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The Bear Market Playbook

As many markets enter bear market territory around the globe, investors are inevitably getting skittish. Bear markets are a regular part of the financial markets, but that doesn’t make them easy to handle. Here are some keys to handling a bear market: 1. Don’t lose your perspective. In the last 45 years, a globally allocated 60/40 stock/bond portfolio has never had a negative rolling 5-year return. Of course, it’s not easy to maintain a 5-year time horizon, but if you have less than a 5-year time horizon, you probably shouldn’t be owning stocks and bonds in the first place. Resisting recency bias is the greatest struggle for most investors. And unfortunately, most people never overcome it…. I’ve witnessed this for decades with clients. The financial markets are a revolving door of investor after investor dying one funeral at a time, thanks to excessive short-termism. You don’t have to be irrationally long term, but focusing on the short term is just as irrational. Of course, if you don’t have a proper allocation in the first place, then you need to ensure that your risk profile is aligned with your asset allocation . 2. Turn off the news. Most of the financial media isn’t there to help you. They’re there to get your attention so they can earn a profit selling ad placements. Unfortunately, there is no emotion more powerful than fear. This is why financial TV ratings surge during bear markets. You tune in, get scared out of your wits, churn up a bunch of taxes and fees in your account, sell into panics, rinse wash repeat. I turned off financial TV almost a decade ago. It was one of the best financial decisions I ever made. 3. Stop looking at your account. Fidelity once found that investors who don’t log in to their accounts perform better than investors who log in regularly. The best thing most investors could do is lose their password to their account about once every five years. Logging in and incessantly focusing on your portfolio is just about the best way to ensure that you become a victim of recency bias. If you have a reasonable plan in place, you just need to let time do the heavy lifting for you. 4. Focus on something else. Get your mind off the short-term swings in the market. There is nothing you can do to control the markets. Excessive activity is the illusion of control during the course of creating inefficient portfolio frictions. Get your mind off your portfolio by focusing on hobbies or work. Sitting around worrying about your portfolio isn’t going to help you or your portfolio.

