It is no secret, having a well diversified investment portfolio can reduce the market rollercoaster effect. Without it, you are subject to the swings of a few investments.
Investments that react similarly to economic and market conditions can be grouped into class buckets. To have a diversified portfolio you must choose complimentary classes. That is they do not react the same under similar conditions.
The choice of asset classes and relative size of the buckets has been found to be the best predictor of overall portfolio performance. Getting the class and industry choices correct is about getting the strategy right. It is important to choose the right investment in each but, if you don’t get the strategy right, it won’t matter.
For example, you could choose a strong bookmaker stock but if the industry is shrinking, it may not do well.
We can use historical data to choose the assets classes and mix for our portfolio. A problem arises when the relationships between the classes, and performance, change under economic and market stress.
This was a problem in 2008, different classes reacted the same, they moved down together. To keep on top of these interactions can be a daunting task. Fortunately, if we move to a higher altitude and take a bird’s-eye view of the landscape we can see how the forces influence asset classes, industries and individual investments. We are seeing macroeconomic forces in play.
We are interested in looking at the economic conditions to guide us in choosing those classes that are aligned with economic forces. This means the forces will be pushing the class or industry forward, not holding it back. It is difficult to succeed when fighting global forces. For example, if we look at interest rates (low) and money supply (increasing), we can conclude that at some point rates and inflation will increase. Both of these conditions are not good signs for the bond market at today’s rates. It would be wise to consider this when allocating your investments to avoid poor performance in the future.
By taking an overall view, we avoid focusing too closely on hot classes and see where the markets are heading. Focusing on longer term trends allows proactive execution of a strategy, rather than reactive moves.
You can find economic indicators in various financial and government publications. Start looking at the Wall Street Journal, Financial Times, US Bureau of Economic Analysis (bea.gov) and U.S. Bureau of Labor Statistics (bls.gov). The difficulty is determining which of the indicators is most valuable in seeing how the forces are moving. Numerous analysts monitor these changes and can provide guidance. You still must determine which of these reports provide factual information and which are just opinion. You may find it more productive to enlist the services of an adviser to help sort through the information and apply it to your situation.
Blindly choosing an allocation based on past data will lead to unexpected results in the future. Your portfolio can benefit by adjusting the allocation based economic trends. Once you have set your strategy, the mix, you can use this information in choosing specific investments to fill the buckets. That is a topic for another day.
Tom Roberts, owner of A New Approach Financial Planning in Lakewood Ranch and Sarasota, can be reached at 941-927-9590 or Tom@ANewApproachFP.com.