Think Big, Investor
Facing Your Fears, Conjuring Winning Portfolios
If you are anchored to your old ideas about financial markets, they may well be keeping you from embracing the new world of investing and embarking on your financial future.
The irony is that the opportunities today may be bigger than you think.
Consider these anomalies: Many companies' stocks are outyielding their bonds; government bond yields in many countries are negative after inflation (and in some cases before); and municipals are paying more income than comparable Treasuries on a pre-tax basis. Clearly, building a watertight portfolio today requires different types of action than it did five years ago. Perplexed investors are asking:
So what do I do with my money?™
"We're concerned, but not surprised, that investors have lost confidence in recent years," says BlackRock CEO Larry Fink, adding that it's once again time for investors to be bold in their thinking.
The first step, according to Mr. Fink, is to accept that it's a new world of investing. "There's no sense in waiting for a return to what was. Investors should be seeking to capitalize on what is."
Seeing what "is"—and then adjusting your portfolio to benefit—often requires understanding what "is not." Below, we seek to debunk several myths that continue to pervade investor thinking and offer some advice to help you right your financial ship and chart your future course.
Myth 1: Cash is the safest place to be.
When conditions are uncertain, as they have been for the past several years, investors tend to migrate out of riskier assets and into cash and cash equivalents. There is a degree of safety in holding cash, and it should be part of a well-diversified portfolio—but all in good measure.
"Cash should be in your portfolio, but it should not be your portfolio," says Mr. Fink. Investors should hold enough cash for their liquidity needs and as "dry powder" to jump on opportunities. But having too much can be costly, particularly in a new world where cash is providing zero interest and, in fact, is producing a negative return on an after-tax, after-inflation basis.
Myth 2: Stocks are too risky.
Equity investors have seen enough in recent years to give them pause. The first 10 years of this century have been dubbed "the lost decade" for stocks, having provided investors with negligible returns. Investors also experienced two of the worst bear markets since the Great Depression in the span of as many years. It's hardly surprising that many have decided to "check out" of equities. But investors must realize two very important things: 1) doing so could well mean missed opportunity, and 2) not all stocks are created equal.
Skittish investors can ease back into equities with an allocation to what BlackRock global equity pro Richard Turnill refers to as "investment-grade" stocks. The term is essentially a reference to high-quality companies whose strong business models, pricing power, generous free cash flow and healthy balance sheets position them to generate consistent returns over the long term. "These types of companies have management teams that are adept at allocating cash efficiently and committed to returning this cash to their shareholders," says Mr. Turnill. As such, high, sustainable and growing dividends are a key signpost of "investment-grade" equities; simply choosing those with the highest yields is likely to buy you more volatility.
Myth 3: Income is only important for retirees.
Income is critical in retirement, once you forego the regular paycheck, but it is also a powerful wealth builder while you are still working. Some may be surprised to learn that income historically has accounted for a large percentage of investment returns. As illustrated in the bar chart below, over the past 85 years, the income component of both stocks and bonds added significantly to the total investment return of each. In fact, dividends made up 43% of stock returns and coupons accounted for nearly 90% of bond returns over the period.
No Myth: Income Has Been Shown to Drive Returns Over Time
Average Annual Returns, 1927–2011
Sources: BlackRock; Morningstar. Past performance is no guarantee of future results. Assumes reinvestment of income and no transaction costs. For illustrative purposes only and not indicative of any investment. Stocks are represented by the S&P 500 Index; bonds represented by the Morningstar/Ibbotson Intermediate-Term Government Bond Index. It is not possible to invest directly in an index.
Achieving meaningful income is complicated in today's low-interest-rate world. It requires investors to cast a wider net and to diversify their sources of income. High yield bonds, municipal bonds and dividend-paying equities are ripe with potential.
Myth 4: Better to wait for markets to settle down before making changes.
