Finding Balance: Asset Allocation in a Post-COVID Economy
The coronavirus pandemic has caused countless small businesses to close, and unemployment numbers are staggering. At the same time, the S&P 500 index is strong and recently reached its all-time high. On the surface, this seems difficult to reconcile, but the stock market has always been a leading indicator. Investors have historically looked three to six months into the future, hoping to identify sources of profits. Now it seems that Wall Street is looking at least six to 12 months ahead, and it is pinning economic hopes on a successful launch and distribution of the coronavirus vaccines. Moreover, the Federal Reserve has made a commitment to keep interest rates at their current lows for years. If there is a spike in economic activity, this will increase the likelihood of looming inflation over the next few years. The challenge for yield-seeking investors is to determine exactly how to properly allocate their accounts while facing so much uncertainty.
Maintaining diversification is always a primary investing objective, but today’s market conditions make this trickier than usual. The basic tenet of diversification requires that investors hold varying securities with low correlations. The complication for wealth managers is to identify diversifying securities without sacrificing too much in way of return.
In times of great uncertainty, investors have typically fled to the shelter of the “blue chip” sectors such as banks and pharmaceuticals. In 2020, investment money was heavily channeled to the largest internet technology and consumer stocks such as Amazon, Apple, Facebook, Google and Microsoft. Meanwhile, traditional large cap value stocks slowly plodded along. It was not until late October, and particularly after Pfizer announced that it had a viable vaccine, that value stocks began to reclaim their previous highs. Even so, the ongoing debate continues as to whether value or growth stocks will provide better returns in the coming months and years.
Evaluating the Options
Aside from the stock market, investors have fewer appealing choices to balance their portfolios. With interest rates at their current level, the traditional option of purchasing bonds for safety offers only limited prospects for income. Depending on the type of bond, duration and term, interest rates are essentially the same as the current inflation rate, which translates to a miniscule real rate of return.
Bond mutual funds, which can offer both income and capital gains, are generally low to moderately correlated with broader stock market price fluctuations. These funds performed reasonably well in 2020 as interest rates plummeted to near zero percent. However, it is uncertain whether these bond funds can sustain their returns now that interest rates have reached their floor. Preferred stocks can also be an excellent choice for those seeking income, especially in taxable accounts.
Cryptocurrency is an interesting option, but its price volatility makes it optimal only for those investors who have the stomach for risk and the ability to grasp its inherent complexity. A portion of portfolios can also be allocated to commodities and precious metals, but these investments typically do not generate income.
With this landscape, alpha-seeking investors must find a way to diversify their equities in order to reduce risk. While most equity prices tend to move concordantly, certain industries such as health care and pharmaceuticals, can be less correlated with the broader market, and others, such as utilities and energy, are often barely correlated. Both international-developed and emerging-market equities can offer excellent opportunities for investors to further diversify their largely U.S. portfolios.
Mind the Risk
As is always the case, wealth managers would do well to revisit the topic of risk tolerance with their clients. Additionally, caution should be applied to avoid making too many drastic changes in portfolios that could result in drifting away from clients’ long-term interests and objectives. Crises give rise to innovation, and it can be tempting to steer client assets too far toward unproven technologies with the aim of generating rapid growth. Care should be taken to prevent over-concentration in any industry sector.
Following these guidelines, diversification through proper attention to correlation can help clients navigate any potential financial market volatility in 2021.
David L. Tepp
David Tepp, CPA, PFS, MBA, is the managing member of Tepp Financial Planning, an independent wealth management firm in Westfield, New Jersey. He is a member of the NJCPA.
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This article appeared in the Spring 2021 issue of New Jersey CPA magazine. Read the full issue.