Market conditions are changing—the U.S. Federal Reserve (Fed) is setting the course for normalized rates, questions surround global growth, and valuations are no longer compelling in any market. Uncertainty around rates, economic growth, and the market environment mean that strategies that have worked so well in the bull market since 2009 are not likely to be as effective going forward. We believe investors would do well to refocus on long-term, risk-adjusted performance, not just short-term absolute returns, as the best strategy for wealth accumulation over time.
Read Wittman’s full Q1 2016 CIO Insight:
Reassessing, Not Avoiding, Portfolio Risk
Changing Markets, Changing Strategies
Markets have been volatile but essentially rising steadily since 2009. As a result, we think it is high time to reevaluate risks in investor portfolios, and to think critically about the continued efficacy of strategies pursued in recent years. For example, relying on a high-beta strategy in stocks, or holding stock-like bonds in your fixed-income allocation, is not likely to be as effective going forward as it has been in the past. Indeed, from a valuation perspective, all assets are rich, or at least, no major asset class is cheap.
For these reasons, we think it is reasonable to expect lower returns and higher volatility going forward. Indeed, bond market volatility in 2015 reached levels not seen since 2009, while stock market volatility reached its highest point since the government shutdown and debt debacle of 2011.
Reining in Risk
Our concern is that investors have essentially been conditioned or lulled into complacency by favorable markets, and therefore be ill prepared for an increase
in volatility among risk assets. If we are correct about the coming normalization of interest rates and market conditions, then these investors would do well to review
their risk exposures and trim overly-aggressive allocations.
Or think of it this way—many market participants (retirement plan sponsors, investors, consultants) make asset allocation decisions based on three- and five-year track records. However, performance of financial assets tends to be mean reverting over the intermediate to long term. That is to say, a particular asset class or investment approach that has worked well for an extended period will typically then endure a period of underperformance relative to another style or type of investment.
For example, we can look back on an extended period of growth outperformance relative to value stocks. Would the best strategy be to double down on growth, or to take the more prudent approach and expect a reversion to the mean? We believe the answer is clear—in our asset allocation portfolios we have reduced our long-running growth overweight, and are now neutral in terms of exposure by investment style.
Maximizing Risk-Adjusted Return
Similarly, we would argue that managers of many balanced or target-date strategies have added return in recent years by ramping up risk. Such approaches appear to add value in rising markets, but are highly vulnerable to disappointing results when market returns moderate or rotate away from popular styles toward out-of-favor investments.
As a result, we believe it is important to evaluate managers on a risk-adjusted basis—the central challenge for investors going forward is likely to be maximizing return for the risk taken, not simply ramping up risk and return. In particular, we would argue for well-diversified approaches offering historically attractive Sharpe and Sortino ratios.
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.