As we enter the eighth year of the current bull market, many “experts” are calling for a correction and the arguments (as always) are compelling. I don’t believe anyone knows what the future will bring, but I do believe prudence dictates taking a more balanced approach to risk management. The following strategies are ones I believe worth consideration in the current environment.
Low volatility strategies: Defensive equities tend to focus more on sectors of the market that are less influenced by market cycles such as utilities and health care. These sectors tend to perform better during market corrections as consumers can’t forgo their products and services during economic stresses. Interesting research into defensive equities has produced the “low volatility anomaly.”
This anomaly can be attributed to Haugen and Heins (1972), whose early studies concluded that “over the long run, stock portfolios with lesser variance in monthly returns have experienced greater average returns than their ‘riskier’ counterparts.” Further research by Baker et al. (2011) stated that “while there are many candidates for the greatest anomaly in finance, the most worthy is the long-term success of the low volatility and low beta stock portfolios.”
Caution should be used in over-allocating to defensive equities as your sector exposure can become concentrated and therefore your results in the short term can deviate quite substantially from the broader indices.
Dividend portfolios: Dividend portfolios are not immune to market cycles, but they can help keep investors grounded during periods of market volatility as they provide a tangible link between investors and their investments. The mere payment of profits in the form of a dividend can help many otherwise skittish investors maintain discipline during periods of market stress.
Caution should be used in over-allocating to dividend portfolios as a cut in dividends by one company, depending on the level of diversification, can greatly impact the overall performance of a portfolio. The focus should be less on the dividend yield and more on the safety of the dividend. Look for structural advantages that a company might have that would provide a competitive advantage over competition leading to more predictable earnings.
Insurance strategies: Insurance strategies including structured notes and/or annuities can provide downside protection as well as a complement to a bond allocation. A great deal of research over the past decade has shown that partial annuitization of a portfolio can improve retirement income stability over portfolio-based strategies alone.
Caution should be used in over-allocating to insurance strategies as the costs associated, whether implicit or explicit, can inhibit the long-term growth of your portfolio, which could lead to a reduction in your standard of living over time. You also need to consider the impact of such investments on your needs for liquidity.
We are now in the second-longest bull market in history. By definition we have seen this before, but some caution would be appropriate. We think the most efficient way to reduce portfolio risk is by making a few changes to portfolio construction and consideration of the risk management policies as described above.
Gardner Sherrill, CFP, MBA, is an independent financial adviser with Sherrill Wealth Management. To learn more visit sherrillwealth.com.