When Volatility and Inflation Strike: 4 Actions to Consider


When volatility strikes and stock markets decline, it can rattle even the most experienced investors. As behavioral science tells us, the pain of an investment loss is felt more keenly than the enjoyment of an investment gain.


The urge to soothe the sting of short-term losses can lead to hasty decision-making that could be costly in the long run. Staying invested and focusing on the things you can control may be your best bet during challenging markets. Here are four actions you can consider in the short term to enhance your long-term investment approach.


1. Rebalance


Stocks tend to outperform bonds over the long run which can push a portfolio’s stock and bond ranges out of bounds. When markets get choppy, it can be a great time to review your portfolio and see if it needs rebalancing.


What Does it Mean to Rebalance Your Portfolio?


The practice of rebalancing entails trimming portfolio positions that have outperformed and reinvesting the proceeds into areas that have underperformed.1 It's also one of the best tools an investor can use to “buy low and sell high” in a disciplined manner without running the risk of trying to time markets.


In the chart below, we show that over the long term, a portfolio that is rebalanced annually (light blue bar) can experience better performance and maintain risk than a portfolio that is not rebalanced (dark blue bar).



2. Lean in to Find Opportunities


Opportunities can be found in most market cycles, down markets included. In the chart below (on the left), you can see that returns often rise in the one-year, three-year, and five-year periods following a bear market, particularly if you’re not confronting a severe recession such as the 2007-2008 Financial Crisis.


Furthermore, leaning in during a drawdown by increasing stock positions may make sense for investors with longer time horizons. In the chart below (on the right), you can see that increasing the stock allocation of a 60/40 portfolio by ten percent can boost returns.



3. Diversify


For investors thinking about pulling out of the market and moving to cash during a market decline, consider shifting to diversifying positions instead. Diversifying positions (or alternative investments) typically have better long-term return expectations than cash and can provide valuable diversification benefits.


Diversify Beyond Traditional Asset Classes


One such example is managed futures, an equity alternative investment style that can buy and sell stocks, bonds, currencies, and commodities. Unlike traditional stock and bond investments, managed futures can take advantage of negative market trends by selling investments in a variety of different asset classes and providing potential positive returns during declines while improving diversification.


Adding alternative investments like managed futures will not eliminate negative returns for portfolios but can potentially reduce losses. For example, in the chart below, adding a 10% allocation to managed futures can lessen the impact of a drawdown by 5.2%.



4. Defend with an Inflation Buffer


With US inflation experiencing record highs and financial markets in correction territory, investors and their portfolios are being stress tested for the first time since the pandemic-induced drawdown of March 2020.


With some components of inflation slowing in terms of price trends, others are starting to pick up which likely means that inflation will remain higher for longer. This environment offers no shortage of challenges and it could be time to consider your defensive playbook to help buffer inflation.


Inflation Beneficiaries


Asset classes respond differently to inflation and those experiences can differ substantially based on the level of inflation currently in action. Commodities and gold have been standouts in terms of benefiting from higher inflation, and have outperformed equities and bonds on a real return basis when inflation is above four percent.


Looking at the last inflationary period of the 2000s, there were additional components that helped during times of higher inflation. The chart below shows how commodities and gold can be complemented with natural resources, infrastructure or real estate investment trusts (REITs) to help create an inflation buffer.


Natural resource miners, for example, benefit from the inflation-elevated prices that vehicle manufacturers are willing to pay for nickel and copper to keep up with the surging demand for electric vehicles.


Average 12-month real return when CPI is above certain levels (2003 – 2007)1



Sensitivities and Interactions


Knowing how asset classes perform during levels of higher inflation is only half the battle. Knowing how sensitive they are in relation to changes in inflation and how they interact or correlate with other asset classes and the traditional balanced portfolio is critical.


Asset class sensitivities to inflation and correlation to a Global 60/40 portfolio

(Nov 2001 – Jun 2021)2

The chart above shows that commodities have the greatest sensitivity to inflation and are a good addition to a portfolio, but it’s only part of the story as they don’t clearly complement just equities or just bonds.


REITs and natural resources complement equity exposure since they have similar characteristics but provide higher sensitivity to inflation. Inflation is a nemesis to bonds as seen by their negative beta.


Alternatively, Treasury Inflation-Protected Securities (TIPS) and gold provide a similar low-correlation experience to help with risk management in addition to typically faring better during inflationary environments.


Portfolio construction 101 tells us to diversify assets to help manage overall portfolio risk, and the same also applies to building an inflation buffer.


In Summary


While portfolio losses are painful for everyone, market drawdowns can provide opportunities to strengthen portfolios by rebalancing (all investors), leaning in (aggressive investors or those with longer time horizons), and diversifying (all investors, particularly nervous investors).


It’s essential to think about having a broad mix of investments, pinpointing the right areas to diversify into while building in some defense into the portfolio to enhance your results over the short and long term.


If you're wondering whether your portfolio could use a tune-up, schedule a call with me to learn more about my investment philosophy during rocky times.


 

Sources

1. VanEck, “Still Early Innings for Inflation”, March 2022

2. AssetMark, Zephyr Style Advisor


 

Disclosures


This is for informational purposes only, is not a solicitation, and should not be considered investment, legal or tax advice. The information in this report has been drawn from sources believed to be reliable, but its accuracy is not guaranteed, and is subject to change. Investors seeking more information should contact their financial advisor. Financial advisors may seek more information by contacting AssetMark at 800-664-5345. Investing involves risk, including the possible loss of principal. Past performance does not guarantee future results. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss. Actual client results will vary based on investment selection, timing, market conditions, and tax situation. It is not possible to invest directly in an index. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Index performance assumes the reinvestment of dividends. Investments in equities, bonds, options, and other securities, whether held individually or through mutual funds and exchange traded funds, can decline significantly in response to adverse market conditions, company-specific events, changes in exchange rates, and domestic, international, economic, and political developments.

Bloomberg® and the referenced Bloomberg Index are service marks of Bloomberg Finance L.P. and its affiliates, (collectively, “Bloomberg”) and are used under license. Bloomberg does not approve or endorse this material, nor guarantees the accuracy or completeness of any information herein. Bloomberg and AssetMark, Inc. are separate and unaffiliated companies. AssetMark, Inc. is an investment adviser registered with the U.S. Securities and Exchange Commission. #104530 | C22-19072 07/2022 | EXP 07/31/2024 AssetMark, Inc. 1655 Grant Street 10th Floor Concord, CA 94520-2445 800-664-5345