It’s been an awfully good time to be in the equity markets over the last few years, they’ve risen sharply and in a very smooth manner. However, they’ve left valuations pretty extended and investors when they look around at other options that they have, perhaps in the fixed-income markets, are left with a bit of a dilemma. Yields are low and the prospect of rising rates means that bond prices themselves might come under pressure. And the equity risk premium, the gap that you’re paid the additional amount to own equities, is actually pretty elevated.
So I know I need the asset class, but I’m afraid that the downturn, which we know is inevitable at some point, will come and I’m afraid of that. So what can I do about that? Well, we’ve been talking to investors increasingly about focusing not just on the level of performance, but on the pattern of performance you can have.
And we’ve been using a concept called upside/downside capture to get there. This measures how much you participate when the markets are rising versus how much you participate when markets are falling. So imagine, an approach that allowed you to get 90% of the market when it was rising, but only 70% of the market when it’s falling.
Now you may think that over time this will trail the markets as a whole, but actually the power of compounding works in your favor and you end up with higher returns over time. This risk reduction is particularly valuable in more volatile asset classes, like emerging markets, where it can drive an even greater appreciation of assets. We think it’s important for investors to think about this pattern of performance. In those moments of the most stress when you’re likely to let your emotions drive you to decisions that will harm your long-term financial health, you’re going to have some protection there and be able to stick with your long-term plan. And finally, you’re just going be able to sleep better at night along the way.
It’s important to think about defensiveness even now when times are good. Now we’ve been having conversations with clients around this and we think that’s important that we think about that downside protection so you don’t have to.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.