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Navigating a market rife with uncertainty requires knowing how the uncertainty came to be. In our previous article, we examined the Federal Reserve (the Fed) and how its far-reaching policies came to be — as well as the implications they have on investors. This article dives into the actions investors may take in an attempt to circumnavigate uncertainty, volatility, and potential losses in today’s markets.

Risk tolerance and financial needs as the guiding principles

Well-managed businesses and institutions have established policies and frameworks for their working capital, term financing, and equity capital to meet their internal and external needs for liquidity, operations, and solvency. 

Veteran investors follow similar frameworks on a personal scale , understanding the critical need to adopt a sophisticated investment and risk framework. Using their own risk tolerance, they formally define their financial needs for liquidity, income, and capital growth for future time horizons. Their investment and risk management plans consider the risk profile and future financial needs to develop a customized asset allocation strategy that is diversified across asset classes, seniorities, and markets. 

Developing a diversified asset allocation strategy

Public equity (stock) markets may attract the most media attention (as do the many success stories stemming from them), though this does not mean equities are the  most optimal investments for all investors at all times. Different investors have different needs and financial situations and thus varying needs for liquidity, income, and capital appreciation (growth) over time.  To create a strategy, investors must first develop a portfolio construction framework that considers not only the financial instruments in public markets, but private markets as well.  This strategy could consider financial instruments of companies operating in a variety of economic sectors. This may not only include the stocks of blue chip companies that may provide stable dividends; due consideration may be paid to fast-growing businesses whose stocks may provide faster capital appreciation. (Specific investments may be assessed and chosen, depending on the risk profile of the individual investor). Markets such as those dealing with private equity and debt may enhance returns, as they are typically less correlated with performance of public markets. This is because they are not publicly traded with mark-to-market gain or loss.

Once a framework is structured, investors may consider investments in different tiers of businesses’ capital structures. Such considerations may include institutions with lower ratings, as their debt (senior or subordinated) may be significantly higher in seniority of principal and interest payments to the holders of common equity. It is also worth mentioning that not all holdings need to feature long maturity  fixed rate debt. Investments across different maturities, coupon types (floating rate vs. fixed), convertible debt, and varieties of structured debt may also be considered.  

When constructing a portfolio, it’s worth remembering that not all investable funds need to be completely invested and allocated to the above mentioned asset allocation approaches. In a portfolio construction framework, cash (or liquid investments) may be utilized as an additional component, “dry powder,” to allocate to stocks or fixed income when new attractive opportunities arise are presented.  

Traditional asset allocation frameworks often suggest ratios such as 60% equity and 40% fixed income. Other frameworks recommend keeping cash as “dry powder” for additional investments over time with ratios such as 60/30/10 (60% equity, 30% fixed income, 10% cash). Any number of effective asset allocation strategies should be tailored to an investor’s specific risk tolerance and financial needs.An additional approach to consider is to institute rebalancing activation triggers. This can be accomplished by rebalancing investment buckets as the ratios deviate from targeted ranges over time and/or with market movements.  

Implementing a carefully considered diversified asset allocation strategy has, by many investors’ and analysts’ opinions, three critical steps: 

  • Developing a macro market thesis
  • Selecting financial instruments based on said thesis to comply with risk profile
  • Rebalancing investments between asset classes based on rules and triggers.

Developing a Market Thesis: Monitoring Market Drivers, Indicators, and Catalysts

At the moment, there is much uncertainty in the economy and financial markets due to a variety of factors. (You can read our article on this here). This has translated into price volatility in financial markets as investors buy, sell, and reallocate across different financial investments. 

When attempting to circumnavigate uncertainty, volatility, recession risk, and factors triggered by the Federal reserve (just to name a few), investors may begin to monitor multiple indicators and outlets to help develop a thesis. Taking into account of the current risk of recession implied by the inverted Treasury yield curve and the now-twice-contracted real economy, along with declining indices, household spending/net worth, and a vast amount of ongoing macro and microeconomic factors, one can begin to develop a thesis using available indicators and information to guide their view on how the market will perform in coming weeks and months, as well as where it could head beyond that. Such a thesis may factor into account the different outcomes of the aforementioned catalysts, indicators, and drivers so as to hedge against the unexpected.   

Selecting financial instruments based on the macro market thesis 

Once a thesis is developed, investors may then select financial instruments that work within their bespoke framework. Investments may be diversified across asset classes within public and private debt markets with instruments that are floating rate, shorter duration, coupon or dividend paying with principal amortization, low beta, high yielding, and structured products that provide a higher yield — all with the aim of hedging against volatility (among other benefits). Private debt markets, for instance, present investment alternatives for earning additional credit spreads over similar credit-quality debt in public markets, as well as typically offering a lower correlation to equities. 

Rebalancing investments between the asset classes based on rules and triggers

Not all investments are long term. Funds do not necessarily need to remain perpetually invested in any capital structure/seniority,credit class, or other criteria within the defined asset class ratios. (There is something to be said for market timing with regard to chasing performance, chasing sentiment, or sitting out.) 

It is prudent to conduct event analysis to understand the impacts of major drivers and catalysts that drive markets. Consider the risk-return profile and whether or not it remains symmetric for many of the sub-categories within an asset class. It is also prudent to consider alternative investments in private markets (with the same asset sub-categories) that will be typically less correlated with the price performance of financial instruments in the public markets.

The principles of rebalancing with thesis-driven rules require that whenever a certain asset class or asset sub-category drops below (or exceeds) its allocated thresholds, its stake should be supplemented with the uninvested (or reduced) cash . This may help to minimize risk and maximize returns.

No investor or firm can predict the future. Even the most savvy, risk-averse, and market-conscious investors can build a thesis with an investment strategy to follow and still come up short — especially in today’s volatile markets. 

To potentially hedge against current inflationary and volatile market conditions, investors can monitor market indicators and catalysts, develop a diversified asset allocation strategy for the current environment, and rebalance investments based on indicator-backed parameters/events. Doing so offers no guarantee of success, but nonetheless charts a potential path in braving stormy markets ahead.

Mohit Sudhakar

About The Author

Mohit Sudhakar is the founding partner of FIRM Advisors, a strategy consulting and operations solutions firm in Tysons Corner, Virginia. With over 25 years in capital markets and risk-management strategy and execution, Mohit previously served in a variety of strategic, execution, and leadership roles at Freddie Mac for 20 years. He is a frequent panel speaker at conferences sponsored by financial institutions, professional publications, and industry associations, for fixed-income and risk topics.

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