Re-Sectioning the Pie Chart

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Re-Sectioning the Pie Chart

The whole idea behind asset allocation is to prevent extremes. Experience has taught us that the three main categories of investment assets—equities (stocks), fixed-income (bonds), and cash equivalents—each behave differently in reaction to any given set of circumstances. The term for this difference is “negative correlation.”

Investor.gov, the website of the U.S. Securities and Exchange Commission, explains asset allocation by comparing it to street vendors who sell both umbrellas and sunglasses, two items consumers are unlikely to purchase at the same time. The vendors know that when it’s raining, umbrellas will be in demand; when it’s sunny, the glasses will become the hot item. By diversifying, the vendors reduce the risk of losing a lot of money on any given day.

There’s no question that, in recent years, the investment asset allocation balancing act has become trickier, with the most noticeable change being in the area of fixed income. With interest rates so low, investors cannot look to bonds as a source of steady, “low-risk income” when stock prices fall. In fact, with near-negative interest rates, many investors literally cannot afford to own bonds. As a result of the lack of current yield on fixed income investments, Sheaff Brock Managing Director Dave Gilreath points out what we are seeing in place of the “push-and-pull” effect of negative correlation is a trend towards positive correlation between stocks and bonds. Reality is, Gilreath writes in Financial Advisor, “the behemoth tech stocks driving the market are trading more or less in tandem with bonds.” Should stock shares “go south,” he cautions, “bonds offer little in the way of a reliable cushion.”

That traditional 60/40 portfolio allocation may have been fine for your grandparents’—and even your parents’—retirement portfolio, but given today’s historically low interest rates and ever-extended life expectancies, it can be imperative to rethink asset allocation in order to ensure adequate income for retirement.

The solution? Ironically, Gilreath posits, it may lie in hedging stock risks with other stock risks. To counter the positivity in correlation between stocks and bonds, he suggests substituting shares of value stocks that generate reliable dividends. Carefully chosen large, midcap, and small-cap value stocks may provide bond-like correlation while paying several times the yield of high-quality corporate bonds.

It may be time to re-section the pie chart!

 

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