After a year of rising stock prices, your portfolio may be overly reliant on equities. How do you rebalance when bonds are also expensive? We went to Aldwin Callen Wealth Advisor James Gerald Harper for some answers and thoughts.
James, what are the most important factors to consider while structuring/rebalancing portfolios in 2021?
JDC: It's always vital to reconcile long-term positioning with short-term expectations, which is made more difficult by today's markets. Longer term, we are concerned about the impact of deficit spending, which is expected to result in inflation, increased interest rates, a lower US dollar, and less future growth. In the meanwhile, changes in fiscal and regulatory policies in the United States are anticipated to present both challenges and opportunities for investment portfolios.
The most difficult problem for asset allocators is that most financial assets appear to be overpriced in the short run. Of course, there are possibilities in sectors that haven't seen significant recoveries since the March 2020 market crash. However, after two years of high returns and Covid-19 remaining the leading market determinant in 2021, investors will need to be more selective, even if a thorough rebalance isn't required.
Long-term returns are anticipated to be less robust – certainly when compared to the previous decade – due to current valuations, lower forecast growth, lower yields (even if they eventually trend higher), and possibly inflation. When you combine these factors, there will almost certainly be a pull to make portfolios riskier in order to fulfill long-term return objectives in a market that appears to be costly.
To meet long-term objectives, asset allocators will likely need to: (1) think strategically about the impact of any additional risk on the portfolio over a full market cycle; (2) accept some measure of increased portfolio risk and volatility; and (3) ensure that diversifying asset classes, including fixed income and private market investments, have the right types of exposures required to buffer volatility when it arises.
Which asset classes, if any, are you particularly interested in right now?
JDC: We're keeping a tight eye on real assets, both in the short and long term. Commodities, natural resource stocks, REITs, and infrastructure shares are all examples of this, in our opinion. In 2020, the majority of these sectors trailed both the stock and bond markets. Infrastructure stocks, in particular – power plants, water utilities, toll roads, telecom towers, airports, hospitals, and so on – took a beating in 2020. These assets appear to be ideally positioned to perform well as cyclical plays in 2021 and 2022. Longer term, real assets should gain from rising demand for infrastructure repair and development, bipartisan government backing, and some built-in protection from inflation, as the bulk of infrastructure companies are able to pass on price increases to customers.
Another asset type worth considering is core [high-quality] fixed income. Bond rates are remain low, though they have begun to rise in recent months. With the 10-year Treasury yield lately at 1.3 percent, it's not unexpected that asset allocators are still looking for yield outside of bonds, especially if they're ready to accept additional volatility.
That being said, I would not lose sight of the reality that the fundamental objective of fixed income in a portfolio is to minimize risk rather than to generate return. Consider an investor who is increasing his or her allocations to high-yield credit at the expense of core fixed income. They are, indeed, increasing the portfolio's expected yield. At the same time, they are undermining the role of quality fixed income as a diversifier.
Even at a period of low returns, high-quality fixed income is likely to provide the simplest and cheapest diversification to portfolios that are primarily driven by stock risk. Portfolios may contain less fixed income than in the past, but there must be an emphasis on improving the quality of what remains to ensure it offers value when needed.
What role should cash play?
JCD: What we've witnessed over the last year is typical of any challenging market climate. During market downturns, there is always a rush to increase cash, but this often ends up being a drag on portfolios as conditions improve. Our approach has always been to prioritize appropriate liquidity for each client, preventing them from needing to raise funds during market downturns and accepting a discount when the asset being sold is not substantially impaired. Generally, we recommend keeping at least three to six months' worth of cash outside of an investing portfolio, and in some circumstances, 12 months or more. The range varies widely based on the client's demands, ambitions, and financial situation.
Some say that cash is a better investment than fixed income in a portfolio. That could be the case in the short term if interest rates are expected to climb. However, with a few exceptions, quality fixed income has outperformed cash during big market selloffs as investors reduce their growth and inflation expectations and long-term interest rates follow suit. Even with interest rates reaching historic lows, keeping a portion of your portfolio in high-quality bonds is a wise idea.
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