At a glance
When market uncertainty is high, it is important to stay invested but manage downside risk by diversifying globally across asset classes and regions, which includes maintaining an adequate level of high-quality bonds. But there are also alternative ways to diversify beyond cash and bonds.
Recommended ways to diversify
Stocks have rallied strongly from their March lows. We recommend staying invested, but also prudently managing risks, as we cannot rule out our downside scenario. Here we see governments in major economies re-imposing lockdowns intermittently to prevent their health systems from being overrun.
First and foremost, to manage these risks, this means diversifying across regions and asset classes. A 60%/40% stock/bond portfolio would have experienced an average of –19.9% peak-to-trough drawdown in the past seven bear markets, versus –34.5% for an all-equity portfolio. Given low starting yields, the ability for high-quality bonds to provide significant positive returns in the event of equity market declines is currently very limited. Even worse, bonds could have negative real returns at the same time as equities if inflation were to become a future source of equity market concern.
So aside from bonds, we also recommend a number of other ways to diversify:
A vital part of protecting against the downside includes not having to sell out of the market at the wrong time due to a cash shortfall. As a result, we recommend investors adopt a financial plan. Our Liquidity. Longevity. Legacy. (3L)* framework starts with a Liquidity strategy to ensure sufficient resources to meet cash flow needs for the next three to five years. Because well-diversified portfolios have historically experienced a full recovery from most previous bear markets in this timeframe, this allows investors to confidently invest the rest of their capital for growth, either for retirement spending (i.e. the Longevity strategy) or for inheritance and philanthropy (i.e. the Legacy strategy). Setting aside resources for spending needs provides an ample buffer to help ensure that investors aren't compelled to sell assets at the wrong time—a comfort that's particularly helpful during periods of market panic. Investors that we advised to structure a strong Liquidity strategy—which includes cash and short-term bonds—had no reason to sell out of the market during the recent sell-off, and could even take advantage of opportunities as they arose. Given that interest rates are historically low, the arithmetic favors using borrowing strategies—which can also help investors avoid cash shortfalls—as a complement to the asset-based component of the Liquidity strategy.
Key investment takeaways:
- The global coronavirus outbreak has resulted in considerable uncertainty. Market downside cannot be ruled out.
- Setting aside resources for spending needs provides a vital buffer against short-term uncertainty, and allows long-term capital to be invested for growth.
- Global diversification remains paramount. Risk-averse investors have several options beyond just high-quality bonds.
- We advise adding exposure to alternative diversifiers to protect against the downside.
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