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Try a Low Risk Strategy Instead of a Low Risk Investment

Try a Low Risk Strategy Instead of a Low Risk Investment
Given the market turmoil of 2008, many committed long-term investors have been tempted to abandon their investment plans, wait for the financial storm clouds to evaporate and stay “out of the storm” until sunny skies return. This trend has resulted in a sprint to US Treasury Bonds, which are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal. Or more likely, cash. While this investment strategy certainly feels like an obvious one, sometimes the obvious thing to do isn’t the right thing to do with your investments.

For most investors, keeping true to your stated investment plan is the right course of action. Investment strategies are constructed to be roadmaps to deliver investors to their goals by anticipating and modeling a wide range of possible market conditions, including great, average and poor returning market environments. In other words, investment strategies have built in factors to account for markets like this one. Turbulence occurs on any long-distance flight, but the answer is rarely to land the plane and wait for better weather. Similarly, investors must have faith that their investment plan will get them to their destination, despite some temporary instability along the way. The late J.P. Morgan, when asked what suggestion he had for clients who couldn’t sleep at night due to market volatility, responded “sell to the sleeping point”. His wise advice illustrates that investors must find the balance between being comfortable with the risk inherent in their investment plan and having enough market exposure to generate the returns they want to achieve their goals.

Moving to low risk investments like cash should not be the best answer for investors that need to adjust their investments to their own “sleeping point”. Rather, investors are far better served by moving to a low risk strategy, like the Income with Capital Preservation model, a highly conservative (lower risk) investment strategy, managed to avoid risk but still acquire moderate appreciation on their investment. One advantage of such a broadly diversified low risk strategy over a single allocation low risk investment is the potential benefit from correlations between asset classes. This approach should create an optimal investment strategy that delivers a balance of both downside protection and upside participation, resulting in a contented “sleeping point” for the low risk investor who is seeking shelter from the storm.

In the tables that follow, we look at the most recent bear market, from 2000 through 2002, and compare this period to the first three quarters of this year. As measured by the S&P 500, the equity market suffered negative returns during both of these periods. Investments in cash substantially saved downside volatility relative to stocks during these periods. [Table 1] Remarkably, the Income with Capital Preservation strategy, which actually includes a 20% strategic allocation to equities, performed just as admirably in protecting client assets. The reason that a low risk strategy can perform as well as the most low risk asset class is the “free lunch” provided by diversification. By incorporating multiple asset classes that are relatively uncorrelated to each other, diversified portfolio strategies can help minimize risk by adding more aggressive portfolio components. In a sense, this approach illustrates that the “puzzle” really is more important than the individual “pieces” when it comes to portfolio management.

However, in the four quarters following the 2000-2002 bear market, the low risk investment strategy (Income with Capital Preservation) did far better than the stand-alone low risk investment (Cash) in capturing the market rebound. [Table 2] The low risk strategy outperformed during the down market, while also capturing far better returns in the subsequent rebound over the next year.

Income with Capital Preservation is the lowest risk strategy of the five Investment Objectives at LPL Financial. The recommended model emphasizes current income and preventing capital loss. Currently, the Income with Capital Preservation recommended model is comprised of a strategic allocation of 69% fixed income, 10% cash and 21% equities.

Table for Low Risk Strategy Article


Conclusion
Bear markets are scary times for most investors. But we maintain that the best course of action is not to abandon your current investment strategy. However, you may want to consult with your financial advisor to discuss how your risk tolerance may have shifted, and how your portfolio should be correspondingly adjusted. Although we expect that moving to cash, while an obvious choice, will not be the best course of action, shifting to a lower risk investment strategy may offer a more optimal balance between downside protection and upside participation—and bring you to your “sleeping point.”


Highlights

  • For most investors, keeping true to your stated investment plan is the right course of action.
  • Investors must find the balance  between being comfortable with the risk inherent in their investment plan and having enough market exposure to generate the returns they want to achieve their goals.
  • The reason that a low risk strategy can  perform as well as the most low risk asset class is the “free lunch” provided by diversification.
  • Income with Capital Preservation is  the lowest risk of the five Investment Objectives at LPL Financial.
  • Consult with your financial advisor to  discuss how your risk tolerance may have shifted, and how your portfolio should be adjusted to correspond with it.

IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specifi c investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly

There is no guarantee that a diversifi ed portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversifi cation does not ensure against market risk.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.

The S&P 500 is unmanaged index representing a market-value weighted index of 500 blue-chip stocks representing all major industries and is considered to be a benchmark of the overall stock market.

Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.

Russell 3000 Growth Index measures the performance of those Russell 3000 companies with higher price-to-book ratios and higher forecasted growth values. Russell 3000 Value Index measures the performance of those Russell 3000 companies with lower price-to-book ratios and lower forecasted growth values.

Lehman Brothers Aggregate Bond Index - is made up of the Lehman Brothers Government/Corporate Bond Index, Mortgage-Backed Securities Index, and Asset-Backed Securities Index, including securities that are of investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $100 million.

This article is not intended to provide specific investment or tax advice for any individual. Consult me, your financial advisor, or your tax advisor if you have any questions. 

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