Diversifying differently

In 1991, investors needed to know only two things about the positioning of their investment portfolio as they entered retirement: Move to a higher allocation of bonds and fill the rest of the portfolio with large, well-known American stocks.

This simplistic approach proved quite successful throughout the 1990s. However, investors facing retirement investment decisions today are in a far more precarious position.

Just a few years ago, investors witnessed the culmination of a multiple-decade bull market for large U.S. stocks. Despite the recent three-year bear market, large U.S. stocks, historically speaking, are still in the top 10 percent of highest valuations ever. The outlook for bonds is not much better.

We are facing what appears to be the finale of a 20-year bond bull market. This is because bond prices tend to move in the opposite direction of interest rates.

With interest rates steadily declining for the past 20 years, bonds enjoyed an unprecedented period of excellent performance. Now that interest rates are near all-time lows, continued strong performance from bonds is unlikely.

Timeframe is critical

For investors with a lengthy investment time horizon — 20 years or more — an extended market correction may not be so damaging. But for those who have an intermediate timeframe — 10 to 15 years — substandard returns in both the equity and fixed income markets may prove disastrous if they are nearing or are already in retirement.

To add to these difficulties, inflation is likely to gradually increase. With bonds and stocks poised for at least a decade of mediocre performance (4 percent to 5 percent, according to legendary investors Warren Buffett and Bill Gross), where will retired investors and those nearing retirement turn?

The well-diversified portfolio, much as it has in years past, will serve the retired and near-retired investor well. The difference this time is that investors must be willing to incorporate different asset classes into their portfolio, asset classes that do not normally move in the same direction with one another.

This means they typically react differently to market conditions and thus offer downside protection when one class may be underperforming. Examples of such asset classes are hedge-like investments, commodities and real estate, in the form of Real Estate Investment Trusts.

While these may sound complicated and risky, they aren’t. Most are less risky than most domestic stock portfolios and are available in a standard mutual fund format. These types of investments have helped investors essentially avoid losses for the past three years.

When combined with more traditional investments like stocks and bonds, these investments can produce superior performance with significantly less risk; in fact, almost bond-like risk. Although bonds do not fare well in rising interest rate markets, certain fixed income investments do well when interest rates rise because their rate of return adjusts upward. Examples include stable value funds, bank loan funds, and TIPS (Treasury Inflation-Protected Securities).

By investing their portfolios in this manner , retired individuals and those nearing retirement will be able to preserve wealth, receive cash flow from their portfolio and stay ahead of inflation while obtaining returns not possible from the standard large U.S. stock and bond mix that served investors so well in the 1980s and 1990s. Louis P. Stanasolovich is president Legend Financial Advisors Inc.