October 2015 rescued many investors from a dismal year on returns, but the same isn’t true for those investors whose bankroll was wrapped up in products other than core U.S. Equity and fixed income products. Developed foreign markets, as well as emerging markets, finished the year in the red.
The broader U.S. Equities markets were some of the rare survivors of 2015, but by no means does that mean they didn’t struggle. Multiple markets saw more than a 1% decrease, for example, small-cap investments declined 2.1%, and the overall value was -8.4% for the year.
Despite the somewhat positive end to 2015, 2016 is expected to be a year of change in the markets both at home and abroad. It is crucial that your clients are prepared for the bumpy road ahead and here are a few things to watch as we dive into 2016:
The Federal Reserve
The Fed, as well as other centra banks, may not necessarily be in control of the world financial markets right now but they are almost certainly driving the vehicle. Even a mention of possible changes from Federal Reserve Chair Janet Yellen or European Central Bank President Mario Draghi can cause major activity in markets across the world.
A big part of U.S. investment market performance in 2016 will center on Ms. Yellen’s management of the U.S. transitioning interest rates back to a normal, non-zero status. If The Fed increases rates too quickly, the U.S. economy could be thrown back in the direction of recession. If they lag too much on increases, the cheap cost of credit could fuel a possible bubble in asset prices.
Overall, higher rates are going to usher in slower economic growth, as well as a less robust profit margin for U.S. firms, indicating to less-experienced investors that the longer The Fed holds off in raising rates, the better U.S. stocks will perform.
Federal Reserve actions are one of the major points of near-certainty for the economy this year, as the FOMC has stated emphatically that it will raise rates this year, as many as four occasions. It is important to keep current on their communications. Luckily, this Federal Reserve board has been fairly transparent thus far.
Don’t Put All of Your Effort into One Strategy
It’s important to encourage diversification as much as possible in client portfolios in this possibly volatile year. Take the time to develop a thoughtful asset allocation approach for investment management clients, then make sure it’s adhered to by clients.
There are benefits of strategic diversification that make it almost on par with choosing the singular most successful investment strategy. This approach is so effective because incorporating strategies with diverse investment processes will encourage different portions of a portfolio to cycle through periods of underperformance separate of each other. Riding the wave through independent sectors is a lot easier on both investment manager and client if the portfolio diversification is strong enough that one product cancels another product out, which helps to create more consistent returns.
It is conceivable that incorporating five or more separate asset allocation approaches in one portfolio is more than a single firm can handle. However, incorporating just 2 or 3 can be both feasible for the firm to execute and the average investment management client to follow, especially if ETFs are used as part of the mix.
2016 Will See Volatility
Available data shows that periods of intense volatility tend to group together. The market saw some months of extreme volatility in 2015, so it wouldn’t be out of the norm to prepare for the same behavior in the market for at least the first two fiscal quarters of 2016.
It is also important to remember that any adjustment to interest rates from the Federal Reserve tends to cause market adjustments leading to volatility, a trend that has held true for the last several decades. Preparing for a treacherous road for at least the first half of the year is a prudent tactic.
There Is No “Diamond In The Rough”
There is no single strategy, no single investment product, which is entirely safe from poor returns or volatility. No one strategy is an end-all-be-all for success year in and year out.
This is what makes diversification so important. Even if investment management approaches outperformed specific financial sectors in the U.S. market over the long term, they will still experience short-term periods of loss or underperformance.
Educate Investment Management Clients
It is important for financial planning professionals to educate clients on what different trends in the markets mean. This can be vital to maintaining strong client relationships as it helps clients see through the tough times and thus provides a sense of security when volatility strikes a portfolio down in any given year. The most effective place to start is often educating investment management clients about the differences between cyclical and secular trends in the markets.
Cyclical trends are fairly straight-forward. These are market trends that move in a particular direction for a period of time, then as conditions change, correct themselves and complete the cycle. The best example is also one of the easiest to spot: watching the broad stock market indexes fall leading up to a recession then watching them rise again once the economy resets and pulls itself out of recession.
Secular trends are a bit more complex. These are longer-term trends in a specific industry or market that has been brought on by some major change. For example, the contraction of newspaper value as the web grew in popularity or the fall of film companies as digital cameras became the new industry standard.
It can be difficult to differentiate between these two trends. Will financial sector stocks eventually recover despite new regulations in place to keep these products, like credit derivatives, from decimating the global economy once again? Or are low stock prices an indicator of the disruption occurring in the industry? Will PC sales rebound as smartphones become ubiquitous? Or is the decline in PC production irrevocably linked to the rise of smartphone sales? Quite often, a change in a cyclical trend can become a secular trend if the cycle is long enough.
For many investment management clients, there is simply too much knowledge they are missing, too much information to try and grasp and too little time to adequately research what is necessary to know for them to successfully implement a strategically diversified portfolio that can withstand turbulent markets. For the prudent financial advisor, educating clients on the basics, then walking through various strategies designed to take advantage of even the most difficult market conditions, combined with the fore-knowledge that allocations will need to be re-examined frequently, especially in difficult conditions, are the best ways for successful investment management relationships, and hopefully portfolio returns will reflect this extra time and effort.