Advice Into Action
Large market moves can significantly alter a portfolio’s risk/reward profile. That’s why we believe now may be a good time for investors to review their portfolios.
Tracie McMillion, CFA, Head of Global Asset Allocation Strategy
It has been more than 290 trading days (or about 14 months) since the S&P 500 Index experienced a decline of at least 3% and more than 2 years since there was a 10% correction in this index. Since 1988, the market has averaged a 3% pullback every 14 trading days. Given such an extended rally, investors’ equity allocations may have grown disproportionately large. If that is the case, then a correction may erase more of an investment portfolio’s value than investors may be expecting. We recommend investors be prepared for a potential pullback by holding a diversified portfolio and making sure that current allocations correspond with their original investment plan. It may be time to rebalance.
Strong performance in equity markets could have increased risk in your portfolio
The market is represented by the S&P 500 Index. Index returns reflect general market results, do not reflect actual portfolio returns or the experience of any investor, nor do they reflect the impact of any fees, expenses or taxes applicable to an actual investment. The S&P 500 Index is a market-capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.
Our outlook for the rest of 2018
What we expect
- Stock prices should continue to rise through 2018, although higher interest rates could be a near-term headwind.
- Modest inflation should gradually lift bond yields but weigh on bond prices.
- Notwithstanding the expected benefit to U.S. markets in 2018 from the new tax legislation, global diversification will likely be increasingly important as the U.S. moves further along in its economic recovery than international markets.
Actions to take now
- Evaluate how hypothetical portfolio allocations might have performed during past crisis events.
- Make sure your plan and current asset allocation are aligned with your risk and return expectations.
- Consider using excess cash to bring your current portfolio allocations into alignment with your plan’s targets.
2017 was a great year for global stocks. Bonds, public real estate, and many hedge funds also posted positive returns. Following an unusually broad-based market rally, the way a portfolio is allocated can shift dramatically, sometimes without the investor’s knowledge. As a result, we recommend investors regularly identify the risks in their portfolios in case of a market downturn. An evaluation of hypothetical historical investment performance is a good way to see how a portfolio allocation may have performed in past crisis events. A portfolio that has more risky assets like equities tends to rise more in positive markets and suffer greater losses in negative markets. The chart below shows that during certain historical crisis events, growth portfolios declined the most, income portfolios tended to decline the least, and growth and income portfolios experienced moderate declines.
Performance of model portfolios against historical events
Performance results for the model portfolios are hypothetical and for illustrative purposes only. The indices reflect the historical performance of the represented assets and assume the reinvestment of dividends and other distributions. An index is unmanaged and not available for direct investment. Index returns reflect general market results and do not reflect actual portfolio returns; the experience of any investor; or the impact of any fees, expenses, or taxes applicable to an actual investment. Hypothetical and past performance does not guarantee future results.
Keep in mind, there are difficulties in assessing hypothetical asset-class performance during certain crisis periods, in part, because these results do not represent actual trading and cannot completely account for the impact financial risk has on actual trading. In addition, any actual portfolio or account will invest in different economic conditions during periods with different volatility and in different securities than those incorporated in the hypothetical performance shown above. It is possible there are other scenarios or crisis events that could have resulted in heavier losses for a portfolio than those that occurred during the time periods shown. There is no guarantee any asset class will perform in a similar manner in the future. Please see the end of this report for the model portfolio compostions, definitions of the indices, and risks associated with the representative asset classes.
Consider rebalancing now to help manage risk
If you find your portfolio has shifted away from your desired asset allocation, we recommend you consider rebalancing. This means selling investments from allocations that have outgrown their targeted portion of your portfolio and using the proceeds to purchase investments that are underallocated in comparison with your target. For example, if a targeted 60% stock/40% bond portfolio is now at 75% stocks/25% bonds, you may want to sell stocks and buy bonds. While rebalancing might reduce your portfolio’s upside potential in the near term, it also can lessen the possible downside when a market correction occurs, potentially enhancing your longer-term returns (see chart below).
Rebalancing is advisable when there has been market activity like we’ve seen during the past few years. We recommend rebalancing at least annually as a standard practice to help manage risk and return on an ongoing basis.
Hypothetical benefits of diversification and rebalancing
Performance results for the Four Asset Group without private capital and the 60/40 portfolios are hypothetical and for illustrative purposes only. Hypothetical results do not represent actual trading. The indices reflect the historical performance of the represented assets and assume the reinvestment of dividends and other distributions. Index returns reflect general market results and do not reflect actual portfolio returns, the experience of any investor, or the impact of any fees, expenses or taxes applicable to an actual investment. Because the HFR indices are calculated based on information that is voluntarily provided their actual returns may be higher or lower than those reported. Unlike most asset class indices, HFR Index returns reflect deduction for fees and expenses. An index is unmanaged and not available for direct investment. Hypothetical and past performance is no guarantee of future results. Please see the end of the report for the risks associated with the representative asset classes and the definitions of the indices.
