Keeping emotions under control is one of the most difficult aspects of investing. When stocks are rising, investors feel too smart for their own good and enter a state of euphoria. When stocks plunge, they often hold on in disbelief until they sell at the worst possible moment — the bottom. However, this emotional roller coaster can be slowed through proper allocation methods and realistic expectations.
Given the recent record-breaking year for all three major U.S. indexes, some investors might be tempted to throw caution to the wind and bet the farm on stocks soaring higher once again. The Dow Jones Industrial Average and S&P 500 both defied expectations in 2013 to post their best annual gain in more than a decade. Meanwhile, the Nasdaq returned to levels not seen since the dot-com bubble. Despite these impressive gains, investors should keep the bigger picture in mind.
“You need to be realistic about equity markets and the potential for returns,” says Joe Costigan, director of research at Bryn Mawr Trust, in a phone interview. “You certainly don’t want to get drawn into a false sense of security that we’re going to have 20 percent returns every year going forward, that’s an unrealistic expectation.”
Let’s take a look at three vital steps to protect your investments and maximize your asset allocation.
1. Match duration needs
Investors need to recognize and analyze their cash flow needs. If you need cash next year, you obviously don’t want to place cash in a long-duration asset like equities. The volatility in the stock market can interrupt your cash flow stream at any given moment, especially since we now have a market that tends to hang on to every word of the Federal Reserve. If you are concerned about a serious rebound in interest rates, long-term bonds are also a poor choice.
“It comes down to common sense,” says Costigan, who oversees $4 billion in assets. “If you are concerned about rising interest rates, then don’t buy something that has the potential to put you where you don’t want to be, like long-term bonds. If you know you’re going to need to spend money in a year or two, don’t put money in an asset class that puts you at risk. If you’re investing for the long run, at least have an opinion about what you think an investment will produce in terms of returns over your investment time horizon.”
2. Keep expectations real
The past few years have been extraordinary for the stock market, but investors need to make sure their long-term financial goals don’t depend on lofty expectations being sustained over a long period. Since the Dow Jones Industrial Average made its low of 6,470 on March 6, 2009, the index has rallied about 10,000 points. It has also managed to rally for five consecutive years to make fresh inflation-adjusted highs. The S&P 500, which also made its record low of 666.79 on March 6, 2009, has surged more than 170 percent over the same period.
As the chart below shows, this type of performance is not typical. Between 1926 and 2012, stocks have an average annual return of nearly 10 percent. However, inflation-adjusted returns are only 6.7 percent. Depending on your tax situation, stocks have returned 4.5 percent after taxes and inflation. Cash is the worst place to be over the long term, as it has returned only 0.5 percent after inflation and a negative 0.8 percent after taxes and inflation.
Bonds have returned 5.4 percent over the same period, but only 2.3 percent after inflation. Distorting the results even more, bond returns are skewed by their 30-year bull market that drove interest rates straight down to all-time lows.
Costigan cautions, “I think people who simply apply historic returns as they apply to fixed-income investments are going to be surprised.” He adds: “In terms of equity returns going forward, I think we’re entering a period where if interest rates do begin to rise, we will see below-average returns. The bold assumption is that interest rates at some point will go up.”
3. Diversify your assets
Even though volatility has been trending below average recently, the time-tested wisdom of diversification should not be ignored. Most investors, if not all, are unable to consistently predict which assets will outperform each year. Diversifying into different asset classes like stocks, bonds, real estate, and commodities can dampen volatility and reduce risk.
Target-date funds, which automatically reset an asset mix according to time frames, have become popular in employee-based retirement accounts, but investors should be careful about these one-stop shopping investment vehicles.
“I don’t like target-date funds that blindly use long-term historical returns to allocate people to long-term bond funds in an environment where you are unlikely to get paid for the risk you are bearing,” says Costigan. “The way they’re structured and the way their investment policies are written, I think some of their clients could potentially be bearing more risk than they realize. It’s an unusual moment, where you have unnaturally low interest rates. I would view bonds as bearing significantly more risk than they have historically, in terms of potential loss for principal.”
In regards to commodities, Costigan recommends that investors who want protection against inflation or the Federal Reserve buy the actual commodities themselves, or a related exchange-traded fund. Investors who want exposure to a commodity for other reasons should consider an income-producing operating business like a miner that has a connection with the underlying commodity.
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