Portfolio Analysis In R: Part VI | Risk-Contribution Analysis

Do you know where the risk in your portfolio is coming from? Well, of course, you do. After all, you designed the portfolio, and so the asset weights reflect the risk contribution. A 50% weighting in stocks translates into a 50% contribution to risk for the portfolio overall, right? That’s a reasonable first approximation, but it’s a crude estimate, and one that’s prone to error as market conditions change – particularly for a strategy that holds a mix of asset classes. For a precise profile of the relative contributions from each piece of the portfolio – an essential piece of intelligence for risk management – we’ll have to go deeper into the analytical toolkit. The reasoning for decomposing portfolio risk into its constituent parts is straightforward – the relationship of risk across assets is in constant flux through time. As a result, correlation and volatility are changing. The main takeaway: Your portfolio’s risk profile may differ from your assumptions, perhaps radically so at times. The only way to know if your estimates match reality is to routinely run the numbers and make periodic adjustments to the asset allocation when appropriate. An exaggerated example tells us why this facet or risk management is essential. Let’s say that you’ve designed a portfolio with a 10% allocation to emerging market stocks on the assumption that 10% of total portfolio risk will be driven by these assets. Because of shifting relationships with other assets, however, it turns out that the risk contribution from emerging markets rises to twice your assumption after three months – 20%. The problem is that this change might not be obvious without formally modeling the risk-contribution factor. Let’s dig into some details with a real-world example. As in previous installments in this series (see list of articles below), we’ll use our standard sample portfolio (unrebalanced in this case), which consists of 11 funds for testing a global mix of assets, spanning US and foreign stocks, bonds, REITs and commodities, based on the following target allocations: Calculating risk contribution requires building a covariance matrix and running matrix algebra calculations, but don’t worry – we can streamline the task with user-friendly functions in the PortfolioAnalytics package via calculations in ” R ” (here’s the code for generating the raw data that’s discussed below). For simplicity, we’ll use the conventional definition of risk-standard deviation, aka return volatility. In practice, we can apply other risk measures, such as value at risk, extreme tail loss, and other quantitative metrics. But in the example below, we’ll stick to standard deviation to illustrate the basic outline. As a preliminary step, here’s the risk contribution for the sample portfolio (defined above). Note that this is based on the daily data from 2004 through yesterday (January 11). It’s no surprise to find that the contributions generally align with the target allocations. For instance, the 30% weight for the US stocks (NYSEARCA: SPY ) compares with a risk contribution of roughly 33%, as shown in the chart below. But there are some deviations as well. Consider how real estate investment trusts (REITs) compare in terms of the target allocation versus the risk contribution. We initially allocated 5% to REITs (MUTF: VGSIX ), but it turns out that the risk contribution is twice as high at nearly 10%. Note too that the risk contribution is slightly negative for the allocation to Treasuries (NYSEARCA: IEF ). The negative number indicates the relatively strong degree of volatility reduction that this asset brings to the mix. As a result, the negative risk contribution means that increasing (lowering) the weight to IEF will lower (raise) the portfolio’s volatility. In other words, IEF’s unique role as a diversification agent is quite clear when we run the numbers for this portfolio. The problem with looking at risk contribution across long periods of time as a single data set is that the analysis suggests that this facet of the portfolio is static. In fact, risk contribution is constantly changing. The evolution is usually gradual, but it’s valuable to keep an eye on the changes through time in order to minimize the surprise factor vis-à-vis sudden shifts in the portfolio’s risk profile that may conflict with the investment goals, risk tolerance, etc. For a more realistic (dynamic) measure of risk contribution, we can monitor the ebb and flow based on rolling historical windows. For example, here’ how the risk contributions for the funds compare on a rolling one-year basis, as shown in the next chart below. Based on this history, we can see that the risk contributions are relatively well behaved through time. The allocation to US equities, for instance, has generated risk contributions ranging from the high-20% level up to around 40%. We may or may not find these results satisfactory, depending on the portfolio’s goals and our risk expectations. The key point here, however, is that we now have hard data on the historical relationship between the relative share of risk for each asset. What can we do with this information? There are several applications that may be productive. Let’s consider just one by focusing on the US equity holding (SPY) in terms of its rolling 1-year return versus its risk contribution (see chart below). As you see, there’s a moderately negative correlation between the two metrics. The relationship implies that there may be useful signals here that tell us that an asset allocation adjustment is timely, particularly when the risk contribution and trailing return move to relatively extreme levels simultaneously. Monitoring risk contribution doesn’t replace other risk-management tools – instead, it’s a compliment that enhances our overall risk-management process. It’s part of what is known as the risk budgeting process. Although conventional asset allocation focuses on the relative share of each holding’s capital contribution, there’s a strong case for monitoring portfolios through a risk lens as well. In fact, it’s reasonable to consider the possibilities via a risk allocation process versus a traditional capital allocation framework. Ultimately, it’s the risk exposures that matter for engineering return outcomes. That’s an intuitive point, of course, and one that’s been widely embraced. Using a risk-attribution toolkit allows us to refine the concept in order to maximize the associated benefits and minimize any unexpected results that can arise when relying on vague rules of thumb for managing risk. *** Previous articles in this series: Portfolio Analysis in R: Part I | A 60/40 US Stock/Bond Portfolio Portfolio Analysis in R: Part II | Analyzing A 60/40 Strategy Portfolio Analysis in R: Part III | Adding A Global Strategy Portfolio Analysis in R: Part IV | Enhancing A Global Strategy Portfolio Analysis in R: Part V | Risk Analysis Via Factors Tail-Risk Analysis In R: Part I