Don’t let low cash returns interfere with your goals
Holding enough cash in cash alternatives, such as money market funds, to cover living expenses in the event of an emergency is critically important for money management. This practice may allow your longer-term investments to grow over time and reduce the likelihood that you’ll be forced to sell during unfavorable market conditions. However, we suggest holding only 6 to 18 months of living expenses in cash alternatives because of their low returns. Once you have determined the right amount of cash for your circumstances, consider investing any excess. One approach is using dollar cost averaging—investing a set amount over time at a specific interval, such as monthly or quarterly.* We recommend investing the cash in underallocated asset classes first and then spreading it across your full portfolio.
*A periodic investment plan such as dollar cost averaging does not assure a profit or protect against a loss in declining markets. Since such a strategy involves continuous investment, the investor should consider their ability to continue purchases through periods of low price levels.
Diversifying can help you avoid the fear of investing at the wrong time
Although we expect 2018 to be another positive year for stocks, no one knows for certain how much further stocks will climb before they experience a significant decline. Holding a variety of assets in an investment portfolio provides the opportunity to participate in market advances while potentially mitigating a market decline’s impact on your portfolio. A diversified portfolio can also be a good place to invest excess cash, knowing that if markets continue to advance, you can reallocate some of your gains to assets that are expected to be less volatile, like high-quality bonds. If markets decline, those less-volatile asset classes should help reduce the potential for portfolio losses.
*Hedge Funds are not suitable for all investors and are available only to persons who are “accredited investors” or “qualified purchasers” within the meaning of U.S. securities laws. Hedge funds trade in diverse complex strategies that are affected in different ways and at different times by changing market conditions. Strategies may, at times, be out of market favor for considerable periods with adverse consequences for the investor.
Whether you have been investing for a long time or are new to managing your investments, we firmly believe that taking steps now to be more nimble can help you recognize potential investment opportunities. We recommend reviewing your portfolio as a regular, routine step, and believe now is a good occasion to contact your investment professional to discuss new opportunities we expect will materialize in the year ahead.
Compositions and definitions for model portfolios
Compositions for model portfolios, page 2:
Moderate income model portfolio: 3% Bloomberg Barclays 1–3 Month Treasury Bill Index, 19% Bloomberg Barclays U.S. Aggregate Bond Index (1–3Y), 30% Bloomberg Barclays U.S. Aggregate Bond Index (5–7Y), 7% Bloomberg Barclays U.S. Aggregate Bond Index (10+Y), 6% Bloomberg Barclays U.S. Corporate High Yield Bond Index, 5% JPM GBI Global ex.-U.S. Index, 5% JPM EMBI Global Index, 12% S&P 500 Index, 2% Russell Midcap® Index, 2% Russell 2000® Index, 4% MSCI EAFE Index (USD), 5% FTSE EPRA/NAREIT Developed Index.
Moderate growth & income model portfolio: 3% Bloomberg Barclays 1–3 Month Treasury Bill Index, 4% Bloomberg Barclays U.S. Aggregate Bond Index (1–3Y), 16% Bloomberg Barclays U.S. Aggregate Bond Index (5–7Y), 7% Bloomberg Barclays U.S. Aggregate Bond Index (10+Y), 6% Bloomberg Barclays U.S. Corporate High Yield Bond Index, 3% JPM GBI Global ex.-U.S. Index, 5% JPM EMBI Global Index, 21% S&P 500 Index, 9% Russell Midcap® Index, 8% Russell 2000® Index, 6% MSCI EAFE Index (USD), 5% MSCI EM Index (USD), 5% FTSE EPRA/NAREIT Developed Index, 2% Bloomberg Commodity Index.
Moderate growth model portfolio: 2% Bloomberg Barclays 1–3 Month Treasury Bill Index, 2% Bloomberg Barclays U.S. Aggregate Bond Index (1–3Y), 3% Bloomberg Barclays U.S. Aggregate Bond Index (5–7Y), 3% Bloomberg Barclays U.S. Aggregate Bond Index (10+Y), 3% Bloomberg Barclays U.S. Corporate High Yield Bond Index, 2% JPM GBI Global ex.-U.S. Index, 3% JPM EMBI Global Index, 29% S&P 500 Index, 13% Russell Midcap® Index, 13% Russell 2000® Index, 10% MSCI EAFE Index (USD), 10% MSCI EM Index (USD), 5% FTSE EPRA/NAREIT Developed Index, 2% Bloomberg Commodity Index.
Compositions for model portfolios, page 3:
Moderate Growth and Income Four Asset Group model portfolio without private capital: 3% Bloomberg Barclays 1–3 Month Treasury Bill Index, 11% Bloomberg Barclays U.S. Aggregate Bond Index (5–7Y), 6% Bloomberg Barclays U.S. Aggregate Bond Index (10+Y), 6% Bloomberg Barclays U.S. Corporate High Yield Bond Index, 3% JPM GBI Global ex.-U.S. Index, 5% JPM EMBI Global Index, 20% S&P 500 Index, 8% Russell Midcap® Index, 6% Russell 2000® Index, 5% MSCI EAFE Index (USD), 5% MSCI EM Index (USD), 5% FTSE EPRA/NAREIT Developed Index, 2% Bloomberg Commodity Index, 3% HFRI Relative Value Index, 6% HFRI Macro Index, 4% HFRI Event-Driven Index, 2% HFRI Equity Hedge Index.
