Underpinning investor’s retirement goals is the need to have enough income to live how they want, for as long as they need. Though that goal has remained static, today’s market backdrop poses unique hazards for those attempting to balance the desire to grow their portfolios while not losing the nest eggs they have already built. Supplementing a portfolio with alternative strategies may be an option to help balance both objectives, but they also can have unique risks due to the complex nature of the advanced techniques they employ.
Traditional Portfolios Worked Under Old Conditions
In market cycles past, investors relied on equities to drive returns and fixed-income investments to reduce risk. Going forward the ability of stocks and bonds to accomplish these objectives is more uncertain.
The current equity bull market is over eight years old, fast approaching one of the longest on record. Post-election optimism has also driven already high stock valuations even higher. And bonds have benefited from generally falling interest rates for the better part of thirty years.
Today bonds face rising interest rates as the Federal Reserve seeks to tighten monetary policy. Based on projections from individual board members, rates could rise to near 4% over the next two years.
These factors have led industry experts to curb growth expectations. For example, consultants McKinsey Global Institute recommends downplaying investor expectations for the next 20 years, and several large public pensions have reduced their portfolios’ expected rates of return.
Add those factors to enduring geopolitical uncertainty and increased volatility may be expected.
Time Poses a Problem
Under old rules, investors were encouraged to reduce risk by adjusting their allocations as they approached retirement—more in fixed income and less in equities.
Enter the potential for a perfect storm—increased volatility, tempered earnings growth and rising rates. The problem is time. Investors approaching retirement may not have enough of it to recover from a correction.
A Different Diversification Approach May Be Needed
While there are different paths you can take to enhance diversification, I want to explore one — adding alternatives to a traditional stock and bond portfolio.
Investors focused on positioning their portfolios for rising rates and other potential market stressors may consider alternative income strategies as an option. By design, alternative income strategies include income-producing assets, while employing advanced techniques to attempt to reduce volatility and limit correlation to traditional markets. These techniques may potentially help with specific goals, but investors also may be unfamiliar with certain risks that should be carefully considered.
Alternatives May Help with Specific Income Goals
There are many objectives investors have for pursuing alternatives. Here are three that may be important for longer-term goals such as retirement.
1. Balancing risk and maintaining growth
Alternative income investments provide different risk and return sources than traditional investments. Because of this, their returns tend to move in different patterns and can potentially help manage volatility.
2. Reducing interest risk and credit risk
Historically alternative income strategies have been resilient under different interest rate environments. However, they use non-traditional techniques that may not be as conservative as core investment-grade bonds or U.S. Treasuries.
3. Enhancing diversification
Alternative income strategies have historically had lower correlation to stocks, which may add balance during severe market downturns.
Adding Alternatives Takes Forethought
Expectations are fairly high that the market environment over the next several years will look very different than it has in the recent past. Enhancing diversification with alternative income strategies is something to consider, along with the unique risks they pose. It also takes understanding and strategy to figure out which type of alternative is best-suited, and at what percentage for each person.
While alternative strategies typically use advanced techniques, these techniques have risks not generally found with traditional investments. The following apply to income alternative strategies:
Derivatives are contracts where the value is based on the performance of other assets, interest rates or indices. They are typically bought for much less than the asset costs, and you can earn large returns from small movements in the asset’s price. However, investors can have large losses if the asset price moves against them or if a contractor defaults.
Short selling attempts to take advantage of falling prices. Portfolio managers borrow and sell stock or bond that they believe will decline in price, making money on the difference between the borrowed price and the selling price. It’s risky if the borrowed security price rises instead of falls, resulting in a loss that theoretically could be unlimited since there is no price ceiling.
Each of these alternative asset classes and investment strategies have unique risks, typically making them more suitable for investors with an above average tolerance for risk. Investors should fully understand the asset classes, investment strategies and their risks before investing.
Individual Investors: Learn more about alternative investments and their role in a portfolio.
Investment Professionals: Find out more about implementing alternatives for income for your clients.
Diversification does not assure a profit nor does it protect against loss of principal.
Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.