The value of leaning into laggards

What you need to know

  • Rising yields have pressured portfolios for a few years now, but there are reasons to believe the future looks brighter, including for bonds.
  • With tighter financial conditions weighing on the economic outlook, cyclical equities have dragged on portfolios the most. But opportunities may be forming in lagging segments of the market.
  • The drawdown in fixed income has been painful, but bonds have become increasingly attractive. Diversified allocations can play a valuable role in a portfolio.
  • Consider rebalancing by leaning portfolio allocations toward laggards that have become underweight, possibly through a systematic investing strategy.

Portfolio tip

You can help manage risk and benefit from diversification by looking at how investments may work together in your portfolio.

Where have we been?

Rising yields have been a headwind for bond portfolios, but higher yields could provide a tailwind from here. Interest rates have moved sharply higher in recent months, with the 10-year Treasury yield hitting 5% last month, a level not seen in more than 15 years. These recent moves continue the three-year upward trend in yields: The 10-year Treasury yield was less than 1% in 2020.

“Higher for longer” interest rates have pressured portfolios for a while, but the reasons for rising rates have shifted over time. They include tightening central bank monetary policies to fight inflation, resilient global growth and the expectation for additional Treasury bond issuance, among others.

Given the pressure from rising rates, bonds have been a pain point for investors. U.S. investment-grade bonds have dropped almost 3% in 2023 and about 6% on average over the past three years, pulling bond-heavy portfolios into negative territory. However, moderating inflation and a likely end to central bank interest rate hikes may signal long-awaited relief.

The best single predictor of future returns for high-quality bonds is their starting yield. Given where yields are today, the future for bond allocations is looking brighter than what we’ve experienced over the past three years.

Higher rates have impacted broad markets, extending the recent weakness through October. Rising rates have weighed on asset prices more widely than just within fixed income, particularly considering the impact tighter financial conditions may have on future growth. Almost all asset classes fell last month, and some economically sensitive investments led the way down.

Small-cap stocks, which tend to be more cyclical in nature, weighed on portfolios the most in October. U.S. small-cap stock allocations have recently been a significant underperformer, falling 7% last month and nearly 17% over the past three months. International small- and mid-cap stocks, which fell about 6% in October, also dragged portfolios lower. Over the past year, however, international small- and mid-cap stocks remain up nearly 9%, while U.S. small-cap stocks trailed all asset classes, down nearly 9%, given the potential economic impact of higher interest rates in the U.S.  

Large-cap stocks, which tend to be higher-quality, have not only held up better in recent periods but provided the most support for portfolios over the past year. U.S. large-cap stocks dropped 2% in October but have returned over 10% from a year ago. International large-cap stocks dropped 4% in October but are still in the lead over a one-year period, posting a return of over 14%.

What do we recommend going forward?

Revisit the value of a well-diversified bond portfolio. The drawdown in fixed income over the past three years has been painful. But not all segments of the fixed-income market have been impacted in the same way. We expect the value of diversification to continue benefiting bond allocations as yields peak and begin to pivot lower.

We recommend allocating to bonds across a variety of maturities. Cash and short-term bond investments may provide stability for your portfolio but tend to be a drag on returns over the long term. Reducing overweight exposures can help you manage reinvestment risk. Longer-term bonds have become increasingly attractive as rates rise, given the greater income potential and enhanced diversification benefits of today’s higher rates.

Lower-quality bonds offer a yield premium relative to higher-quality bonds, which has supported portfolios this year. We believe neutral allocations can help your portfolio benefit from their higher yields while balancing the potential that they could underperform if the economy weakens.

Rebalance by leaning into laggards. Underperforming investments may become underweight in your portfolio, potentially causing you to drift too far from your original intention. Rebalancing back to your target allocations can help tie your portfolio to your risk and return objectives.

Consider allocating to areas of the market that have lagged and become underweight in your portfolio. For example, look at U.S. and international small- and mid-cap stocks, value-style stocks and U.S. investment-grade bonds, given the softness we’ve seen in these areas. Opportunities may be forming to add quality investments at more attractive prices. Markets remain sensitive to economic trends, supporting our neutral recommendation in these areas, but balancing these allocations can help you prepare for a more sustained recovery ahead.

Within U.S. equities, the consumer discretionary sector has fallen toward the back of the pack as financial conditions tighten. However, ongoing consumer demand supports our recommendation to overweight the sector, creating potential opportunities for your portfolio.

Systematic investing could provide natural opportunities to rebalance. Systematic investing, such as dollar-cost averaging or regularly contributing to your portfolio, can help your portfolio stay within your intended targets over time. It can also help remove the stress of trying to perfectly time the highs and lows of the market. Systematic investing can help you take advantage of market opportunities as they occur, particularly in periods of higher volatility.

We’re here for you

In a diversified portfolio, there will always be an allocation that lags in performance, possibly over an extended period. It’s important to remember that each of your investments plays a specific role. Talk with your financial advisor about the “why” behind your allocations and whether there is an opportunity for you to lean into the laggards. Doing so can help ensure your portfolio is positioned to deliver on your risk and return objectives and aligned with your financial goals.

If you don’t have a financial advisor and would like help evaluating your portfolio, we invite you to meet with an Edward Jones financial advisor to discuss your goals and investment objectives, as well as our recommended portfolio allocations.

Strategic asset allocation guidance

Our long-term, strategic asset allocation guidance represents our view of balanced diversification for the fixed-income and equity portions of a well-diversified portfolio, based on our outlook for the economy and markets over the next 30 years. The exact weightings (neutral weights) to each asset class will depend on the broad allocation to equity and fixed-income investments that most closely aligns with your comfort with risk and financial goals.

Diversification does not ensure a profit or protect against loss in a declining market.

 Strategic asset allocation guidance
Source: Edward Jones.

Opportunistic asset allocation guidance

Our opportunistic asset allocation guidance represents our timely investment advice based on current market conditions and our outlook over the next one to three years. We believe incorporating this guidance into a well-diversified portfolio may enhance your potential for greater returns without taking on unintentional risk.

 Opportunistic asset allocation guidance
Source: Edward Jones.

Tom Larm, CFA®, CFP®

Tom Larm is a Portfolio Strategist on the Investment Strategy team. He is responsible for developing advice and guidance related to portfolio construction, asset allocation and investment performance to help clients achieve their long-term financial goals.

Tom graduated magna cum laude from Missouri State University with a bachelor’s degree in finance. He earned his MBA from St. Louis University, is a CFA charterholder and holds the CFP professional designation. He is a member of the CFA Society of St. Louis.

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Important information

Past performance of the markets is not a guarantee of future results.

Investing in equities involves risk. The value of your shares will fluctuate, and you may lose principal. Small-cap stocks tend to be more volatile than large-company stocks. Special risks are involved in emerging-market investing, including those related to currency fluctuations and foreign political and economic events.

Diversification does not ensure a profit or protect against loss in a declining market.

Before investing in bonds, you should understand the risks involved, including credit risk and market risk. Bond investments are also subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease, and the investor can lose principal value if the investment is sold prior to maturity.