Asset Allocation: ‘Scenic Route’ For Fed Should Lend Support To Risk Assets

As we move into 2016, investors are anticipating a period of sustained interest rate increases by the Federal Reserve – not an aggressive climb as sometimes seen in the past, but a mild, steady stroll to modest heights. Meanwhile, Europe and Japan remain on level policy ground, as they look to quantitative easing to maintain recovery and avert further contraction, respectively. Potential turbulence in the form of slowing Chinese growth could make the journey a bit uncomfortable, given that country’s central role in global economic health. Putting all this together, the Neuberger Berman Asset Allocation Committee believes that still-friendly monetary conditions and gradual economic improvement should lend support to risk assets and underscore our preference for stocks over bonds in the coming year. Global Equities: Leaning into Europe We are positive on global equities, particularly in Europe, where stocks stand to benefit from continued quantitative easing and a weaker euro. While we had an overweight view on U.S. stocks just a few months ago in light of reasonable valuations and potential for earnings improvement in 2016, that positioning has moved to neutral given the sharp price recovery in October. However, we see opportunity in master limited partnerships, which, despite near-term concerns around energy prices and the sustainability of distributions, still appear to offer attractive valuations and yields. We are relatively cautious on Japan’s market. Although stocks are benefiting from the weak yen and reallocation of pension fund assets, the country faces slow or negative growth and is vulnerable to a slower Chinese economy. Elsewhere, we have a neutral view of emerging markets, where China volatility, commodity weakness and dollar strength are creating economic headwinds, while corporate profitability remains under pressure. In our view, selectivity from a country and company perspective remains paramount. Fixed Income: Appeal of Spreads We are underweight global fixed income for the coming year given our low return outlook for the large, developed-country sovereign bond markets in light of a trend toward higher rates in the U.S. and easy policy in Europe and Japan. In the U.S., we believe the Fed’s rate normalization will be a dovish process relative to past tightening cycles. A meaningful spike in long-term rates appears unlikely to us, but investors should be prepared for periods of heightened volatility. We maintain a preference for credit based on our outlook for modest economic growth and current attractive spread levels. In particular, we see appeal in high yield, where spreads remain at wide levels due to commodity-related weakness. In our view, credit quality among issues in the rest of the high yield universe remains quite good. Credit fundamentals in emerging markets debt remain relatively strong, in large part due to higher reserve levels and much-improved policymaking over the last two decades. Recent troubles, however, have exacerbated weak growth stemming from soft domestic demand in the major emerging markets. We are neutral on a one-year horizon, but are more constructive further out, as we believe the developed market recovery should lend support to emerging markets’ growth and credit fundamentals. Alternatives: Directional Hedge Funds Could Benefit from Volatility Within alternatives, we now have a slightly overweight stance on directional hedge funds, as increased volatility is creating more opportunities for astute traders and active managers to add value. Within this group, distressed managers have suffered in 2015 from exposure to Puerto Rico, Greece and the energy sector, but we believe there are ample opportunities over a 12-month time horizon. We have a modest overweight view on lower-volatility hedge funds and believe that they continue to play an important role in asset allocations, particularly in an environment of higher volatility and likely rising rates in the U.S. Our view on private equity continues to be neutral in light of its long cycle of growth and more elevated valuations. Elsewhere, we are neutral on commodities – an improvement from six months ago – believing that these markets have come under so much pressure that they are not likely to deteriorate much further. China growth concerns may lend support to precious metal prices, while the drought in many parts of the U.S. should help soft and agriculture commodities. We believe oil is likely to be range-bound, but we anticipate better supply/demand dynamics on the margin. For the broader commodity complex, the potential for higher interest rates and the resulting stress on certain commodity producers may lead to production cuts and more balance across markets. Uncertain Journey We believe elevated uncertainty is likely to accompany investors for much of 2016, whether around future monetary policy, geopolitical events, the price of oil or the extent of slowing growth in China. We will continue to monitor developments as we seek to provide guideposts for the current challenging environment. Market Views Based on 1-Year Outlook for Each Asset Class Regional Focus Fixed Income, Equities and Currency * The currency forecasts are not against the U.S. dollar, but stated against the other major currencies. As such, the forecasts should be seen as relative value forecasts and not directional U.S. dollar pair forecasts. Currency forecasts are shorter-term in nature, with a duration of 1-3 months. Regional equity and fixed income views reflect a 1-year outlook. The Committee members are polled on the asset classes listed above, and these discretionary views are representative of an Asset Allocation Committee consensus. As of fourth-quarter 2015. Views expressed herein are generally those of the Neuberger Berman Asset Allocation Committee and do not reflect the views of the firm as a whole. Neuberger Berman advisors and portfolio managers may make recommendations or take positions contrary to the views expressed. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. About the Asset Allocation Committee Neuberger Berman’s Asset Allocation Committee meets every quarter to poll its members on their outlook for the next 12 months on each of the asset classes noted. The committee covers the gamut of investments and markets, bringing together diverse industry knowledge, with an average of 24 years of experience. 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