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The state of risk today

While the global economy continues to grow and many markets have had positive results so far this year, it doesn’t mean that investors can suddenly forget all about monitoring risks in their portfolios.

In fact, the best time to be extra-vigilant may be when markets are lofty and less volatile. You have to be ready for what might be waiting around the corner.

Here are three risks we’re monitoring right now:

  • Future earnings growth. Some economic data suggest that earnings growth might weaken later in the year. While the U.S. economy continues to grow at a modest pace, recent results for retail sales, auto sales and personal income have been worse than expected. Additionally, the U.S. dollar has weakened relative to many other foreign currencies so far this year, which could spur inflation, especially as wage growth hasn’t kept pace with inflation growth. Earnings growth that doesn’t meet expectations could mean increased market risk.
  • Developments in D.C. When Donald Trump was elected president and the Republican Party won control of both the House and Senate last November, many investors were optimistic that a business-friendly agenda would likely be implemented rather quickly. Fast forward to today, and the expectations aren’t as clear. Changes to healthcare legislation have stalled, and debate on tax reform is just beginning. With uncertainty surrounding the Trump administration’s plans for these and other priorities that he expressed to voters during his campaign, plus scant details on initiatives such as infrastructure spending, we will have to wait and see how many are developed and ultimately carried out. Political and regulatory risk will be just some of the risks affected by policy changes.
  • Central bank policy. After the global financial crisis, central banks around the world delivered massive amounts of stimulus to help support an economic recovery. Ten years later, central banks in developed markets are beginning to change course; the U.S. Federal Reserve has already raised rates twice this year and plans to hike interest rates one more time before 2017 is through. The European Central Bank and Bank of England are both debating when they will begin hiking interest rates. Interest-rate risk and credit risk could be affected by these policy actions.

So, what should an investor do now? In our view:

  • Stay aware of the potential risks. Investors need to stay informed about the markets and the global economy in order to measure possible risks and decide on ways to mitigate them within their portfolios should they arise. Ask yourself: How would certain world events affect my portfolio? Is my allocation overweight in an area that’s particularly sensitive to various risks right now?
  • Have a good grasp of your risk tolerance. And that doesn’t mean just knowing the volatility and standard deviation of an asset class. Ask yourself: How much can I really afford to lose so I can sleep at night? How significant of an impact would this loss have on my overall investment plan and goals?
  • Make sure you’re thinking far enough into the future. Part of managing risk is having a strong long-term asset allocation strategy. Rather than being fearful about the risks that exist today, plan to stick with your strategy – even during volatile markets. Ask yourself: Is my allocation well-balanced in accordance with my risk and reward profile? Do I have a strategic plan for my investments? If I don’t, should I get some help?

Risks will continue to evolve over time, but investors who take a proactive approach to measuring and monitoring investment risks within their overall strategy should have a better ability to remain calm. It is important to keep the focus on your long-term investment objectives and look at the bigger picture, particularly during uncertain times.

Risk on the Outset

Risks in a portfolio can be grouped into two large buckets: systematic and unsystematic.

Risks in a portfolio can be grouped into two large buckets: systematic and unsystematic. Systematic risks are those that impact numerous assets within a portfolio. For example, a political event would fall under systematic risks. A significant policy change in the U.S. could impact domestic equity and fixed income investments, as well as foreign investments that are tied to the U.S. in some form. Such risks are harder to protect against because they are difficult to avoid or influence. In other words, diversifying may not help to completely dodge these risks.

The other bucket of risks is unsystematic; they affect a smaller number of investments because they are often "specific" to a particular asset class. So in contrast to systematic risks, unsystematic risk can be reduced by diversifying into other categories where risks differ—offering investors more cushion to their portfolios.

  • U.S. Market Contraction and Expansions

    Future investment performance results are often difficult—and perhaps impossible—to predict accurately. Look closely at history though and you will note that long-term market performance results delivered overtime.

