The Newlywed’s Dilemma

April 25, 2012

As investors look to change priorities with relatively constrained risk budgets, low-volatility equities could help ease the transition.

 

For most adults, the New Normal of their personal lives starts not long after saying “I do.” The habits, schedules, hobbies, possessions, and even relationships garnered over the past 10 or 20 years must be altered or outright replaced. Married life changes one’s priorities, and priorities change just about everything. Nowhere is this more evident than in the disappearance of free time. Building a new life together, it turns out, is quite the time commitment. For most men, the big game over the weekend is out—replaced by, paraphrasing Will Ferrell in the movie Old School, “a nice little Saturday” at the Home Depot to buy some wallpaper and flooring. For women, “girls’ night out” becomes a rare treat. Unless the new spouse can find more hours in the day, the discretionary time of our single years fades sharply.

Our 3-D Hurricane1—the interconnected influence of relentless deficits, soaring debt, and an aging demography—is creating a similar demarcation for investors. Old investing patterns—for example, tracking error to the ubiquitous 60/40 blend of mainstream stocks and bonds, the comfortable reliance on “first-world” developed markets, and conventional cap-weighted indexing—may not fit with our new investment priorities: more effective inflation protection, absolute returns and better Sharpe ratios, a greater emphasis on developing economies and markets, and so forth.

In this issue, we explore ways investors can make the break from the “mainstream” investing approaches to which they have become accustomed to approaches that will position them better for the future.

The Volatility Of 3-D Hurricane Assets

It is a simple fact that mainstream stocks and bonds empirically do a very poor job of hedging against inflation, especially in the early stages of renewed inflation. It is also self-evident that stock and bond yields—especially in the United States—are both well below historical norms. For these reasons, we suggest that most investors begin building a “third pillar” to their stock and bond allocations. The third pillar would encompass a mix of real return investments. We also suggest that investors adopt a tactical asset allocation component to address the higher volatility and more frequent dislocations found in these asset classes.

Our inflation-fighting toolkit includes an array of assets that can shelter us from the growing 3-D hurricane.2 These include both the traditional real return asset classes (TIPS, commodities, and REITs) and a set of “Stealth Inflation Fighters” such as emerging market debt, high yield, and bank loans. Typically, the volatility of these asset classes is higher than mainstream stocks and bonds, as the highlighted lines show in Table 1. For many investors, these asset classes “feel” even riskier, due to their large “tracking error” relative to our classically invested 60/40 peers. After all, while no investor likes losses, there are few more lonely feelings than “wrong and alone,” as Peter Bernstein liked to say.

 

 

 

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