capitalizing those losses because that distributed cash will never be able to participate in the subsequent recovery.

Unfortunately, we can’t always control when we need to take withdrawals, but there are many different options available for investors to defray sequence risk.

One of the most effective we’ve found is for investors to consider shifting some of their fixed-income allocations into a defensive strategy with a focus on stability and principal protection. This defensive option has the effect of insulating against fixed income losses during rising interest rate environment.

For a typical investor currently invested in 60% equities, 40% fixed income, considering a move of just 20% of their portfolio to a defensive strategy for the fixed income portion of the portfolio can reduce overall portfolio risk, by providing a bucket of assets to tap for withdrawals that is principal protected.

When we need to take a portion of our portfolio as income, and we don’t have many good options to choose from, a defensive choice that has not been subject to the same daily fluctuations can provide that income without subjecting us to capitalizing losses in a down market.

As your financial advisors, we manage risk and volatility for our clients in many ways:

  1. Knowing your portfolio performance requirements per your long-term financial planning needs
  2. Understanding your risk tolerance and allocating accordingly
  3. Systematically re-balancing
  4. Using cash reserves for short-term income needs
  5. Utilizing alternative, defensive strategies for income bucketing and as a hedge against fixed income volatility

We know that each client’s situation is unique and risk tolerance can change over time, so it’s important to be open to your advisor about this so we can reexamine your tolerance for risk more thoroughly.

In the next article, I’ll discuss how using a stable, principal protected asset allocation for a portion of your portfolio can also help mitigate another type of risk, known as sequence risk, which is especially important for distributors as well as accumulation investors who are approaching retirement.