Alternative Investments

It has been a good run. Ten years after the 2008 “meltdown,” the bull market in securities is beginning to show its age. And, after a very placid 2017, volatility in the market is showing it’s alive and well. That volatility has been driven by interest rate expectations, trade/tariff discussions, and the mid-term elections. The elections are (mostly) behind us, but volatility may still be around for a while. Investors have made some money with this long bull market; now the goal is to protect those gains.

 Alternative investments can play a major role in hedging risk in the stock market; however, there are many different hedging strategies available. Many investors are not familiar with these strategies or how to access them. In general, there are two broad categories of alternatives: 1) those investments offering diversification from the stock market, and 2) those investments that reduce risk of loss of portfolio value while still maintaining some return potential.

Access to hedging strategies used to be a major problem; lack of liquidity (the ability to easily buy and sell) being a prime example. Many of these strategies are now available in a mutual fund format. Shares can be purchased or sold daily with valuations set at the end of the day. Some strategies are available as exchange traded funds (ETFs) which provide intra-day liquidity.

Correlation

Correlation is an analysis of the relationship of two data variables, or how the variables move in relation to each other. Normally this relationship is combined into a single number—the correlation coefficient. A correlation coefficient can have a value of +1 to -1. A value of 0 indicates that the variables have no relationship, i.e. they are independent. Positive values (>0) imply that when one variable goes up, the other variable goes up also. Negative values (<0) imply that wen one variable goes up, the other variable goes down. The magnitude of the number (the closer the coefficient is to a value of +/- 1) explains the degree to which moves in one variable are like moves in the other variable.

Diversification Alternatives

Since most investment portfolios contain stocks, alternative strategies which have a lower correlation to them can provide diversification benefits. Listed below are three strategies which have lower correlations to the S&P 500 over the last 10 years.

• Managed Futures- A fund manager utilizing this strategy usually invests in different asset classes (both long and short positions) depending on the manager’s analysis of which asset classes are going to increase or decrease. Successful ability to capture both rising and falling markets have a substantially different return profile from the stock market—a correlation coefficient of about -0.10.
• Market Neutral- A market neutral manager usually has a portfolio long (owned) on stocks the manager expects to rise and short (sold) on stocks the manager expects to under-perform the market. When the portfolio has similar long and short holdings, the return of the portfolio has returns less related to the stock market- a correlation coefficient of about +0.34
• Multi-currency- A multi-currency manager usually invests in different currencies depending on the manager’s perceived relative strength. Since returns are usually different between stocks and fixed income investments, this strategy has had a correlation coefficient of +0.48.

Risk Reduction Alternatives

Ideally, investors would like a diversification strategy that doesn’t significantly sacrifice returns. Such strategies would not only have less losses in down equity markets, but would also have more positive returns in up equity markets. Over longer time periods, these alternatives would outperform those alternatives that provide only downside risk mitigation. Examples include the following:

• Long/Short Equity- A long/short manager usually has a long (owns) position in stocks in which the manager expects to outperform the market and short (sells) stocks which are expected to under-perform the market. The manager may use the sale proceeds from the short positions to increase his/her holdings in the long positions.
• Non-traditional Bonds-Such a manager usually has the ability to invest in bonds of varying maturities, differing credit quality, differing economic sectors, or varying geographic areas as the manager perceives have value. A successful manager has the ability to move according to interest rate changes and other variables affecting the returns markets.

The Bottom Line

Make no mistake—investing involves risk! So does putting money under the mattress in times of inflation. However, if one can mitigate risk (even in a minor way), it surely is worth the effort. Please contact us at Paragon Financial Advisors to see if such alternative investments might benefit your investment portfolio.  Paragon Financial Advisors is a fee only registered investment advisory company located in College Station, TX.  We offer financial planning and investment management services to our clients.

Rocky Road Ahead?

October 2018 marked the 10^th year of the longest bull market in history. In 2017, the stock market (S&P 500) moved placidly upward; in fact, the market set record highs over 100 times since the Presidential election in November 2016. This year, 2018, has given investors pause to think, however. In late January, the S&P 500 peaked around 2873, fell just over 10% in February, and recovered to January levels by mid-August. Another record level in late September (around 2930), then the market fell about 7% in mid-October. The roller coaster ride, especially following last year’s “tranquility,” has been a concern to investors. This might be a good time to step back and look at the bigger picture. 

