Few market phenomena cause more angst than volatility, inflation and rising interest rates. Individually, they can be unnerving enough. But when they team up—as they have this year—they can be downright disruptive.
“On any given day, you have people telling you what the market or interest rates or consumer prices are going to do,” says Mark Riepe, head of the Schwab Center for Financial Research. “The trouble is, these predictions are often at odds with one another—and are tough to get right in any case.”
Rather, success in attaining your financial goals is often about ignoring all that noise, Mark says, “and that’s easier to do when your portfolio is well-positioned.”
Toward that end, here are some of the most common tools you can use to cope with these sometimes disconcerting market conditions.
For active traders who capitalize on price moves, the return of higher volatility earlier this year came as welcome relief. But for many investors, market swings are synonymous with heartburn.
One of the best ways to put volatility in its place is to invest a set dollar amount at regular intervals (through automatic deductions from your paycheck, for instance). This strategy, known as dollar-cost averaging, may help you lower your average cost per share by capturing a broader spectrum of prices than you would if you purchased all your shares at once. (See “Slow and steady,” below.)
“We all know in theory that we’re supposed to buy low and sell high, but in practice we often do the exact opposite, because we let our emotions get the best of us,” says Liz Ann Sonders, Schwab’s chief investment strategist. “Dollar-cost averaging puts your purchasing on autopilot.”
Another potentially effective strategy for dealing with increased volatility is rebalancing your portfolio from time to time, so you don’t stray too far from your target asset allocation.
Retired savers whose portfolios favor fixed income, for example, might find themselves with an uncomfortably high exposure to equities after a sustained market run-up. While this can increase the value of your overall portfolio, it can also exacerbate your downside if the market suddenly swings the other way.
Regular rebalancing is even more critical during periods of increased volatility. That’s because prices by definition fluctuate to a much greater extent and, as a result, can push your asset allocations above or below their targets more frequently.
“Rebalancing helps keep your exposure to any single asset class within acceptable limits, so that market events don’t hit you harder than absolutely necessary,” says Liz Ann. (See “Rebalancing act,” below.)
Rising interest rates
You won’t find many retirees complaining about higher rates of return on Treasuries and other fixed income investments. But for many investors, rising rates can undercut their bond and stock portfolios.
For example, as rates rise, bond prices generally decline, spurring some investors to sell. However, just as you wouldn’t want to unload your equity positions at the bottom of the market, neither should you rush for the exits where your bond holdings are concerned.
Instead, consider shortening the duration of the bonds in your portfolio if you think interest rates are likely to keep climbing, says Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. “The shorter the term of the bond, the sooner you can reinvest your capital and capture the higher yields that tend to accompany rising rates,” she says.
Investment-grade floating-rate notes, or floaters, are a particularly good way to implement this strategy. Not only do they have very short durations, but they also do well when short-term rates are rising because their yields rise as well.
Less directly, rising rates can detract from your stock portfolio, as increased borrowing costs squeeze company profits. As a result, you might consider cutting back on stocks—but not below the lower end of your equity-allocation range—and shifting the money into an interest-bearing savings account, a money market fund or a short-term certificate of deposit.
That said, some companies, such as those in the Financials sector, tend to benefit from higher rates because they can earn more on the money they lend. Thus, upping your exposure to banks and other lenders might also make sense in an environment of rising rates.
Just as rising interest rates can increase a company’s borrowing costs, so too can inflation boost the cost of goods and services, potentially compromising company valuations. At times like these, investors commonly seek out Treasury Inflation-Protected Securities (TIPS), along with precious metals and other commodities whose prices tend to rise alongside inflation.
However, even these relatively safe investment vehicles can react differently to inflation depending on what’s behind it, according to new research by Charles Schwab Investment Management (CSIM). For example, TIPS were among the best-performing assets during those times since 1982 when inflation was driven by cost increases on raw materials—but among the worst when inflation was caused by rising prices for materials coupled with strong demand.
“It’s never as simple as saying, OK, during times of higher inflation you should add these four asset classes, because inflation isn’t driven by one thing,” says Liz Ann. Rather, CSIM’s research concluded that a well-diversified portfolio of stocks, bonds and cash is the best antidote to higher inflation—whatever its cause.
Stocks, in particular, may be worth hanging on to. While it’s true that valuations have historically suffered during periods of hyperinflation, inflation today is far tamer. “Indeed, if you look at the long term, stocks tend to be a better inflation hedge than gold,” Liz Ann says.
No silver bullets
The challenge for investors is that volatility, inflation and rising interest rates rarely occur in isolation, and a solution purported to address one can intensify the effects of another.
“There are always trade-offs with any single solution, and what works this time might not work the next,” Mark says. “In the end, the best portfolio isn’t one that’s perfectly positioned for any single market environment but rather one that’s built to weather all kinds of forces. And holding a healthy mix of assets based on your goals is a great way to achieve that.”
What You Can Do Next
Discuss your goals with a Certified Financial Planner™ professional when you enroll in Schwab Intelligent Portfolios Premium™.