With continued economic and political uncertainty, how do we convince our clients to stay the course? Ongoing communication is critical. Here is an excerpt of what I sent to my clients with their third quarter reports:
I hope that this letter finds you and your families doing well and that you enjoyed your summer.
I’m starting to sound like a broken record when I say that this past quarter was once again marked by volatility and that news out of Washington was the root of much of that uncertainty. This past quarter was a period affected by debt-ceiling concerns, squabbling in Congress and a bond market hinged on announcements from the Fed. Despite some rather significant swings in the market around those headlines, the equity markets were a bright spot over the last three months.
I feel it’s a good time to mention, as I’m sure you’ve heard me discuss in the past, the importance of proper diversification. Diversification helps take the guesswork out of investing, since we never know which markets will outperform from year to year. The chart below illustrates the unpredictability of returns by plotting annual returns (%) of various asset classes from 1998 – 2012:
The returns we’ve seen recently are no different from the randomness depicted above. Investors previously swarmed to emerging markets stocks when they were riding high, but so far they’ve been rewarded with negative returns this year. US REITs out-performed domestic stocks of all sizes from 2009 through 2012, but now that trend has reversed itself. We don’t know what the patchwork quilt of returns will look like in the future, but by holding a globally diversified portfolio, you are positioned to capture returns wherever they occur.
Another benefit of diversification is that you may improve your risk adjusted return by adding additional asset classes that are less correlated to each other. As you can see in the chart below, the addition of multiple asset classes to a sample portfolio helped increase returns while dampening the overall volatility (i.e. producing a lower standard deviation), over an identical time period.
Sometimes it can be tempting to deviate from a disciplined diversified asset allocation strategy, especially when certain asset classes are underperforming others. It can be uncomfortable checking your account statement only to see that one asset class has lost money while another is riding high. While it may feel good to move your money to something that’s doing well, that is the quickest way to lock in a loss in the pursuit of performance. It’s important to not follow your emotions and instead remain disciplined.
This has been particularly challenging this year as we’ve watched bond prices fluctuate. It may be helpful to keep in mind that even if a bond price is down, the bond itself will still continue to pay interest and the full principal amount will be paid out when the bond comes due at the end of the contract. The only way that a lower price will cause an actual loss of principal is if it is sold and the lower value is locked in - even if interest rates increase. In order to lessen the potential volatility in your bond portfolio, we avoid holding longer-term bond funds, which tend to be more volatile and more sensitive to interest rate changes, and instead hold shorter-to-intermediate term bond funds, which tend to fluctuate less. Bond fund managers can also take advantage of rising interest rates by buying higher yielding bonds as the shorter-term bonds mature.
The market rarely moves in a straight line and portfolios are divided among the different asset classes to cushion the ride. An informed investor will keep in mind that the various sections of their portfolios will move in different directions but to not use the returns of one portion to judge another.
As always, please remember to reach out to us if there are any changes in your financial situation. If you have any questions about your accounts or investment strategy, please don’t hesitate to call or email me or any member of my team.
Sheryl Rowling, CPA/PFS