Broker Check

Balancing risks to find new sources of return

| July 08, 2018
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This week, we published a few articles that echo our concerns about sub-par market returns.  We include one graphic below that examines projected "real" returns (after inflation) for different market groups over the next decade (Source: Morningstar).  Given this backdrop, our objective is to help investors find new ways to earn attractive returns.  Our belief is that new types of risk will need to be digested in order to meet investors' return needs. 

DEALING WITH A "RETURNS DEFICIT"

Let's start with the "returns deficit" shown in the graphic below.  Morningstar's projections that real returns will only be marginally positive over the next ten years surely isn't a recipe for investing success.  But it does start an important conversation about how we might achieve the growth that we need in order to meet our financial objectives...

We should note that  "expert" forecasts are often (dare we say, usually) wrong, so building one's portfolio based solely on the "overvaluation" concern raised here is likely to be foolhardy.  But when one considers a higher likelihood of recession, rising debt and government deficit levels, trade friction and peaking corporate profitability, there are many reasons to be preparing for a future that could be vastly different from the past. 

By coincidence, we met with a prospective client last week who had a very aggressive portfolio that she was looking to possibly move. In light of the concerns highlighted above, we were faced with a bit of a dilemma:   

How does an investor maintain the prospect of growing their wealth in an environment of low single-digit stock market returns? 

What are the best investment options for a risk-tolerant investor?

My first thought for this investor was that high risk doesn't necessarily result in higher returns.  Small cap growth stocks, which are among the riskiest segments, have seldom given investors return that are commensurate with the risk being taken.  Some risks aren't worth taking.  And at certain points in time, a risky segment just isn't going to add value to a portfolio.   When a "core" portfolio segment, like large cap domestic stocks has a low return / high risk profile, less conventional moves need to be contemplated.  

DEFINING RISK

In a more challenging stock market environment, investors will need to ask themselves:  What risks can I take?  

Market volatility is a familiar, albeit painful, risk. Investors who need to tap their money soon, can tolerate less volatility risk since that could diminish the balances available for withdrawal.  Conversely, longer term investors can tolerate more volatility since they have sufficient time to let short term price declines correct themselves. 

Longevity risk is less often discussed risk, but it is an important one.  It's the risk that you outlive your money!  Lower equity market returns over the next decade will reveal that many investors are exposed to longevity risk. We'll address this risk by trying to find other growth sources that will help investors to meet their return needs. 

Long term investors should also ask themselves if liquidity risk is one risk that they can tolerate.  This is the risk that you can't get your money out for a period of time.  It's a new question for many folks.  But upon further examination, many investors realize that a large portion of their investment effectively ARE illiquid, thanks to the tax "wrapper" that surrounds them. 

Consider this definition of illiquid:  For a pre-retirement investor, removing money from an IRA triggers taxes and penalties that may result in as much as a 50% loss of principal.  Unless you are in the distribution phase of your investment program, you likely have similar liquidity issues.  Whether you have thought about it that way or not. Clearly, most investors tolerate liquidity risk every day. 

As investors, we need to decide which risks are manageable in our specific situation.

PORTFOLIO OPTIONS FOR A LOW RETURN ENVIRONMENT --TAKING DIFFERENT RISKS

INTERNATIONAL:  One part of the solution to low returns could be to tilt away from US stocks and towards foreign markets.  Most portfolios already include exposure to non-US investments.  Adding to this allocation would bring additional risks -- especially the risk that currencies may depreciate versus the dollar, undermining US investors' returns.  So, we'd advocate only a modest increase in exposure towards foreign markets given the high correlation among bourses around the globe.  US weakness tends to coincide with foreign market weakness.

INCOME:  A more interesting portfolio solution is to shift returns sources from capital gains potential to income generators.  The predictability of income vehicles, and lower correlation with US markets, means that more of the returns are "in the bag" than for investments that are dependent on investor confidence (i.e., stocks).  

Income-focused investments include far more than just bonds, of course.  (But at least bonds now provide returns that are above the rate of inflation.  That's a big improvement for investors.)  Instead of just bonds, we're particularly interested in "infrastructure" investments that can deliver stable cash flows for decades.

Typical infrastructure sectors include pipelines, railways and utilities.  These are less interesting to us since they are publicly traded and have the same overvaluation issues that plague other stock market segments. Instead, we're excited about private infrastructure:  Renewable energy is one area where, if an investor can lock up a portion of their money for 5 - 7 years, they could earn equity-like returns over that period. Such investments also can include tax benefits that make the cash flows tax free for many years.

In the case of renewable energy, investors are accepting liquidity risk while reducing volatility and longevity risks.  This is a risk that we feel is increasingly prudent should these low return expectations come to fruition.  And if these projections are wrong, the returns should still be competitive.

QUESTION:

How do you balance your risks to get the returns that you will need? 

We welcome your thoughts and comments.

Scott

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