Investors have been on a roller coaster since the 2008 financial crisis. Surely things will settle down eventually, or so the thinking goes. Unfortunately, investors with that mindset are missing out on opportunities right now. S&P 500 equity valuations, although they've increased double-digits so far this year and over 100% since their crisis low in March 2009, are still quite reasonable, particularly compared to bonds. And interestingly, equity market volatility, while it may feel bad, is close to historic norms.
Mr. Turnill explains: "Data suggests the period of low volatility we had all grown used to, known as the Great Moderation, could be the anomaly. The most recent period of heightened volatility may actually be more the norm." The good news, he says, "is that it is possible to invest in such a way that produces an equity portfolio with approximately one-third less volatility than broader equities." (For the "how-to," refer to Myth #2.)
Myth 5: Inflation is not a concern today.
While it is true that inflation has been moderate in recent years, it would be a mistake to underestimate its erosive powers, particularly with bond yields as low as they are.
"We're in one of the toughest environments we have ever seen as investors," says Dennis Stattman, portfolio manager of the BlackRock Global Allocation Fund, pointing out that low interest rates are one of the primary culprits. "We have very low nominal (pre-inflation) rates. With nominal rates at such unappetizing levels, real (after-inflation) yields are spectacularly bad, and that means the possibility of making a profit after inflation is very slim—even with inflation as low as it is today."
A portfolio that cannot keep pace with inflation results in an erosion of purchasing power and income over time. This offers another reason why investors need to consider the growth and income potential of stocks, such as those Mr. Turnill described earlier. While inflation may be harder to notice on a one-, two- or three-year basis, BlackRock research has shown that annual inflation of just 3% can reduce the purchasing power of a portfolio by 50% over a 25-year timeframe.
Myth 6: Diversified? Yes, I hold an assortment of stocks and bonds.
In the past, investors with exposure to stocks, bonds and cash could feel pretty comfortable that they had enough of a mix to weather various market conditions. This is no longer the case. If we learned anything from the financial crisis, it's that when things are at their worst, traditional assets tumble in tandem. In the new world, diversification requires an allocation to non-traditional or alternative investments, which tend to have lower correlations to traditional assets. This might include allocations to commodities, real estate and alternative strategies, to name a few. This type of broad diversification is available in many professionally managed multi-asset products, which are readily available to investors today. Of course, diversification cannot ensure a profit or prevent loss, but it has been shown to smooth the ride over time.
Myth 7: I don't have access to the same tools the pros use.
We beg to differ. "Whether a large institution, a government or an individual investor," says Mr. Fink, "we offer all clients a breadth of active and index strategies to help them navigate the new world."
One case in point is the aforementioned alternatives, which typically had been viewed as exotic investments available only to institutions or ultra-high-net-worth individuals. In fact, individual investors today can access alternative assets and strategies via mutual funds that enjoy the same low investment minimums and liquidity as a fund investing in traditional assets. While it is true that some alternative investments have experienced periods of extreme volatility and, in general, are not suitable for all investors, coming in a mutual fund package means they are diversified and professionally managed. This may help ease the intimidation factor.
Individual investors also have access to the same indexing the pros use. BlackRock's iShares exchange-traded funds (ETFs) track broad market indices and can be a low-cost and tax-efficient addition to any portfolio. ETFs are increasingly becoming a central component of investor portfolios and can be a nice complement to actively managed strategies.
It's Time to Be an Investor Again
While markets today seem to present more questions than answers, they also present opportunity. "It's time to be an investor again," says Mr. Fink. "We are committed to helping our clients navigate today's choppy waters and uncover and capitalize on opportunity."
Investment involves risks. Stock and bond values fluctuate in price so the value of your investment can go down depending on market conditions. The two main risks related to fixed income investing are interest-rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income may be taxable. Some investors may be subject to Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable. Investments in non-investment-grade debt securities (high yield or "junk" bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories.
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This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the BlackRock investment professionals profiled as of December 3, 2012, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that, in certain respects, may not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.
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