“Begin With the End in Mind”

                                                                                                                                              Stephen R. Covey, Author

Although, Stephen Covey was not referring to investments when he assigned this declaration as Habit #2 in his book, “The 7 Habits of Highly Effective People”, it seems applicable to the anticipatory nature of portfolio management. “The ability to envision in your mind what you cannot at present see with your eyes” is, in essence, the forecasting aspect of managing a portfolio. It is all well and good to analyze current economic data points and review corporate reports; however, the foresight to set personal goals and keep those ends in mind can be complicated when barraged with short-term prognostications. Our subconscious friends, fear and greed, also add fuel to the fire in conflicting directions.

So, we pose the question of goals to all of our prospects and clients, and encourage every individual investor to do the same. Often there are different “pots” of money – one for retirement, one for education expenses for children or grandchildren and so on. Different goals have varying time frames, longevity needs and risk parameters. As markets adjust to economic conditions, geopolitical issues and corporate activities, whether bull or bear, history details the importance of portfolio asset allocation. Your specific “end” or objectives for your funds should be one of the overlays in this decision process and should be reevaluated annually. For those of us that have been in the business longer than we care to mention, we have had the opportunity to work with clients from the beginning of wealth creation to retirement. Over that time, portfolios were monitored and adjusted for their changing life stages. Because of the importance of diversification and inter-asset correlations, allocation decisions should consider domestic and international securities, and risk assets versus less risky assets, such as cash, U.S. Government Obligations, investment grade corporates and municipals. Note that high-yield (or junk) bonds are included in the riskier category since over time they have been shown to have a greater correlation with equities than higher quality fixed income securities do. Other higher volatility assets in the riskier mix are commodities, real estate and currencies.

An individual whom is investing for a planned retirement years in the future, most likely looks to growth of capital as a primary objective within their risk tolerance.  Retirees often have a different objective as they may no longer be adding to their total pool of funds and depend on a stream of income going forward. How many years is ultimately an unknown variable, even with the assistance of actuaries.  Preservation of capital is, in the long run, the primary “end”, as no income can be generated from zero funds; however, it may be easy to lose sight of this in the search for income in a low yield environment. We have been in a historically low yield environment for years now, although some of us can still (vaguely) remember ten-year Treasury yields of over 10%.

Initially, after the last (and great) recession ended some marginal firms and their securities were washed out of the financial markets. As the economy improved, yields declined, but most corporate balance sheets and the economy were stronger. The trade-off was good. In mid- 2007, US Treasury ten-year notes were yielding around 5%, not bad for a “risk-free” return. By the end of 2010, the yield was down to less than 3.5% – less income, but still decent plus capital appreciation. Currently, the US Treasury ten-year yield is hovering around 1.60% and with inflation (so far this year) in the 1% camp – investors are not seeing much in the way of net income from this fixed income portfolio component. Not a surprise then, that corporate bonds are playing a greater role in income portfolios, as are dividend stocks.

For many retirees, and investors with a lower risk tolerance, understanding risk differentials is even more essential. There is of course, a risk disparity overall between stocks and bonds, but taking that to the next level, requires decision-making on high yield bonds and stocks as compared to the typically stronger, more credit-worthy companies. This is of even greater importance in a slow growth, no growth, or recessionary scenario. As an example, Standard and Poor’s has a few dividend indices, the S&P High Yield Dividend Aristocrats has a ten-year standard deviation of 15.27% (a measure of volatility), comparable to that of the S&P 500 index of 15.24%. Investors that are looking to stabilize total portfolio returns by buying high yielding dividend stocks need to take this into consideration when analyzing their portfolio’s risk parameters. Although dividends typically provide stable and hopefully growing income, just like bonds – it is important to analyze the underlying company and its balance sheet. The same holds true for Exchange Traded Funds (ETFs), the S&P 500 Dividend Aristocrats Index, for example, has lower volatility, 14.07% standard deviation and a higher ten-year risk adjusted return (0.75 versus 0.56 for the high yield ETF). Furthermore, higher-yielding stocks, and bonds for that matter, are often found in the same economic sectors and there may be a corresponding increase in volatility due to these concentrations.

There are a multitude of variables to consider when allocating investment funds, and aligning the process with a “begin with the end in mind” approach.  Once you have a stated goal, objectively analyze your risk tolerance and create an asset allocation target. Active investment requires the constant monitoring of allocation in relation to the world economy, asset class valuations and expected returns. Consider whether there is a place in your portfolio for international securities. Currently, the US equity markets appear at the least, fully valued in relation to earnings, and some international markets appear undervalued in comparison. Country risk and currency risk are other factors to deliberate on. For now, most international fixed income securities will provide even less income than domestic bonds unless you have a substantial risk tolerance. Negative and minimal interest rates internationally have led those investors to look to the U.S for income. In addition to slower domestic growth, demand from abroad has also contributed to the appreciation of US government bond prices.

Drilling down, into asset categories, correlations between cash, domestic stocks, international stocks, bond classes, commodities and real estate are inputs in diversification strategies.  Asset correlations describe the historical price movements of one class of assets relative to another class.  Keep in mind that correlations between asset classes can, and do change depending on the time period that is being considered and the timing of data gathering during the time frame. A 2014 Morningstar correlation matrix shows that although you will not get a return on cash (to speak of), it does have negative to low correlation with other assets. U.S. stocks and foreign industrialized markets’ stocks have a correlation of 0.5 to 0.6.  As touched on previously, U.S. investment grade bonds have a low positive correlation to our equity markets, whereas domestic high-yield corporates have an over 50% correlation.

And finally, as we have stated many times before, once you have evaluated the big picture, it’s time to inspect from the bottom up. Whether it be individual issues, ETFs or closed-end mutual funds, it is imperative to do your research.

 

Margarita V. Fernandez

Vice President – Alhambra Investment Partners, LLC

 “Wealth preservation and accumulation through thoughtful investing.”

 

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Margie Fernandez can be reached at:

 305-233-3774

mfernandez@4kb.d43.myftpupload.com