One steadfast investment philosophy is the notion that a heavy investment in bonds is a guarantee of consistent and steadfast earnings. In many traditional portfolio strategies, investors cite the "rule of 100" as a method to deciding asset allocation. In this strategy, the investor holds a percentage of equities equal to 100 minus their age - so for an investor age 60, they would hold a split of 60% bonds and 40% equities.
While government-issued, municipal and private business bonds have historically been valuable tools for predictable accumulation, their primary disadvantage is that interest rates and bond prices have an inverse relationship. Combine that with ongoing market volatility, and you have a perfect storm for set-it-and-forget-it investors who had hoped their simplistic financial strategies would weather any storm.
In the following examples, let’s take a look at alternative strategies to the traditional rule of 100 and examine why that traditional investment strategy no longer works.
Not every investor is comfortable in an approach as aggressive as the Warren Buffett model, with 90% stocks and just 10% bonds. But strategies do exist that can help overcome the challenges of market volatility and still produce predictable returns. Integrating a mechanical model can introduce a level of stability that can help offset the often emotional response to market fluctuation. (For more, see: 6 Common Portfolio Protection Strategies.)
With a mechanical model, the investor buys and sells stocks according to pre-set criteria or triggers. While mechanical models take the emotion out of investing, they are not limited in their application. In some cases, the mechanical model is as simple as deciding a pre-set amount to go into a 401(k) each paycheck. In other instances, a mechanical model can become more sophisticated by committing to buy a stock when its valuation falls to a certain price-earnings ratio and to sell it when the valuation reaches a higher predetermined level.
Another mechanical model, that I’ll go into more detail in the next section, is equal sector investing, an investment strategy that has the ability to grab upside gains while also protecting against extreme market volatility.
Equal Sector Investing
In equal sector investing, the emphasis is placed on equally weighting investments in 11 sectors rather than the traditional emphasis of portfolios balanced by a mix of equities and bonds. Those 11 sectors are:
- Consumer discretionary
- Consumer staples
- Real Estate
Often, a traditional portfolio might appear diversified, but can find itself too heavily weighted in one, or a couple, of sectors. For instance, if the tech sector were to take a hit, an investor could find themselves exposed to the market drop. Equal sector investing, however, spreads risk across the 11 investment sectors, providing more risk mitigation and minimizing losses. Gains will lag behind market benchmarks such as the S&P 500, due to the equal weighting but because the risk is spread out, it is also designed to limit losses when a single-sector crash occurs.
Likewise, building stop-loss features into a portfolio may also provide an additional element of security, helping to ensure that stocks will be sold if they drop below a pre-established safety level. This strategy removes emotional investing from the equation, but it also protects against catastrophic losses. During the 2007-2009 financial crisis, for example, the S&P 500 lost 37% of its value. Typically, stop-loss targets are placed at 10% of equity value, so the holding is sold when an asset reaches the 10% threshold.
Whatever strategy an investor chooses to take, those simply hoping that bonds will do the heavy lifting in their investment plans need to recognize that there are alternatives to the traditional stock-bond philosophy. (For more from this author, see: Protect Your Investments With a Stop-Loss Plan.)