These days, it’s difficult for me to watch the news without a feeling of dread. The Breaking News is a stream of political turmoil, division, violence and geopolitical stress. If it’s not a mass shooting next door, it’s a prediction for World War III around the corner. It makes for exciting evening news headlines, but I would prefer calm, reason and compassion.
When something unexpected happens, it’s important to understand the facts and risks without panicking. In the short term, political disorder may result in temporary market disruption, or a fluctuation in the stock market. For younger investors who have a long investment window, stock market turmoil isn’t as concerning because they have time on their side and can ride out the temporary ups and downs. However, retired investors who have less time to recover from market volatility, and rely on their investment portfolio for steady income, may want to consider making a conservative adjustment to their investment portfolio.
Analyzing Your Asset Allocation
As we know, financial markets can be unpredictable, no matter how much we might hope for comfortable stability. Although good times can make us exuberant and tough times can make our stomachs churn, reacting to market ups and downs isn’t useful. There are few guarantees in life, but taking sensible precautions and staying focused on your important long-term goals can make a real difference as change inevitably comes.
A practical starting point is reviewing your asset allocation to ensure it is still appropriate for your life circumstances. Typically, investors start with an asset allocation that is appropriate for them with a balance of US equities and International equities for growth, and fixed income or bonds for downside protection when the market experiences a decline. A well-constructed asset allocation can reduce the volatility of your portfolio, and serve you well over reasonable fluctuations in the market.
However, when significant life events occur, such as retirement, it is important to review and revise your asset allocation to reflect the change in your goals. During your working years, your investment goal may have focused primarily on growth. In retirement, the goal of preservation may take priority instead.
Understanding Fixed Income
Fixed income or bonds are often a significant portion of an investor’s portfolio. Commonly investors will say, “That bond fund hasn’t been doing well – maybe it’s time to sell it!” However, fixed income is never added to a portfolio with the intent that it will be the best performing fund in the batch. Rather, fixed income is in your portfolio to give you downside protection if the stock market goes south. When uncertainty arises, the value of fixed income tends to increase and counteracts the loss on the equity side of your portfolio. Fixed income is meant for protection.
In years past when interest rates were at moderate levels, we often suggested individual tax-free municipal bonds, or corporate bonds for our clients. Individually-held tax-free municipal bonds, or corporate bonds are great fixed income products that provide stable interest income to investors and return of principal at maturity. However, we are now in a period of record low interest rates and buying moderate or long-term bonds today essentially means you are locking in yesterday’s low rates. The Federal Reserve has increased interest rates twice this year and four times since 2015[i]. In other words, if you bought a 10-year Treasury at 2% at the beginning of the year, the same investment would be paying a higher return of 2.5% today. Consequently, if you had to redeem your 2% bond prior to maturity, you would probably have to sell it at a loss.
In a rising interest rate environment, like we are currently experiencing, short-term fixed income mutual funds work well. Short-term is considered anything with a maturity of 5 years or less. In this “basket” of many individual bonds, there are bonds maturing every week. As they mature, they are replaced with new bonds at the (probably higher) market interest rate. This allows your fixed income fund to keep up with rising interest rates and still provide you downside protection if the equity market dips.
When interest rates go back up to normal levels, you can reposition from fixed income mutual funds into individual bonds. The advantage of an individual bond is that it can lock in high interest, and as long as you hold onto it until it matures, the return of principal can be guaranteed.
Ask for a Second Opinion
As you get older or transition into retirement, you may want to reduce volatility in your portfolio and take a more conservative stance. Act proactively, and have your financial advisor review your asset allocation (the balance of the different elements that make up your investment). He or she may recommend that you increase your fixed income holdings now while the market is at a high. Making changes to your investment portfolio as your life changes is natural and prudent, and is the opposite of market timing.
It may feel like today’s news headlines are more alarming than ever. However, keep in mind that over the history of the stock market, the Dow Jones Industrial Average has recovered from what nay-sayers have called the end-of-investing…. many times. From the Great Depression, to Black Monday of 1987 to the Dot-com Bubble and through the Great Recession in 2008 and 2009, the market has shown resilience and strength. If you feel it’s time, ask your Certified Financial Planner™ for a check-up, and for candid answers to your concerns. If you don’t have a financial sounding board already, many financial planners will offer you a free initial consultation where you can ask questions and get timely feedback, no (financial) strings attached.
[i] http://www.npr.org