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Diversification in Investing – Protection Against Market Volatility

The public markets have substantially outperformed many investors’ expectations since the beginning of the pandemic, with the S&P 500 doubling in value from March 23, 2020 to August 16, 2021. Following this equity runup, there have been many claims and headlines by the investing community and pundits of public equities being overvalued. An example of the data to support these claims is below. We can see in the chart that equities are currently over one standard deviation expensive as compared to their average price / earnings valuation over the last 25 years. Standard deviation is a measure of variation from a pool of values and simply, the greater the standard deviation, the more of an outlier the value is.

While it may be true that equities look expensive on a historical basis, we know that investors cannot successfully time the markets and we believe investors should focus their attention on the bigger picture. It is crucially important for each investor to have an asset allocation target based on their own individual circumstances and to stick with it during periods of market turbulence. We believe that diversifying portfolios across asset classes can help mitigate market risk and is intended to provide a more consistent, less volatile investor experience.

Diversifying Asset Classes: Protective vs. Growth Assets

At Columbia Pacific Wealth Management, we view investments as falling under two different umbrellas—protection and growth—represented in the graphic below. Protective or defensive asset strategies are intended to generate cash flow within the portfolio while protecting principal. We seek to achieve this through investing in fixed income assets, such as investment-grade corporate and municipal bonds, to generate income and fund liabilities. Growth assets include public equities, private equity, real estate, high yield bonds, and other forms of alternative investments, which involve an extra level of risk but is intended to generate higher returns, allowing for portfolio growth and protection against inflation.

We believe that clients are often better served by having a diversified portfolio of protection and growth strategies. Protection assets are intended to increase the security of clients’ principal and can be used to fund current cash flow needs, while growth assets are intended to compound over a long-run, with risk-adjusted return that can grow the portfolio to fund future capital outlays.

How to Manage Portfolio Asset Diversification

Strategies for portfolio diversification should be based on a client’s specific financial situation, personal circumstances, and future goals. Diversification can be achieved by mixing assets with different correlations and return characteristics – assets that might perform differently from each other in different market environments.

For example, a portfolio with a very large equity exposure during a time of market turbulence can leave it susceptible to market declines.  So, incorporation of non-correlated positions may be recommended to help reduce the potential for loss. By also considering a client’s goals and objectives, we can construct a portfolio that seeks to address specific long-term needs.

In an ideal world, we would aim to invest in assets that generate the greatest returns annually, while selling those that underperform for that year. Unfortunately, no model or investment strategy is known to predict these future returns with any high level of certainty, and it is not our expectation that it can or will ever be done.

We believe that having a blended portfolio of protection and growth strategies can allow for sustained growth and produce the cash flows necessary to fund our clients’ expenses. We believe that long-run asset allocation, which is customized based on each client’s circumstances, is essential to the success of the investment portfolio, as the underperformance of some assets can be balanced out by the outperformance of others.

The Benefits of a Long-Term Asset Allocation Strategy

Having a long-term asset allocation target and sticking with it can make the difference when encountering market turbulence. Volatility can trigger emotional responses, sometimes resulting in panic selling and other irrational investment decisions. It is for these reasons that it is important to stay the course and keep investments aligned with long-run asset allocation targets.

At CPWM, we focus on providing clients with the allocation targets and risk management services that are intended to address current financial and personal situations. Asset allocations can be rebalanced based on unexpected changes in circumstances or portfolio fluctuations from market changes. It is important to communicate with your financial advisor during times of market distress or if you have any concerns prior to making any final investment decisions. If you have any further questions, please contact a member of our wealth management team today.

Sources: Guide to the Markets | J.P. Morgan Asset Management

Important Disclosure Information:

Different types of investments involve varying degrees of risk, including the risk of loss of your entire investment. Past performance is not indicative of future results. CPWM and its employees can give no assurance that the performance of any specific investment recommendation or investment strategy discussed herein, whether directly or indirectly, will be profitable, or that it will be equal to any historical performance level discussed herein. The discussion or information contained herein is not intended to be, and should not be deemed as, personalized investment advice. The recommendations made may not be suitable for your specific individual situation and we encourage you to discuss with your financial professional before undertaking any investment strategy or recommendation contained herein. The discussions contained in this blog is current only as of the date hereof and may change due to a number of factors, including varying market conditions.

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