The Economy, Markets, and Your 401(K) Portfolio, Pt. 4 of 4

Having a truly diversified portfolio is the goal of portfolio management, and it is best revealed when the market throws an unexpected curve ball. One of the first things that I look for when conducting a portfolio review is which asset class is most dominant in the portfolio. Despite how diversified the portfolio might look -because it may hold multiple stocks, or include various mutual fund families- the asset class with the greater percentage weighting in the portfolio will naturally have the most influence on its performance. While this may be good in a bull market, it won't feel so good in a bear market. #assetclasses #economiccycles #eventrisk #wealthcarefginc

In Part 3 of The Economy, Markets and Your 401(K) Portfolio, I explained a disruption to the economy cycle, known as Event Risk; and, how to discern whether a particular event in the economy causes the market to decline (or rise) sharply is a result of government intervention, including the Federal Reserve.

Understanding Event Risk
Understanding Event Risk

Asset Class Diversification: Building The Model Portfolio

Diversification is the art of portfolio management, however, diversifying by asset classes is the science of propelling a portfolio forward, generating reasonable returns in a strong market, and limiting the downside (i.e., risk of loss) during a declining market.

As the economy changes from one cycle to the next, it will reveal how well the portfolio has been diversified. It is not uncommon for someone's brokerage account, or IRA, to hold multiple stocks; mutual funds; or exchange-traded funds; and to be diversified in one sense, but not well enough to provide either adequate growth (or protection) as the economy progresses through the various stages of the economic cycles.

Part 2 of this series focused on the Economic Cycle (aka "Business Cycle").

The Economic Cycle
The Economic Cycle

The portfolio should have an asset allocation strategy that is optimized for where the economy is and where it may be heading. For example, during the top of a recession as unemployment, interest rates, and inflation are potentially higher, one may not think that a Real Estate Investment Trust (REIT) is the ideal investment to include in a portfolio, and it may not be, depending on how the Federal Reserve perceives the economy and whether they have done enough to cool down the economy, and get inflation closer to whatever their target range is.

Once the Federal Reserve begins cutting interest rates, a larger percentage of homebuyers return to the market, stimulating an increase in the economic indicator that tracks new home starts. The asset class within the portfolio that is directly impacted is REITs. In other words, as interest rates decline, we're expecting the value of REITs in the portfolio to appreciate.

A portfolio that holds a variety of stocks and/or mutual funds & exchange-traded funds but lacks diversification by asset class is more likely to experience a positive correlation, as illustrated in the following image. Notice how over time the rate of return ("Return") of "a" is correlated positively with the rate of return of "b." In this example, "a" may represent the S&P 500, whereas "b" represents a portfolio that may be comprised of a variety of stocks, or equity mutual funds. Ultimately, a portfolio that is diversified in this manner has only achieved diversity in name, but not necessarily in style.

Let's talk about style...

Just because the portfolio is showing unrealized gains doesn't mean that it is properly diversified.

What Style Looks Like In A Diversified Portfolio

Diversification by itself doesn't provide adequate downside protection to a portfolio during economic declines or sharp selloffs in the market. The reason for this has everything to do with the type of index [that represents a particular asset class] in the portfolio, including the weighted percentage of each asset class of the entire portfolio.

If the portfolio holds an equal percentage of stocks that represent the S&P 500 and Treasury Bonds, these two asset classes are inversely correlated to one another. Therefore, if the stock market is up, one might expect that the bonds are trailing in performance to the stocks within the portfolio. Alternatively, if the stock market is sharply down for some time, the expectation would be that the bonds will perform to the upside, providing a cushion for the portfolio. The overall performance during a market decline could still be negative, but the bonds will more than likely reduce the degree to which the portfolio performs negatively.

The colorful image below shows different asset classes and the corresponding performance for a given year. The best-performing asset class for each year is positioned in the top cell or each column. The asset class with the lowest rate of return is positioned in the cell located at the bottom of every column. The asset classes featured in this image are Small Cap Value and Growth, Mid Cap Value and Growth, Large Cap Value and Growth, International, Treasury Bonds, Emerging Markets, and Real Estate. Each asset class is distinguished by a unique color.

Notice that one color is not consistent across the entire top row of cells. If your investment strategy is "buy and hold", then you're eventually going to be a bag holder. Therefore, including diversity within your equities (stated contemporarily, Diversity, Equity, and Inclusion) is a good thing! Within the context of portfolio management, asset class diversification can and will protect your hard-earned investment portfolio! Why? The answer is simply because there are times during the economic cycle when small caps may outperform all other asset classes, large caps, international equity, real estate, etc.

Ultimately, and over the longer-term spectrum of the business cycle, the economy has the greatest impact on the performance of the equity and fixed-income markets, i.e., asset classes.#stylematters

Asset Classes Provide Colorful Diversification.

A Counterbalance Can Be A Good Thing

Greed and fear are two forces that tend to have a considerable influence on the up or down direction of the stock market. There are investors whose investment sentiment may be comprised mostly of either of these human emotions and they're probably happy as often as they are sad from one day to the next. The challenge for a person who leans more to one side (greed) vs. the other (fear) is to figure out how to achieve a balance within the performance of their portfolio, and hopefully gain more emotional stability throughout the course of their day.

Inverse Correlation is really about striking a healthy and reasonable balance between risk and reward. In other words, you may not knock the cover off the ball by getting the absolute best rate of return possible. However, at the same time, you are probably not going to go completely down with the ship either, to the very bottom of Davy Jones Locker! Through proper diversification, i.e., which I refer to as asset class diversification, the portfolio has a degree of style where the asset classes offset one another by their percentage weighting within the portfolio; how it performs during a particular session within the economic cycle; and also if the stocks comprised within each asset class are priced at a discount or a premium indicated as "value" or "growth."

Event Risk remains the one outlier that makes inverse correlation a bit more challenging because events require discernment. For example, September 11th was an event -terrorism- that caused the stock market to decline sharply. In this case, as I previously explained, the question that needed to be answered was, "What impact would the attacks against our country on 9/11 have on the economy?" The answer, thankfully, was none, which for some investors may present a unique investment opportunity.

A little more than seven years later, another event, which was marked by malfeasance and moral hazard, led to the Great Recession. When asked the same question about the subsequent impact on the economy we were given a different result; requiring an investment strategy that is drastically different from a portfolio that is diversified and styled across the spectrum of asset classes.

Although there will be asset classes that are going to outperform others depending on the nature of the event, the professional investor must be proficient in understanding how the economy works and a reasonable thesis of what the outcome may be.

True Diversification Provides Balance

Ultimately, inverse correlation is critically important because it helps to put one's greed and fear in check by embracing the correct view of the economy and aligning one's portfolio in such a way that helps the investor establish reasonable performance goals within their risk tolerance. If you have questions or would like to schedule a meeting by phone or Zoom, the following button will allow you to book a time on my calendar that is convenient for both of us.

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