During periods of strong stock performance, many investors over‑weight stocks to take advantage of outstanding returns. Risk often seems minimal during these times as people watch their accounts grow. Bonds — with their limited returns — are largely forgotten. Invariably, though, the party ends and, all of a sudden, economic turmoil and a stock-market downturn create the opposite effect as investors abandon equities and run for the cover of fixed-income investments.
We believe investors’ asset allocations, or the division of assets among stocks, bonds and cash, have been influenced by market extremes in recent years. Now is a good time for a closer look at how an appropriate allocation can help you meet your financial goals.
Establish a Balance
Theoretically, when stocks are up, bond yields are down, and as inflation soars, the dollar loses value. This relationship helps explain why some investors tend to limit their focus to top‑performing markets. As markets shift, investors adjust. (Unfortunately, they often adjust after the rally they’re chasing is behind them.)
For those who wish to avoid huge fluctuations, it is important to keep assets balanced. When assets are diversified, typically at least some portion of your portfolio is working for you. Finding the right balance (or weighting) of assets for your portfolio can help safeguard your savings from market volatility. (Remember that asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.)
Adjust for Your Financial Situation
Beyond increased stability, a balanced portfolio helps investors focus on meeting their financial needs and objectives. To evaluate your allocation, consider current holdings, possible future expenses, and your time horizon before retirement. Also look at employment security, tax implications, the value (and risk) of any stock options, and your risk tolerance. A financial advisor, working with your tax advisor, can help you develop a plan based on these variables.
Cover All Bases
When deciding how to allocate your portfolio, carefully review your expenses and consider the following suggestions:
Plan cash first. It’s important to maintain enough cash to cover emergencies that could last three months or more. Money‑market accounts are short‑term options for your emergency reserve.
To plan for major expenses that are a few years down the road, consider fixed‑income options. Combinations of T‑bills, corporate bonds and municipal bonds with varying benefit and maturity dates can be purchased at intervals to make the funds available for upcoming home purchases and college tuition bills. If these funds are invested entirely in stocks, you might be forced to sell when the market is down.
Investing in equities is generally best for long‑term savings. Though stocks traditionally provide the strongest returns of all asset categories, they also carry the most volatility. With a long‑term investment horizon, you have the freedom to sell stocks that have reached your performance expectations and hold onto those that still have potential for gains.
This advice may sound familiar, but investors who have allowed their portfolios to shift almost exclusively into either stocks or fixed‑income investments might want to give a new order of priority and level of attention to their portfolios. Research has shown that asset allocation may be the most important decision an investor makes. To learn more about how a smart asset allocation can help you achieve your financial goals, contact your financial advisor.
Using Economic Indicators to Track the Markets
Many factors move the markets, but perhaps no factor has more of an influence than the state of the economy. The direction of the economy can dramatically affect the earnings growth of entire industries. What are some of the more important indicators to monitor?
Late in an economic recovery, inflation (the increase in the cost of living) can have a major impact on the market. If inflation rises faster than expected, interest rates rise and borrowing costs increase, which can be a negative for stocks. If inflation declines, rates and borrowing costs fall, which can be a good sign for equities.
You can track the inflation rate monthly by following the Consumer Price Index (CPI). Released by the Bureau of Labor Statistics (www.bls.gov), the CPI is reported in the newspapers and on television. It represents prices for a basket of goods and services, which includes food, housing and transportation.
- Initial Unemployment Claims
Released monthly by the Bureau of Labor Statistics, this report provides a snapshot of the prevailing employment picture. When the number of claims comes in higher than analysts expect, it generally means the economy is slowing, which is usually good for stocks because it indicates that inflation is under control. When the number is lower than anticipated, it generally means more people are working and pouring money into the economy, which could raise inflation, usually a bad sign for stocks.
- Index of Leading Economic Indicators (LEI)
The LEI reflects the economy’s health. It tends to forewarn of business downturns six to nine months before they occur. The LEI consists of 11 economic indicators, such as unfilled durable‑goods orders, average manufacturing workweek, plant and equipment orders, sensitive material prices, vendor performance and new orders for consumer goods. Generally, three consecutive monthly LEI changes in the same direction signal a shift in the direction of the economy. If it increases for three straight months, it means the economy is likely to grow, which investors could view favorably if the growth is moderate. Declines in three consecutive months suggest that the economy could be headed for recession, a negative for stocks. (Slow growth is good for equities in a mature economic environment — but when growth is too slow, the earnings cannot generally support higher stock prices.)
You should consider these and other economic indicators in making a prudent decision about the market’s direction. Of course, past performance is not indicative of future results. Talk with your financial advisor for help in tracking the economy and the markets.