Addressing Long-Term Goals During Short-Term Volatility
Assumptions about future returns are made every day by a wide variety of investors. These assumptions are often based on annualized returns that can mask tremendous amounts of performance variation. For instance, a simple blended portfolio consisting of 55% U.S. large-cap stocks and 45% intermediate U.S. Treasury bonds delivered an annualized return of 8.5% since 1926. However, since the start of that year, in 20% of rolling 10-year windows, a 55/45 blended portfolio failed to achieve a return of even 6%. We believe that the next 10 years may be a period where returns to a passive buy-and-hold balanced strategy are likely to come up short. Investors facing this likely reality have three options: 1. Lower their long-term return assumptions Return assumptions should represent good faith estimates of the likely long-term return on investment. While a lower-return assumption may be necessary for those with unrealistic expectations, others should carefully evaluate their investment approach to determine if there is a way to increase the odds of successfully meeting their objectives. 2. Raise their target allocation to equities However, the greater expected return from stocks versus bonds is also accompanied by greater expected volatility. Greater volatility can result in greater drawdowns that can adversely impact the ability of some investors to meet more near-term objectives. 3. Embrace a flexible, active asset allocation strategy This may be the most realistic of the three alternatives. At any point in time, equity market returns are driven by one or more of the following factors: fundamentals, valuation, and sentiment. As active managers, we prefer a framework that seeks to identify regimes where the risk of sustained capital loss (i.e., a bear market) is high, or conversely market environments that strongly favor owning stocks. Such a framework also acknowledges that the market is likely to go through periods where neither regime is overwhelmingly likely. That last environment is where we find the U.S. stock market at the outset of 2016. While valuations are somewhat elevated, the U.S. economy remains far from overheating, and sentiment is anything but speculative today. In an environment such as this, investors can be rewarded by taking advantage of market volatility to increase their exposure to attractively valued and well-positioned markets/sectors/companies. Nevertheless, successful asset allocation is not just about what an investor owns, it also is about what one chooses not to own. Investors in passive strategies must own whatever allocations make up the index, regardless of the merit of those investments. This can prove disastrous when an index becomes heavily-skewed toward overvalued segments of a market. Valuations suggest that over the next 10 years, a static asset allocation approach is likely to fail to meet the long-term return targets of many investors. The reason is simple – starting valuations both in equity and fixed income are not priced to deliver the returns that history has led investors to expect. In a low-return world, investors can ill-afford to operate without what we believe is the most effective tool for increasing the likelihood of achieving their long-term return objectives: an active approach to asset allocation. History suggests that the volatility of the opening trading days of 2016 is hardly unprecedented. Active asset allocation provides investors the opportunity to respond to these developments and shift the odds of long-term success more in their favor.