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North Bay Business Journal

Monday, April 14, 2014, 6:20 am

As stocks rise, balance remains key

By Seth Scholar

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    In an era of significant economic, geopolitical and technological change, clients are concerned with determining the proper return on an investment portfolio.  Some clients believe the question to pose to a financial adviser is if they can beat the S&P 500 this year.

    Instead, it may be in a client’s best interest to work with an adviser to determine how to fund lifetime and legacy goals while minimizing risk. Stage in life will certainly influence goals; however, going through a planning process with an adviser can provide a road map geared toward achieving them and also provide the investment manager with key information needed to the design the portfolio – a target rate of return.  With that said, to maximize the chances of generating the needed return while minimizing risk requires proper asset allocation.

    What to do in the current environment?

    Last year’s unusually strong rise in U.S. stocks makes it more difficult for investment managers to discuss asset allocation with clients as there is often a tendency to chase performance. Five years into a U.S. equity bull market – and with the potential for interest rates to rise from current low levels – has prompted conservative clients to ask if they should be selling their bonds and increasing their exposure to stocks.  Investment managers have to gently remind them that we remain in an unusual economic environment, with global economic and geopolitical issues and unprecedented central bank policy, while volatility has been unusually tame.  It is unlikely to stay tame, and investors should manage risk through their asset allocations.

    Reasons to own the four major assets classes: equities, fixed income, commodities and real estate

    Equities

    U.S. stocks are still reasonably valued (as compared to past bull peaks); while other parts of the world appear cheaper.  With interest rates likely to remain low for some time, those with an income need will still have to generate some of it with equities. The remarkable health of companies, as evidenced by very strong balance sheets, the prospect for (admittedly modest) economic growth in most major geographies and still-reasonable valuations provide support for equities. 

    Fixed Income

    Bond prices fall when interest rates rise, so why own them when rates remain near all-time lows?  The simple answer is that bonds often provide stability when equity markets decline. If a client is holding individual bonds to maturity, and is not worried about the credit quality of the issuer, price volatility from rising rates should not be a major concern.  Clients will receive the periodic income from the bonds and their principal should be returned at maturity.  What clients may not realize is that if their holding period is long enough, bond funds exhibit the same characteristics as individual bonds.  If rates rise and you don’t sell the fund and recognize the loss, the bonds in the fund will mature and the manager will reinvest in new bonds with higher rates.

    Commodities

    As a whole, commodities are quite cyclical, and they have lagged with slower global growth and a digestion period for China in particular.  Improving global growth should provide support, and owning this group could serve as a hedge against unexpected inflation, particularly in energy.  Sensitivity to supply and demand changes and geopolitical events tend to make commodities less correlated to other asset classes thus providing a diversification benefit.

    Real Estate

    With mortgage rates rising modestly but still below the long-term average, we expect the U.S. housing recovery to continue in 2014, albeit at a slower pace.  Improving economic growth and strong corporate profits will allow for the continuation of the commercial real estate market recovery as well.

    Investors should remember that markets, and asset classes are cyclical and the chances of successfully timing tops and bottoms are very small.  Recognize that while a client’s properly allocated portfolio may not have performed like the S&P last year, it probably did not perform like the S&P during the financial crisis in 2008 either.  Go through the planning process, focus on the client’s goals and stick with an appropriate asset allocation for the long haul.

    ***

    Seth Scholar is vice president, senior portfolio manager with The Private Client Reserve of U.S. Bank.

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