The Bloomberg Barclays 1–3 Month Treasury Bill Index includes all publicly issued zero-coupon U.S. Treasury bills that have a remaining maturity of less than three months and more than one month, are rated investment grade, and have $250 million or more of outstanding face value. In addition, the securities must be denominated in U.S. dollars and must be fixed rate and nonconvertible.
The Bloomberg Barclays U.S. Aggregate Bond Index is composed of the Bloomberg Barclays U.S. Government/Credit Index and the Bloomberg Barclays U.S. Mortgage-Backed Securities Index and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities.
The Bloomberg Barclays U.S. Aggregate 1–3 Year Bond Index is unmanaged and is composed of the Bloomberg Barclays U.S. Government/Credit Index and the Bloomberg Barclays U.S. Mortgage-Backed Securities Index and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of one to three years.
The Bloomberg Barclays U.S. Aggregate 5–7 Year Bond Index is unmanaged and is composed of the Bloomberg Barclays U.S. Government/Credit Index and the Bloomberg Barclays U.S. Mortgage-Backed Securities Index and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of five to seven years.
The Bloomberg Barclays U.S. Aggregate 10+ Year Bond Index is unmanaged and is composed of the Bloomberg Barclays U.S. Government/Credit Index and the Bloomberg Barclays U.S. Mortgage-Backed Securities Index and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 10 years or more.
The Bloomberg Barclays U.S. Corporate High Yield Bond Index covers the universe of fixed-rate, non-investment-grade debt.
The Bloomberg Commodity Index is a broadly diversified index composed of 22 exchange-traded futures on physical commodities and represents 20 commodities weighted to account for economic significance and market liquidity.
The FTSE EPRA/NAREIT Developed Index is designed to track the performance of listed real estate companies and REITs in developed countries worldwide.
The HFRI Relative Value (Total) Index is managed by maintaining positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed-income, derivative, or other security types.
The HFRI Macro (Total) Index is managed by trading a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed-income, hard currency, and commodity markets. Managers employ a variety of techniques: both discretionary and systematic analyses, combinations of top-down and bottom-up theses, quantitative and fundamental approaches, and long- and short-term holding periods.
The HFRI Event-Driven (Total) Index is managed by maintaining positions in companies currently or prospectively involved in corporate transactions of a wide variety, including but not limited to mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance, or other capital structure adjustments.
The HFRI Equity Hedge (Total) Index is managed by maintaining positions both long and short in primarily equity and equity derivative securities. The HFRI Indices are based on information self-reported by hedge fund managers that decide, on their own, at any time, whether or not they want to provide, or continue to provide, information to HFR Asset Management, LLC (HFR). Results for funds that go out of business are included in the index until the date that they cease operations. Therefore, these indices may not be complete or accurate representations of the hedge fund universe, and may be biased in several ways.
The J.P. Morgan Global Ex United States Index (JPM GBI Global Ex-US) is a total return, market-capitalization-weighted index that is rebalanced monthly and consists of the following countries: Australia, Germany, Spain, Belgium, Italy, Sweden, Canada, Japan, United Kingdom, Denmark, Netherlands, and France.
The J.P. Morgan Emerging Market Bond Index Global (EMBI Global) currently covers 27 emerging-market countries. Included in the EMBI Global are U.S.-dollar- denominated Brady bonds, Eurobonds, traded loans, and local-market debt instruments issued by sovereign and quasi-sovereign entities.
The MSCI EAFE Index is a free-float-adjusted market-capitalization-weighted index that is designed to measure the equity-market performance of developed markets, excluding the U.S. and Canada.
The MSCI Emerging Markets Index is a free-float-adjusted market-capitalization- weighted index that is designed to measure equity-market performance of emerging markets.
The Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000® Index.
The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.
The S&P 500 Index is a market-capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. equity market.
Asset allocation is an investment method used to help manage risk. It does not ensure a profit or protect against a loss. Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stocks may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks, including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Cash alternatives, such as money market funds, typically offer lower rates of return than longer-term equity or fixed-income securities and may not keep pace with inflation over extended periods of time. Bonds are subject to market, interest-rate, price, credit/default, call, liquidity, inflation, and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value, which may result in greater share-price volatility. Real estate has special risks, including the possible illiquidity of underlying properties, credit risk, interest-rate fluctuations, and the impact of varied economic conditions.
Wells Fargo Investment Institute, Inc., is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.
The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation; an offer to participate in any investment; or a recommendation to buy, hold, or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs, and investment time horizon.
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