Market volatility at the beginning of 2016 spurred many investors to seek a safe place to ride out the storm. As is often the case, the stocks they favored lagged in the recovery, and may be less safe than investors think. [Let me explain.]
A guest post by Seth J. Masters (blog.abglobal.com) which has been slightly edited and abridged to provide a faster and easier read.
Typically, companies that are seen as safe have high dividend yields and operate in slow-growing but reliable industries such as utilities, telecom, and consumer staples. These are attractive characteristics if you expect an economic slowdown to hurt earnings as these “safety stocks” outperformed dramatically during the market slump in the first six weeks of the year: The telecom and utilities sectors beat the S&P 500 by about 16 percentage points through February 11, as the left side of the Display below shows.
But stocks in these sectors can underperform significantly in some environments. For example, a recession-resistant company might lag when the economy begins to pick up—or when fears of recession fade. Since February 11, the three “safe” sectors have lagged by 6.5% to almost 8%, as the right side of the Display shows. Stocks with generous dividends may also trail peers when interest rates rise. Guess what’s expected over the next few years?
The Risk in Safety Stocks
When many investors simultaneously seek safety, the result can—paradoxically—be higher risk. How does this happen?
- Investors for whom safety becomes the overriding consideration may wind up driving the prices of “safety stocks” into overvalued territory. Overpriced securities are vulnerable to price corrections, and therefore risky. Thus, the search for safety can be self-defeating, as investors who piled into utilities, telecom, and consumer staples early this year have discovered in the last few months.
- High-dividend-paying stocks can also create risk at the portfolio level. Stocks with high dividend yields tend to be more highly correlated to fixed-income investments. The increased correlation reduces the benefits of diversifying between equities and fixed income. A portfolio of bonds and stocks that act like bonds is not well diversified.
Ways to Manage Risk
There is no perfect safe harbor in periods of market volatility. We use a variety of tools to help our clients plan for and benefit from risk.
- First, over the long run it pays to diversify across asset classes:
- Intermediate-duration, investment-grade bonds remain the most effective diversifier of stock risk over time.
- Real assets and alternatives can also be valuable diversifiers, and
- high-yield bonds can replace a portion of the equity allocation to reduce downside risk.
- Over shorter periods, our Dynamic Asset Allocation process seeks to keep portfolio risk levels within or near the client’s comfort zone as volatility waxes and wanes.
Within equities, we think portfolios should be diversified across:
- investment factors (including value, growth, momentum, quality, and size),
- and geography (including US, developed international, and emerging markets).
- Sector and geographic diversification within bonds (both high-quality and high-yield )
- and within real assets is also important.
Ultimately, we think the best way to seek long-term safety is to combine these strategies in an integrated portfolio designed to achieve the investor’s long-term financial goals.