Historical Market Corrections

History can give some guidance on the severity of previous market corrections, as well as how long their recovery took. Since 1926, there have been 16 instances of market downturns more than 10%.

The longest and largest downturn was the Great Depression (Sept 1929-June 1945) during which the stock market lost 83%. That downturn lasted 34 months and the recovery took 151 months. The rampant speculation associated with stocks in the years preceding the downturn resulted in the Securities Exchange Act of 1933 (which regulated the offer and sale of securities—previously governed by state laws, commonly referred to as “blue sky” laws). That law was followed by the Securities Exchange Act of 1934 which created the Securities Exchange Commission and governed the secondary trading of securities.

The second longest downturn was the early 2000 bear market in which the market lost 44.7% and lasted 25 months. The recovery period was 49 months.

The second largest market downturn was the Nov 2007-March 2009 liquidity crisis. The market lost 50.9%, lasted 16 months, and recovered in 37 months.

Let’s look at the record categorically (excluding the Great Depression which, hopefully, won’t happen to such an extreme again because of more stringent securities regulation). The total period is 1926 through October 2018—approximately 92 years.

• Greater than 50% downturn- One occurrence lasting 16 months and recovering in 37 months.
• Greater than 40% but less than 50% downturn- Two occurrences lasting an average of 23 months and recovering in an average of 35 months.
• Greater than 30% but less than 40%- There have been no such occurrences.
• Greater than 20% but less than 30% downturn- Four occurrences lasting an average of 8.5 months and recovering in an average of 18 months. (There have been no instances of a 30-40% downturn.)
• Greater than 10% but less than 20% downturn- Eight occurrences lasting an average of 8 months and recovering in an average of 5 months.

The Take-Away

Make no mistake—watching your investment portfolio lose money is not fun. It brings anxiety, especially for individuals near or in retirement and depending on their portfolio for a portion of living expenses. History is not guaranteed to repeat, but the data above does indicate that “this too shall pass,” and that a portfolio positioned to withstand downturns can prosper. An investor should have cash and short-term fixed income investments needed to cover 36-60 months of normal living expenses in a combination of personal savings and an asset allocation in the portfolio. Stocks remaining in the portfolio will then be given time to recover with no necessity to sell at a loss to cover distribution needs.

For individuals who are not near retirement—congratulations! Stocks just went on sale. You have an opportunity to buy desirable companies at a discount. You should maintain your 3 to 12 months cash “ready reserve,” and consider your risk tolerance and future time horizon, but a downturn may be an opportunity to really boost your future portfolio performance.

Let’s also consider the other alternative—selling stocks when the market is down. We’ll use the 2008 liquidity crisis (market downturn of 50.9%) in our calculations. Our hypothetical stock portfolio will be invested in an S&P 500 index fund with a $500,000 value at the beginning of the market downturn. At the bottom of the downturn, the portfolio retained 49.1% of its original value or $245,500. Definitely an uncomfortable feeling! Now assume the investor takes one of three actions listed below and fast forward to October 17, 2018.

• Sell the equities and go to CDs—Assuming a generous 2% CD rate, the portfolio would now be worth approximately $296,400.
• Sell the equities, wait one year until the market stabilizes, then reinvest in the S&P 500—The investor would have missed a year of gain in the S&P but realized a cumulative increase of 224%: a total portfolio value of approximately $549,900.
• Do nothing, hold the equities and wait—The S&P increased a cumulative of 378%; the portfolio value would be approximately $928,000.

But wait, you say. Suppose the market doesn’t recover as quickly. Let’s look at the periods of consecutive negative stock returns since 1926. There have been four such periods. The market was down four consecutive years during the Great Depression: 1929-1932. In 1933, the market rose 54%. The early 2000s saw three consecutive down years: 2000-2002, followed by a 29% gain in 2003. There were three down years in 1939-1941 followed by a 20% gain in 1942. The market was down two consecutive years in 1973-1974; the market gained 37% in 1975.

There are no guarantees in the stock market. What has happened historically may not happen in the future. However, the next time the market drops, have a cup of coffee and re-consider your long-term investing goals. Maybe the world isn’t ending after all. Paragon Financial Advisors is a fee only registered investment advisory company located in College Station, TX.  We offer financial planning and investment management services to our clients.