Although 2010 turned out to be a pretty decent year for equities and bonds, it's hard to blame investors for feeling like they have been walking a tightrope. Current equity prices are factoring in continued economic expansion, and if it fails to materialise in some form in 2011, things could get very ugly very fast. On the other hand, if the economy grows too spritely, rising inflation or rising interest rates could quickly shoot to the top of investors' worry lists.
True, investors have no power to control those macroeconomic risk factors, but it's also possible to inoculate your portfolio against some of them in case they materialise.
Here are some of the biggest wild cards currently facing the economy and the market, along with some concrete ways to hedge against them. The good news is that if you've done a good job of diversifying, you probably already have some of these hedges in place.
THE WILD CARD: Continued economic growth could lead to a spike in interest rates, crushing bonds.
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Keep risk in perspective: Even if we do see a calamitous rise in interest rates, the magnitude of losses for bond and bond-fund investors would very likely be much less than stock investors have faced during large equity-market sell-offs. This article discusses how to keep worries about rising rates in perspective, and it links to a Fidelity study chronicling how bonds have performed during sustained periods of rising rates.
Avoid long-term bonds: If you're looking at returns during the past decade, long-term bonds, especially Treasuries and gilts, look like a slam-dunk missed investment. (for example, the US long-term bond fund category has gained about 8% on average during the past decade, versus 6% for US intermediate-term bond funds.) If the economy continues to sputter along in fits and starts, long-term bonds could continue to prosper. But the volatility in long-term bonds has also been nearly twice as high as has been the case for intermediate-term bonds. For that reason, I think it makes sense to downplay long-term bonds if the goal of your fixed-income portfolio is income and capital preservation. Esteemed investors such as Jack Bogle and Bill Bernstein are on the same page.
Stress-test your bond portfolio: Even if you don't own long-term bonds, it's still a good idea to investigate just how sensitive your portfolio would be to an increase in interest rates. This article outlines a concrete way to simulate how much your portfolio could lose if interest rates bumped up by 1 or 2 percentage points. Meanwhile, this article discusses the outlook for ECB rates and fixed income ETFs.
THE WILD CARD: Inflation takes off, cutting into the future purchasing power of your invested pounds
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Check to see whether you already have some protection: Yes, there are direct ways to inflation-proof your portfolio (more on these in a second). But before you layer on any investments dedicated to inflation control, use Morningstar's Instant X-Ray tool to see whether you're already holding investments that may indirectly benefit from inflation. For example, emerging markets tend to be heavy on basic-materials producers, and they in turn are beneficiaries of higher demand and prices; check your portfolio's exposure to Latin America and developing Asian markets.
Include inflation protection in your portfolio: Regardless of the current inflation rate, a position in inflation-linked gilts helps provide insurance against an unexpected spike in inflation. This article discusses the outlook for UK inflation, while some simple ways to add explicit inflation protection to your portfolio include inflation-linked gilts and commodities.
Include inflation when making return assumptions: I have written before about the dangers of having overly rosy expectations for stocks. A related pitfall is failing to factor taxes and inflation into those return assumptions. If you're using a calculator to help estimate whether you're on track to meet your financial goals, make sure it's giving your returns a realistic haircut to account for inflation.
Add inflation protection when purchasing products such as annuities and long-term care insurance: If you're purchasing annuities or long-term care insurance, don't just settle for a fixed benefit, which will be worth less and less if inflation takes off. Yes, you'll pay extra for adding an inflation-adjustment feature, but it could be well worth it in a sustained period of rising prices.
THE WILD CARD: Stocks will take a breather (or worse) if economy doesn't continue to grow.
How to Seize Control
Make sure your investment mix includes stable, non-economically sensitive companies: Investors appear to be betting that the economy will continue to do well, given the highly economically sensitive firms (retail, basic materials, industrial companies) that have recently fared best. But if the economy takes a timeout, those more cyclical firms will hand the baton to stable companies that do well in myriad economic environments; think consumer staples and pharmaceuticals, whose products consumers will buy regardless of what the economy's doing. The good news is that you probably already have plenty of exposure to such names if you own a well-diversified large-cap UK stock fund.
Dribble new money into the market: In contrast with two years ago, few consider stocks a screaming buy right now. To help hedge against the risk of putting a lot of new money into the market just in time to see stocks sell off, plan to add to your positions during a period of several months or even more. Yes, such a strategy will mute your gains if stocks take off from here, but it will also greatly reduce your downside risk if stocks see a performance hiccup in the months ahead.
THE WILD CARD: Taxes could head higher.
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Obtain tax diversification: We already saw that VAT rising to 20% from the start of 2011 but it's hard to know whether or how tax rates will change in the coming years, let alone a decade or more from now. Because of that uncertainty, it is always a good idea to take full advantage of the tax-efficient schemes out there. Use your annual ISA allowance to the fullest (this year you can save and invest up to £10,200 in a tax-free ISA), consider setting up a ‘Junior ISA’ for your offspring once these become available next autumn, and make sure you are aware of your tax-free capital gains allowance. The CGT personal allowance in the 2010-2011 tax year stands at £10,100 for individuals.
In planning for the long term, it is worth trying to estimate what income bracket you will be when you want to cash in your investments. If you anticipate your income increasingly significantly after a career promotion, or taking a dip after retirement, then your proportional contribution to the tax man may change substantially. And finally, don’t forget that transferring funds to family members could be subject to inheritance tax. An annual gift of up to £3,000 from grandparents to a grandchild, for example, are tax free at present but check the government website for more information.
