A lot remains uncertain about the near future of the global economy, and there is little investors hate more than uncertainty. How can you invest in the future when you have no idea what it may hold?
You could do what investors have historically always done: Flock to the safety of fixed income and try to wait out the what-if storm. But shifting allocations in reaction to market events is its own kind of risky business. A better alternative, according to GuideStone Capital Management, is to use a defensive investing strategy that allows you and your clients to stay invested in stocks but at a lower risk level.
We spoke with Matt Peden, chief investment officer at GuideStone Capital Management, about their predictions for the stock market and why the best investing offense may be a good defense. Here are edited excerpts from that interview.
What is your perspective on the current stock market? Should we expect more market volatility?
We believe stock markets have gotten ahead of themselves a bit. The Federal Reserve’s stimulus and investor momentum have driven equities well past the levels supported by current economic fundamentals. It would not surprise us if stocks consolidated some from here. In fact, we think a pullback would be healthy for the market and bring stocks closer to a more rational valuation level.
Looking forward, we see multiple potential headwinds facing financial markets, including the upcoming election, high unemployment, a weaker-than-expected economic recovery, and a second wave of economic shutdowns, either consumer-led or locally mandated.
Capital market assumptions, which are used to forecast returns for major asset classes, are currently well below long-term historical averages. For instance, long-term return assumptions for domestic stocks have historically been between 7% and 9%. Today, some return assumptions for equities over the next 10 years are as low as 4% to 6%.
Additionally, long-term return assumptions for core bonds have historically been between 5% to 6%, yet today the 10-year projections are for annual returns below 3%. The major implication is that investors will have to save more to meet their retirement and savings objectives while taking on the same amount of volatility.
Why is trying to shift into fixed income in anticipation of volatility not necessarily the best strategy?
In times of volatility, or when volatility is anticipated, many investors shift assets into fixed income, believing that a reduction in equity exposure can shelter them from the full weight of a potential stock market decline.
Fear-based portfolio reallocations are a form of market-timing, which assumes investors know not just when to get out of equities but also when to get back in. Missing even the three best days of a market rebound can inflict more long-term harm on a portfolio than if an investor had simply ridden through the volatile period with their original portfolio allocation.
Can you tell us what it means to invest defensively? How do you do it?
The purpose of a defensive investment is to provide diversification within a portfolio and help moderate investment losses during periods of market volatility. The defensive nature of an investment can come either from its lower relative volatility to similar types of investments and/or its lower correlation to other investments in the portfolio.
For example, bonds are considered a defensive investment relative to stocks because they have lower volatility and are also generally lowly correlated to stocks. A blue-chip utility stock may be considered a defensive investment in the context of an equity allocation because it tends to be less volatile than the broader stock market.
The best defensive investments for challenging economic times are those that bring the greatest diversification to a portfolio while still allowing the portfolio to achieve its long-term investment objectives. Thus, different types of investments can be used depending on an investor’s unique needs or objectives.
For example, low-volatility stocks may provide sufficient defense for certain investors. For others, investments such as U.S. Treasurys, gold and even cash may be utilized; still others may look to incorporate nontraditional investments, such as options or currency trading into their portfolios.
Does investing defensively require giving up some upside to protect yourself on the downside?
Investors should ensure their allocation to defensive investments is aligned with their long-term investment goals — too much could become an anchor on long-term gains; too little could expose investors to more volatility than they may be comfortable with.
Moreover, investors should beware of relying on one type of defensive investment that may only work in certain market environments. A diversified approach to incorporating defensive investments is generally preferable to a concentrated one.
Defensive investing can help investors win more by losing less. While the benefits of a defensive investment are most obvious during times of market volatility, having a dedicated allocation to defensive investments may help investors remain committed to their long-term investment strategy and avoid knee-jerk reactions to market movements.
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Q&A With GuideStone Capital Management on Defensive Investing originally appeared on usnews.com