Many investors who think they are protected may be surprised when the next market downturn comes. Being invested in different types of bonds, mutual funds and stocks isn’t good enough anymore to avoid significant market losses during the next financial market downturn.

As we experience yet another incredible year of market gains, investor confidence sits at the highest it has been in 17 years, according to the recently released Investor and Retirement Optimism Index.

It is hard not to be confident, when you consider the S&P 500 index is up approximately 300% since its low point back in March 2009. Even more incredible is the fact that 2017 was the least volatile year in over 50 years. 2019 has brought us increased volatility, but also record highs in the markets.

But with confidence also comes complacency … and now is definitely not the time to be complacent. You should ask yourself some basic questions to identify whether your current investment strategy is the best one for you.

“What is the maximum loss of money you can tolerate at this point in your life?”

“What is your current strategy to help mitigate investment losses?”

“Can you show specific examples of diversity within your portfolio?”

Remember the 4^th quarter meltdown ending on Christmas Eve 2018?  The S&P 500 Index pie chart lost 21%.  Many seasoned professionals were shocked to hear their clients say “I didn’t know that could happen”, or “I didn’t know the stock market could drop 20%!”.  It was horrifying to hear some of our own clients utter those words after watching the news or speaking with friends.  Imaging if it was a full-blown correction like in 2008 losing 40-50% of your portfolios value. Pie chart investing models and “set it and forget it” investing models aren’t the answer.

Most investors will point to a “pie chart” found within first few pages of their quarterly statements they receive in the mail. Sometimes they have several statements from several different companies, each with their own pie chart.  But how does this really all relate to your situation?  Pie charts make a great presentation visual but do they really create a better investment strategy?

The Problem with Investment Pie Charts

What do all these slices of pie really mean? Do more pies, and more slices, imply greater diversity? More has to be better, right?

It is most important to understand that diversification is not designed to boost investment returns. Think about that for a second…. Unfortunately, for most investors, the pie chart can be misleading. The original goal of “diversification” is to select different asset classes whose returns haven’t historically moved in the same direction and to the same degree; and, ideally, assets whose returns typically move in opposite directions. This way, even if a portion of your portfolio is declining, the rest of your portfolio is more likely to be growing, or at least not declining as much. Thus, you can potentially offset some of the impact that a poorly performing asset class can have on an overall portfolio. Another way to describe true diversification is correlation. We want to own asset classes that are not directly correlated.

Unfortunately, even though a pie chart may make it look like an investor is safely diversified, it’s probably not the case. They are probably much more correlated to the market than they realize. Making matters worse, investors with multiple different families of mutual funds often own the exact same companies across the different families. We call this phenomenon “stock overlap” or “stock intersection.” You may own 10 different mutual funds, but the largest holdings in each fund are the same companies.

Elton and Gruber performed a fascinating study in the late 1970s. They concluded that a portfolio’s diversity stopped improving once you had more than 30 different securities. In other words, increasing from one or two securities up to 30 showed a big improvement in portfolio diversity. Increasing from 30 all the way up to 1,000 different securities didn’t materially improve the portfolio’s diversity.

Think of Elton and Gruber the next time you open up your quarterly investment statement. How many mutual funds do you really own? How many individual stocks are inside all of those mutual funds? Let alone, how many of your mutual funds share the same stocks?

Problems with the Stock-Bond Mix

Most investment advisors and investors attempt to mitigate risk by allocating a portion of their portfolio to equities and a portion to bonds. The “60/40” allocation, with 60% in equities and 40% in bonds, has been popular for decades. Unfortunately, according to Morningstar, over the past decade a 60/40 portfolio has a .99 correlation to a 100% equity portfolio.

To put it simply, the bond portion dilutes overall returns while providing little to no diversity. When you take into consideration when we are in a rising interest rate environment, the 60/40 allocation makes even less sense.

How about diversification into overseas investments? Again, Morningstar data shows that back in the 1980s there was a low correlation (0.47) between U.S. equities and international equities. That correlation has steadily increased to 0.54 in the 1990s all the way up to 0.88 in the 2000s.

Read:  Just Say No To Pie Charts!

So, What Is an Investor To Do?

If we can’t use international equities or bonds to diversify your portfolio, what can you use?
Portfolio diversifying instruments (PDIs) provide actual asset class diversification by reducing correlation to the stock market.

What are some examples of PDIs, you may ask?

• Private equity –  Some non-traded real estate investment trusts offer durable distributions with low volatility and low correlation.
• Some annuity solutions –  Index annuities provide principal protection and guaranteed rates of return as well as low fees.

Instead of taking 40% of your life savings and investing in bonds that seem to be paying less and less and are still at risk to interest rate hikes and defaults, we prefer to invest in asset classes that thrive in a rising interest rate environment. Real estate is an example of one of these asset classes, and there are more ways to access real estate than ever before. In fact, according to a recent PricewaterhouseCoopers (PwC) forecast, investments in PDIs will more than double by 2025. If accurate, this can present an incredible opportunity for some investors if they want to truly diversify.

The biggest challenge for most is finding an adviser with extensive experience working with various PDIs. If your portfolio is market based, and you are hoping your “pie chart” is going to save the day, now is not the time to be complacent. As 2018 gets underway, dedicate some time and meet with one of our independent financial adviser with experience working with all asset classes.

The Use Of Trailing Stops

A simple but affective was to mitigate loss is the use of Trailing Stops.  A trailing stop is a special type of trade order where the stop-loss price is not set at a single, absolute dollar amount, but instead is set at a certain percentage or a certain dollar amount below the market price. 

When the price goes up, it drags the trailing stop along with it, but when the price stops going up, the stop-loss price remains at the level it was dragged to.

A trailing stop is a way to automatically protect yourself from an investment’s downside while locking in the upside. Trailing stops can be set up to work automatically.