    The U.S. is currently witnessing an economic expansion, which has been underway for more than eight years. Since the financial and economic meltdown of 2009, the market (as measured by the S&P 500 Index) has recorded a cumulative return of 311%. While results have been positive, investors should maintain a consistent diversification strategy to help guard against unknown events that may impact results, such as market cycles, economic and monetary policies, U.S. and global growth, geopolitical uncertainties, and more.

    A contraction is defined by a decline in the stock market from its peak by 20% or more. An expansion measures subsequent market performance from the end of the recovery until it reaches the next peak level before another 20% decline.

    Source: Stocks-Ibbotson Associates SBBI U.S. Large Stock Index. ©2017. Morningstar Direct, Inc. 10/10/2017. Past performance is not an indication of future results. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

  • Asset Class Performance

    Astute investors use a diversified array of asset classes, across both equity and fixed income, which have delivered positive results so far this year. But remember: Each one responds differently to the current market environment. Therefore, since no one knows what markets will look like in the coming years, investors need to maintain their diversification strategy. Look closely at investment results this year alone: emerging markets have delivered notable results, followed by its close cousin, international equity. By carefully examining the multi-colored pattern of results, you will recognize that unpredictable asset classes illustrate the importance of balance and diversification, help reduce volatility and enhance overall results.

    Past performance is not indicative of future results.
    Source: Morningstar Direct, 10/10/2017. U.S. Government Bonds is represented by the Barclays US Agg Bond TR USD Index. U.S. High Yield is represented by the Barclays US Corporate High Yield TR USD Index. U.S. Investment Grade Bonds is represented by the Barclays US Govt Interm TR USD Index. Long Short Equity is represented by the HFRX Equity Hedge USD Index. International Equity is represented by the MSCI ACWI Ex USA GR USD Index. Emerging Markets is represented by the MSCI EM GR USD Index. U.S. Small Cap is represented by the Russell 2000 TR USD Index. U.S. Large Cap is represented by the S&P 500 TR USD Index. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. Individuals cannot invest directly in an index. For illustrative purposes only.

  • Risk/Reward

    Volatility can be gauged through the annualized standard deviation of returns, which means investors can use the standard deviation of historical performance to help predict a range of anticipated market returns. Translation? Volatility can be a useful measure of risk. Recognizing the volatility of different asset classes can help investors carefully develop a long-term, diversified asset strategy. A commitment to investing over the long term requires a certain amount of diversification and confidence, but remember: Not all risk is created equal.

    Past performance is not indicative of future results.
    Source: Morningstar Direct, 10/10/2017. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. Individuals cannot invest directly in an index. For illustrative purposes only. Performance data based on total monthly returns.

  • Correlation of Major Indices

    Prudent investment diversification absolutely makes sense; however, it’s important for investors to look beyond just equities and bonds and examine closely how they correlate to one another—or how two strategies move in relation to one another. Equity indices, both U.S. and emerging markets, have historically had a low correlation to bond indexes. By diversifying their exposure to markets that are less correlated with each other, investors can mitigate the overall risk in their portfolios. This can offset the chance that one event may create an adverse effect on your personalized investment strategy.

    Source: Morningstar Direct, 10/10/2017. All correlation coefficients calculated based on monthly total return data for period 10/1/2002 to 09/30/2017.

    Correlation expresses the strength of the relationship between distribution of returns of two sets of data. The correlation coefficient is always between +1 (perfect positive correlation) and -1 (perfect negative correction). A perfect correlation occurs when the two series being compared behave in exactly the same manner. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. Individuals cannot invest directly in an index. For illustrative purposes only.

  • Asset Allocation Models

    Many astute investors understand that, regardless of current or shifting market conditions, a prudent asset allocation strategy is the primary driver of long-term investment results. That’s why disciplined investors maintain a diversified asset allocation strategy, supported by an allocation to a broad array of investment strategies. Committing to your well-planned, long-term investment strategy can help you meet your financial goals, especially committing to and maintaining regular re-balancing across your investments.