Keeping your investment portfolio in balance in changing times

While stocks bounced back after a nervous start following Donald Trump's unexpected win, bonds, those safe and sound "widows and orphans" securities, lost $1 trillion in value around the world in the aftermath of the U.S. presidential election. Those divergent market reactions highlight a dilemma many investors are facing.

The financial markets are betting that Trump's policies, greenlighted by a Republican Congress, will boost spending, tilting interest rates and inflation higher. In the inverse math of fixed income investors, higher interest rates mean lower prices on existing bonds, a dynamic professional investors call "rate risk."

The Great Recession of 2008 ushered in an unprecedented period of historically low interest rates. Higher rates may be welcomed by small investors hungry for higher returns on savings accounts and CDs. But as the drop in the bond market demonstrated, the abrupt transition holds both short- and longer-term dangers for bond investors, including individuals holding a balanced portfolio that is a 60/40 mix of stocks and fixed income securities. Balanced portfolios are typically promoted as being safer than an all stock portfolio.

A new study reveals that the choices many investors and their financial advisers made over the past several years may leave a large proportion of those supposedly safer portfolios with ­unexpected risks. The study, conducted by BlackRock, one of the largest investment management firms and a leader in exchange traded funds (ETFs), looked at more than 1,500 professionally balanced portfolios managed by more than 1,000 independent investment advisers who use BlackRock's portfolio consulting services.

BlackRock observed that investors seeking more income have bought lower quality bonds that carry higher risk of default, thus behaving more like stocks. As a result, they traded away diversification benefits that bonds are supposed to provide and their portfolios are actually riskier than an all stock index fund like the S&P 500.

"People forgot why they own fixed-income securities," explained Martin Small, BlackRock managing director and head of U.S. iShares. While bonds and other fixed-income securities traditionally serve a dual purpose of delivering diversification and income, with record low interest rates "most investors tipped the relationship over" favoring current income over the safety of their principle, he said.

In addition, BlackRock observed that investors have also added risk on the equity side of a balanced portfolio by adding actively managed mutual funds and sector specific ETFs that have a hard time outperforming the broader stock index over time. While it's no surprise that BlackRock's recommended solution for maintaining a balanced portfolio is a mix of their ETFs on both the stock and fixed income side, investors have other options, as well.

In addition, some investment advisers are urging their individual investor clients to pursue a three-legged approach to a balanced investment portfolio by adding alternative investments that diversify away from both stocks and bonds. This is the strategy adopted by big institutional investors such as pension funds and college endowments.

In recent years, alternative investment mutual funds and ETFs have been launched that are also more accessible to individuals. Alternative investments can be in hard assets that are easily tradable such as Real Estate Investment Trusts (REITs), managed futures that use derivatives to follow a trend like falling oil prices, or long/short equity funds.

Dave Bromelkamp, president and CEO at Minneapolis-based Allodium Investment Consultants, said that balanced portfolio investors "have to diversify away from both stocks and bonds," particularly now with interest rates at a 35-year low, because it is more likely that rates will rise over the next few years. "I can tell you the bonds people are holding now are going to be trading lower than they are trading now, and they're actually going to have capital losses in their bond portfolios." Bromelkamp advises his clients to build a balanced portfolio made up of 50 percent equities, 20 percent bonds and 30 percent alternative investments.

It's not easy for an individual to invest on his or her own, with the possible exception of REITs, without professional advice. These funds are complicated, difficult to evaluate, many are only available through an investment adviser or have very high minimum investment thresholds and generally have high fees.

Bromelkamp says the best alternative managers earn their fees by offering diversification away from both stocks and bonds. "You have to have really good due diligence research to identify really good managers," he cautioned.