Asset allocation is a process of diversifying investments to reduce risk and volatility and help you achieve comfortable returns over time. The most basic asset classes can be broken down into stocks, bonds and cash. Stocks include U.S. Large and Small Cap., International, Emerging Markets, Real Estate and Commodities. Bonds include Short-term, Intermediate and Multisector, to name a few. Similarly to starting a construction project where different tools are required to execute building tasks in a safe and efficient way, diverse investments are required to reduce risk and execute efficient portfolio objectives and goals. When looking at various asset classes, each has a unique purpose in a well-planned and diversified portfolio, similarly to how each tool on your tool belt has a specific and unique function. In starting a new construction project, like when approaching investing, it is important to have the proper tools in your tool box. Considering that each tool is an individual class of investments and has a unique purpose, it is vital to keep the proper tools on your belt to achieve your portfolio goals successfully. When thinking about asset allocations, how much you have in each area depends on your level of risk, as every asset class has a different degree of volatility. While nothing can guarantee that portfolio volatility will be avoided during market declines, asset allocation reduces the risk of not having the proper tools to achieve expected results and allows you to finish your project efficiently.
When embarking on a construction project, you would bring the full set of tools and equipment that you may need as you progress on your work. This is precisely why you don’t show up with just a hammer. During 2014, if you were not diversified and held the majority of your investments in U.S. large company stocks, your portfolio would have done well as U.S. stocks greatly outperformed International stocks and most other asset classes. However, this reversed the first quarter of 2015 when International stocks far outperformed the U.S. market. There is no guarantee that all of the asset classes you’ve invested in will do well in any given period, however proper asset allocation and diversification allows you to better guard yourself against volatility.
Looking at the current economic environment, we are forecasting a period of rising interest rates and anticipate a period of increased volatility in the market. An interest rate hike can create opportunities for long-term growth or cause a decline depending on what’s in your portfolio. While it’s important to have diverse investments, you may find it favorable to be overweight or underweight in some asset classes at certain periods.
Bonds are an important asset class that need to be monitored carefully in a pending interest rate hike environment. When rates increase, the value of bonds may be reduced. Looking at the stock market’s behavior, the average return of U.S. stocks during the 12 months following the beginning of a Federal Reserve Rate hike has historically been at 10%. When comparing the U.S. and International markets, we can look at the Price-Earnings (P/E) ratio, which is one way to measure valuation of companies’ share prices. The P/E ratios in International and Emerging Market stocks are more favorable and are a better value at this time and U.S. market P/E ranges are at the high end of historical averages. This suggests that International stocks are more attractively valued than U.S. stocks. However, if U.S. company earnings are strong, the P/E ratios in the U.S. will become more reasonable.
Even though these returns cannot be guaranteed, a full set of tools will help achieve long term growth. If you need a team of qualified financial advisors to make sure you have all the tools on your belt, we are always here to help.
This article was originally published for the Maryland Construction Network’s Networked & Connected Newsletter.