The Average Investor Is Unprepared For the Next Market Downturn

The last month has been a particularly choppy one for markets, with the CBOE Volatility Index (VIX) spiking more than 80% during October. It’s apparent that the combination of rising interest rates, mounting trade tensions and early-stage recession fears are setting in. But what’s more unsettling is how unprepared the average client is to navigate the next market downturn.

Harry Markowitz’s modern portfolio theory, which stems from his groundbreaking research in 1952’s Portfolio Selection, has led generations to believe that a well-diversified portfolio includes a 60% allocation to stocks and a 40% allocation to bonds. This cross-section of believers includes the 10,000 baby boomer investors who turn 65 each day and need their investments to generate stable income upon retirement.

The harsh reality is that the investible universe is radically different today than it was during the 2008 crisis – let alone during the middle of the twentieth century. It’s increasingly difficult for investors to achieve true diversification in a world where asset classes and investment styles are highly correlated. As evidence, the S&P 500 and Bloomberg Barclays US Aggregate Bond Index each fell more than a percent during the first quarter of 2018.

If stocks and bonds are moving in the same direction when the next downturn hits, it will create significant problems that have no quick fixes. Central banks are not in a position to rapidly intervene to restore investors’ confidence given how their balance sheets are tapped out, not to mention that interest rates remain well below historical averages. Plus Japan reminds us that the ability of central banks to stimulate markets with low rates is quite a bit more theoretical than real. This absence of a safety net – via either accommodative monetary policy or fiscal stimulus – means the destruction of capital may be permanent when a bear market wreaks havoc.

Another issue investors face is the low-yield environment that has rendered fixed income allocations rudderless in recent years. The anemic income generated from a 40% allocation to bonds will not be nearly enough to offset equity losses during a moderate recession.

With all this context in mind, investors should be considering how to redefine portfolio construction moving forward. This is obviously easier said than done when one considers how hard it can be to achieve true diversification without leaving returns on the table somewhere. It also complicates matters that many once-popular diversifiers, including liquid alternatives and risk parity funds, have lost some luster due to the perception of high fees and mediocre performance.

The good news is there are plenty of viable portfolio diversifiers out there.

One often-overlooked option is a hedged equity strategy, which can prioritize capital preservation along with the pursuit of strong performance over a full market cycle. An allocation to this type of strategy – not to be confused with a hedge fund product for accredited investors – can either augment existing stock market exposure or replace underperforming fixed income investments.

The strategy is designed to maintain “always on” exposure to stocks while significantly reducing downside risk using strategic put options. Importantly, this approach allows an investment manager to retain full-cycle exposure and still capture income along the way through options trading. It is also a viable avenue for those who want to avoid trying to time the markets.

Although today’s euphoric environment has led many to forget the pain caused by the Great Recession, we must remember cycles have beginnings and ends. A truly modern portfolio should be built to navigate every step of that journey. Investors will need accessible alternative investments to help protect precious capital, generate income and smooth out returns over a full cycle.