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Dont Unbundle Your Investment Portfolio Dont Unbundle Your Investment Portfolio
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Don't Unbundle Your Investment Portfolio

Brent Schutte, CFA •  March 29, 2017 | Your Finances

Brent Shutte, CFALost in the daily chatter of which individual asset class is the most attractive or has provided the highest recent return is the reality that what matters most to an investor’s long-term success is how a combination of these assets behave together. Unfortunately, many investors “unbundle” their portfolios and look at each part in isolation. This means that after the strong equity returns of the past months/ years, coupled with seemingly never-ending investor fears about the economic outlook and a potential market sell-off, many investors are tempted to make dramatic changes to their portfolios.  

While each investor’s portfolio should be based upon his or her unique goals, objectives, time horizon and risk tolerance, I’d encourage you to consider the following high-level analysis and historical facts to help you contemplate any potential changes. 

1. What is your current portfolio allocation? A properly constructed portfolio should contain the risk and return characteristics that provide you the opportunity to meet your short-, intermediate- and long-term financial goals while not causing sleep deprivation. The first question to ask yourself is whether something has changed with your goals or risk tolerance. 

2. Most investor portfolios often have already been readied for a market sell-off. Why? Because they often contain a combination of stocks, bonds and cash; and one could argue that if you have money in bonds or cash, you have already prepared for a stock market sell-off. After all, if stock markets never went down and/or you didn’t need the money within the next 10 years and could stomach the higher volatility, wouldn’t you allocate heavily to equities since in general they have had the highest historical average return?

3. Still not convinced? Let’s take it to the extreme and compare the historical return of an all-bond portfolio versus a diversified portfolio of stocks and bonds. For simplicity, we will restrict our study to two asset classes: U.S. Large Capitalization Equities (the S&P 500) and U.S. Taxable Bonds (the Bloomberg Barclays Aggregate Bond Index). We will begin by having the diversified portfolio invested 20 percent equities/80 percent bonds. 

From January 1, 1978, to December 31, 2016, the cumulative total return of the all-bond portfolio was 7.47 percent per year. The 20 percent equity/80 percent bond (diversified) portfolio provided 8.51 percent per year (over 1 percent more per year). Somewhat surprising may be that the diversified portfolio containing equities produced a positive return in 329 of the 468 months, while the bond portfolio was positive in “only” 320 months. Furthermore, the largest monthly loss in each was virtually indistinguishable, at -6.14 percent for the diversified portfolio and -6.07 percent for the bond portfolio. 

The math becomes even more interesting as the time horizon is lengthened to be measured in years. Indeed, in a rolling one-year period, the all-bond portfolio has been negative 36 times, with a maximum loss of -9.21 percent, vs. the diversified portfolio having only 24 negatives and a smaller maximum loss of -7.38 percent. Increasing the perspective to three-year rolling time periods, the bond portfolio has had two negative returns (each in the 1970s), while the diversified portfolio has never had a negative rolling three-year return. 

As one continues to add equities to the portfolio, risk does increase. For example, at 30 percent equities and 70 percent bonds, the maximum one-year rolling loss increases to -12.03 percent but still has only 28 negative one-year periods and one negative three-year time period.  And while a “balanced” 50 percent equity/50 percent bond portfolio does have a much larger maximum one-year negative of -21.2 percent, if you can stretch your time horizon to five years, there has been only one negative return (-.69 percent annualized in the period ending February 28, 2009).

This analysis is not intended to provide an asset allocation recommendation for any individual. Indeed, even 90-100 percent equities may be the right mix for those who do not need access to their capital for several years. Similarly, it is not meant to give investors an excuse to do nothing; one should continually and thoughtfully review their portfolio to make sure it is suitable given their goals and objectives.  

I’m hopeful that what it does provide is a heavy dose of context, data and rigor to your decision-making process. Eliminating equities from your portfolio and moving to the “safety” of fixed income is—at least historically—not the right mathematical answer. Maintaining at least a small allocation to equities can potentially increase your return while not adding substantial risk. And if you’re considering increasing your equity allocation, just realize that this strategy may require a longer time frame to reach its full potential. 

Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) (life and disability insurance, annuities, and life insurance with long-term care benefits) and its subsidiaries. Northwestern Mutual Investment Services, LLC (securities), subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC. Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI (fiduciary and fee-based financial planning services), subsidiary of NM, limited purpose federal savings bank.

The opinions expressed are those of Northwestern Mutual as of the date stated on this publication and are subject to change. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources. Sources may include Bloomberg, Morningstar, FactSet and Standard & Poor’s.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.  

Standard and Poor’s 500 Index® (S&P 500®) is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

Barclays Capital US Aggregate Bond Index (formerly Lehman Brothers US Aggregate Bond Index) is a benchmark index composed of US securities in Treasury, Government-Related, Corporate, and Securitized sectors. It includes securities that are of investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $250 million.

Indexes used are unmanaged and cannot be invested in directly.

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