Balanced portfolios, those with allocations to both bonds and stocks, have proven to provide better risk-adjusted returns than all stock portfolios. Even during periods of low fixed income market yields, as is now the case, bonds have a fraction of the volatility of stocks and tend to rise in price when stocks are stressed. Investors often underestimate the value of high quality fixed income investments as market buffers—especially during stock market corrections.
We recommend that retirees emphasize large cap stock portfolios to further insulate themselves from market declines. Large caps typically outperform riskier small caps in bear markets. Additionally, over an entire market cycle, large caps offer a better risk adjusted return based upon the widely accepted Sharpe Ratio. Purchasing stocks that offer above average growth in dividends is yet another way investors may help protect themselves (albeit partially) from the grips of a correction or bear market. Historically, an astonishing half of equity returns have come from dividends. In addition to providing retirees with extra cash flow, many higher dividend paying stocks are also high quality large caps.
Active core stock portfolio management can offer significant benefits unavailable from passive strategies during market corrections. Active managers can often identify fully priced equity markets and intervene by defensively adjusting their portfolios (either through lowering the beta, raising residual cash or equity sector realignment) as valuations warrant. Proactive management that avoids a portion of the correction’s decline, unlike a fully invested benchmark portfolio, can be enough to help investors remain engaged and may be an important value-add opportunity.
While not specifically portfolio management techniques, many of the higher value-add, tax-aware techniques can add significant value during market corrections as well. Location management, the thoughtful assignment of assets based upon their tax implications is one of the more valuable tax planning considerations an investment advisor can provide. Tax-loss harvesting (described earlier), can add extraordinary value during a market correction. Likewise, establishing and adhering to an annual realized gain budget will support the building of losses (to be used against eventual realized gains) while improving after-tax results and avoiding unpleasant year-end tax surprises.
Rebalancing in taxable accounts, unlike those in deferral, should be done in moderation as a means of retaining overall portfolio alignment rather than as a quarterly ritual that often generates taxable gains. While over/under weightings should be corrected over time, minor allocation drift should not be considered a problem. Realignment can occur as a way of managing portfolio risk or when sector strategy changes are necessary. Thoughtful rebalancing with realized gain budget limitations in mind should be a central tenant of asset management best practices.
In challenging markets quality manager selection and due diligence becomes even more important and should be done with great care. We recommend hiring proven experts and taking time to gain insight into their respective disciplines. Within core, long term performance/value-add should always be the primary focus. Once hired, even if early performance proves sub-optimal, managers should be given an extended period to prove themselves as this will avoid wholesale liquidations and the tax problems that can result.