NEW YORK (MainStreet) — Tapering and the ultimate withdrawal of a monetary stimulus will lead to higher interest rates, a welcome sign for investors who have faced weak returns.
Tapering should be viewed as a positive for both the economy and equity markets, said Joe Jennings, investment director for PNC Wealth Management in Baltimore.
"By removing the extraordinary level of stimulus that has been in effect since the recession, the Fed is signaling that the economic recovery is continuing and that growth is self-sustaining," he said.
Investors should reexamine their portfolios, but continue to be disciplined and "stay true" to their long term asset allocation targets since over the short term interest rate movements can be unpredictable, Jennings said.
Many investors could be overexposed to equities because of the strength in the market over the past five years, especially if they have not re-balanced their portfolios over that time frame. Disciplined re-balancing should occur at least annually, he recommends.
"Re-balancing offers investors the opportunity to 'buy low' and 'sell high' and maintain an appropriate level of risk exposure based on the long-term objectives of their portfolios," Jennings said.
Instead of holding back on their contributions, investors will have a "better opportunity" to buy more shares with each regular salary contribution, said Regi Armstrong, president of the Armstrong Wealth Management Group, an independent advisory firm in Florence, S.C. with $195 million in assets under management.
"For the average 401(k) investor, the end of tapering will likely mean greater volatility in their investments," he said. "It also makes a correction such as a 10% drop more likely and 401(k) participants should consider rebalancing their portfolios back to their target allocation."
U.S. stocks will also decrease in value once quantitative easing ends, said Andrew Carrillo, CEO of Barnett Capital Advisors in Miami.
"It's these low rates that have caused an expansion in multiples in the stock market due to the search for yield," he said.
One way for investors to protect themselves from the risks of rising rates is to make sure their portfolio is diversified globally and to own gold or other precious metals as insurance, which are the more "undervalued assets," Carrillo said.
Traditionally, investors have sought U.S. bonds and stocks, which have benefited the most from the low rates. However, these same assets "will be hurt the most when rates rise," he said.
International bonds offer "much higher yields with a much lower duration, which has much less interest rate risk," Carrillo said.
"A portfolio of global government bonds can yield 4% with a 2.5 year average duration," he said. "To get that same yield in a domestic bond portfolio you would have to be out at least 10 years in duration."
Buying bonds from countries with low debt and strong economic fundamentals means investors will receive "less manipulated interest rates," Carrillo said.
"Low debt is important because low debt counties don't need to print money to pay their bills, which should be a good hedge against a spike in interest rates due to inflation here in the U.S.," he said.
Returns are much lower when the Federal Reserve is pursuing a restrictive monetary policy, said Robert Johnson, a professor of finance for Heider College of Business at Creighton University in Omaha, Neb.
While investors should lower their expectations for returns in the stock market during restrictive monetary environments, individuals should refrain from trying to "time the market" by making big adjustments to their asset allocations in response to or in anticipation of market conditions, he said.
"Timing the market requires the individual to make two good decisions – when to get out of the market and when to get back into the market," Johnson said. "For individuals building wealth over the long run, the most prudent way to build wealth is through dollar-cost averaging – consistently putting money into the stock market each and every month."
Investors who are in their 30s, 40s and even 50s should not make any asset allocation decisions based upon expected Fed tapering, he said.
"Those individuals still have a long window to retirement and are well-served to have a large percentage of their 401(k) assets invested in equity securities," Johnson said.
The fear that bond prices will fall once tapering ends does not mean that investors need to reallocate their portfolio mix between stocks and bonds, said Wayne Connors, managing partner of RetirementInvestor.com, a Glastonbury, Conn. retail investment website.
"The financial markets don't like surprises and the end of the Fed's tapering won't have bond investors running for the door because this news comes as no surprise to investors," he said. "Most institutional investors such as large pension plans will still need to continue buying bonds because of their investment policy mandate that requires they be allocated across both stocks and bonds, typically with a mix of 60% stocks and 40% bonds. This will keep bond prices afloat."
- Written by Ellen Chang for MainStreet