One thing we can say for certain is that, after a 10-year bull run with minimal volatility, the market is due for a change. With the return of extreme volatility this year and a late year selloff, the market may well be transitioning at this time. While it may be a bit early to signal the start of a significant decline, investors are starting to get anxious, wondering if their investment strategy is enough to weather the next storm.
The worst mistake investors can make is to react once the storm has hit. That typically involves an emotional response which almost invariably leads to costly behavioral mistakes. The second biggest mistake is to not take a more proactive approach to protect their portfolios ahead of the storm. Traditional asset allocation strategies can work extremely well during periods of low volatility and sustained market advances, but they can leave the portfolio exposed to the type of extreme price changes and moves that have occurred this year.
Storm-Proofing Your Clients’ Long-Term Investment Plans
Every investor with a long-term time horizon should utilize an asset allocation strategy. It not only clarifies how investors expect to achieve their objectives, it provides a structure that enables them to maintain the necessary discipline to stick with their plan. Without it, investors are more likely to let their emotions guide their decisions, which can lead to devastating outcomes. However, changing market conditions, such as what we are experiencing this year, can temporarily introduce more risk in a particular asset class, which can undermine the strategy.
For example, due to a prolonged decline in interest rates, bonds have enjoyed steady returns for three decades. With the recent increase in interest rates, investors are starting to underweight bond exposure at least until interest rates have risen. The same considerations are given to equity exposure when valuation measures, such as PE ratios, climb too high. Investors can generate better returns and reduce risk by reducing their exposure to overvalued companies and investing in companies with lower PE ratios. Or, when the trend in international stocks is decidedly negative, assets can be redeployed to more stable short-term bond fund to ride out the volatility.
Smooth Out Volatility with Tactical Investing
To that end, some investment advisors will embed one or more tactical investment strategies within a broadly diversified asset allocation plan. While the overall investment plan maintains a long-term view, a tactical strategy is layered on top of it to provide more focused investment model designed to smooth out short-term volatility. It is used to respond proactively to market movements by shifting assets to rising asset classes while avoiding falling ones. The overall goal is to maximize risk-adjusted returns during volatile or declining markets while stabilizing the total portfolio or an element of the portfolio.
Tactical investing is a rules-based, trend-following strategy that seeks to identify and profit from price momentum. By analyzing data over shorter time horizons, shorter-term decisions can be made based on factors like fundamental valuations, investor sentiment, and yield spreads. Trend factors are locked onto major leadership trends so that any significant divergence could be an indication of a change in market direction. Although price momentum-based systems are generally reliable over time, they have been known to produce false signals. However, they have a built-in mechanism that enables them to automatically adjust to move in harmony with primary leadership trends.
The net result is more timely responses to market changes, which enables investors to let profits run or cut losses short. The rules-based approach of a tactical strategy adds more discipline to the investment process, thus avoiding the costly knee-jerk tendencies that tend to arise during tumultuous times in the market.