Putnam Investments, March 2019
Asset allocation is an important part of the overall strategy for many, if not all, investors. Ensuring that their portfolios are diversified among several asset classes, including stocks, bonds, CDs, money markets, and others, is a principal method of mitigating risk and damping down volatility. Asset allocation is particularly important for retirement investors, who are looking to achieve a savings goal with risk-adjusted, long-term results.
One of the key concerns that investors and their advisors should keep in mind is the appetite for risk and the ability to absorb losses without panicking. When constructing a portfolio, different asset classes are subject to differing risk. Bonds, for example, are subject to interest-rate risks and, in some cases, prepayment risks. CDs and money market funds, with their emphasis on maintaining nominal dollar value of the principal, pay low rates of return and are subject to inflation risk. Stocks can be affected by numerous adverse conditions, both macroeconomic and company specific, making them a potentially volatile asset class.
Because some asset classes "zig" when others "zag," a diverse portfolio of stock, bonds, and cash investments can be useful in mitigating risk and smoothing the overall trajectory of the portfolio.
Put another way, how much of a loss is too much? During the severe bear market of 2007–2009, the S&P 500 cumulatively lost 51% (Source: Putnam). Would that cause the investor to panic? Would that induce investors to abandon their well-thought-out, long-term plan? Because some asset classes "zig" when others "zag," a diverse portfolio of stock, bonds, and cash investments can be useful in mitigating risk and smoothing the overall trajectory of the portfolio. To that end, balanced, hybrid, target-date, and asset-allocation funds may win a prominent place in many investors' portfolios.
Active allocation managers are instrumental in the design of well-constructed, diverse portfolios. In particular, they tend to put a lot of thought into the mitigation of volatility and inflation.
Volatility is the statistical measure of dispersion of returns for a specific security or market index. Low-volatility portfolios provide smooth and steady performance. High volatility, on the other hand, is characterized by wide gyrations in price movement and can give investors a rough emotional ride on their quest for returns.
Recently, Jason R. Vaillancourt, Co-Head of Global Asset Allocation at Putnam Investments, provided a deep dive into market volatility. He focused on the VIX, the Chicago Board of Trade's Volatility Index, and shared the following observations:
He rounded out his volatility analysis with these comments: "The current environment has a number of issues that can trigger market volatility: jittery investors, the near-decade length of the bull run, trade wars and trade-war rhetoric, a steep drop in the price of oil, and recession fears, to name a few."
Inflation is a risk to portfolios that makes fewer headlines, at least over the past few years. Investors may have become overly complacent to this threat of late, as mild inflationary trends have been kind to market returns. Nevertheless, it poses a long-term and persistent menace to investors' nest eggs, in particular as it can seriously erode their future purchasing power.
Brett Goldstein, Portfolio Manager at Putnam, and Seamus Young, Investment Director, teamed up in a recent article to alert investors to the real threat that inflation poses to their retirement. They maintain that although asset allocation is used by many investors to mitigate inflation, the assets that many choose are inefficient. Asset classes believed by some to be useful in addressing inflation, such as REITs, Treasury inflation-protection securities (TIPs), and certain commodities, often add other additional risk signatures to the portfolio. Instead, a fully invested portfolio, with a significant exposure to stocks, is generally the best approach.
Putnam's approach to risk management is centered on efficient, actively managed asset allocation. Active management is key because it enables the ongoing adjustment of the portfolio as different risk stresses emerge and evolve. An active manager with a keen sense of portfolio risk may be beneficial when pursuing better long-term risk-adjusted returns.
Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.
Consider these risks before investing: Allocation of assets among asset classes may hurt performance. Stock and bond prices may fall or fail to rise over time for several reasons, including general financial market conditions, changing market perceptions (including, in the case of bonds, perceptions about the risk of default and expectations about changes in monetary policy or interest rates), changes in government intervention in the financial markets, and factors related to a specific issuer or industry. These and other factors may lead to increased volatility and reduced liquidity in the fund's portfolio holdings. International investing involves currency, economic, and political risks. Emerging-market securities carry illiquidity and volatility risks. Investments in small and/or midsize companies increase the risk of greater price fluctuations. Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to rebound. Funds that invest in government securities are not guaranteed. Mortgage-backed investments, unlike traditional debt investments, are also subject to prepayment risk, which means that they may increase in value less than other bonds when interest rates decline and decline in value more than other bonds when interest rates rise. Bond investments are subject to interest-rate risk (the risk of bond prices falling if interest rates rise) and credit risk (the risk of an issuer defaulting on interest or principal payments). Default risk is generally higher for non-qualified mortgages. Interest-rate risk is greater for longer-term bonds, and credit risk is greater for below-investment-grade bonds. Unlike bonds, funds that invest in bonds have fees and expenses. The use of derivatives may increase these risks by increasing investment exposure (which may be considered leverage) or, in the case of over-the-counter instruments, because of the potential inability to terminate or sell derivatives positions and the potential failure of the other party to the instrument to meet its obligations. You can lose money by investing in the fund.
The CBOE Volatility Index is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.
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