CIO Insights: Diversification Is the Name of the Game

In this quarter’s CIO Insights, the discussion has been about higher interest rates and the implications for different market segments. Here we attempt to put this information in context. Rather than try to anticipate a single outcome, we would urge investors to focus on what they do know with a high degree of certainty—their saving and investing plan.

Read Wittman’s full Q3 2015 CIO Insight: Diversification Is the Name of the Game

What Do the Stocks Say?

With the first Federal Reserve (Fed) interest rate hike anticipated later this year, much of the talk in the financial media has been about the implications for the stock market. One popular theory suggests that the recent market run-up is based entirely on easy money; therefore, the argument goes, tighter monetary policy necessarily will be bad for stocks. But our intuition and analysis tell us that this is an oversimplification. Rather, there is a great deal of research to suggest that stocks can continue to do well even after the Fed begins to raise rates.

Stock returns are a function of earnings growth, dividend payouts, and price/earnings multiple expansion (often referred to as valuation). Corporate earnings as a portion of stock returns tend to track economic growth. That is, they are generally positive, and contribute more to stock performance when the economy is expanding—even in periods when interest rates are rising. Dividends are also historically positive contributors to stock performance, regardless of economic and interest rate environments.

In terms of contribution to stock returns over time, valuations vary most. However, a recent analysis by Bank of America Merrill Lynch shows that there is no clear trend in valuation changes and stock performance around the start of Fed interest rate tightening cycles. In fact, in recent history, it has often been true that the stock market peaked well after the first rate hike. We believe it’s incorrect to suggest that a Fed rate hike necessarily means the bull market is over. Indeed, we urge you to think of investing not as an exercise in market timing, but rather in financial planning.

Bonds—Same as They Ever Were

For fixed-income investors, the math is more certain—when interest rates rise, bond prices decline. The May and June sell-off in bonds reflects this reality, as stronger U.S. economic growth made a Fed rate increase more likely. Investors reacted to the greater likelihood of higher rates by selling bonds. However, the decline in bond prices and rise in yields occurred before the Fed actually moved.

In addition, the bond market is comprised of securities from highly differentiated issuers at different maturities. So what’s good for one type of bond, say U.S. Treasuries, may not benefit securities issued by corporations, and vice versa. As a result, we caution investors from making wholesale changes to their fixed-income allocation based solely on potential Fed policy moves; we believe it’s better to focus on bonds’ long-term risk-reduction and income-generating potential in the context of your portfolio as a whole. These latter two concepts are likely central to your decision to incorporate bonds into your portfolio in the first place—this reasoning continues to hold.

Power to the (Financial) People

We have argued that financial markets are highly complex and multi-faceted, making it difficult to predict market reaction to economic and interest rate changes. Instead, we suggest that an investor’s best odds of success rest in working with a financial professional to craft a well-diversified portfolio in the context of a larger financial plan.

Diversification does not assure a profit nor does it protect against loss of principal.

The opinions expressed are those of Scott Wittman, CFA, CAIA, and are no guarantee of the future performance of any American Century Investments portfolio.

For educational use only. This information is not intended to serve as investment advice. Past performance is no guarantee of future results.