The stock market (S&P 500) has been steadily increasing since the latter part of 2011. Is it time for a correction?
Can we predict a drop in market prices (before they actually drop)?
There are a number of valuation factors, trends, and indicators you can track in order to make your own judgment. Let's take a look at one such measure, the VIX or, as it's commonly referred to, the "Fear Index".
The VIX consists of futures prices (prices that are agreed upon today for assets that will be delivered on a future date), so it illustrates the traders' expectations of future market prices or the volatility of the S&P 500.
Managing investment risk is the most important factor in developing your portfolio. Projected or expected returns are meaningless if not viewed through the lens of potential risks.
Managing investment risk involves several steps:
• Identifying your Risk Profile
• Identifying investment risks
• Matching your investment portfolio risks to your Risk Profile
• Monitoring and adjusting your portfolio to match changes in your Risk Profile, goals and time horizons.
All investments have risks, although the risks may not be the same for every investment. Investing in US Treasury bonds expose you to market, inflation, interest rate, credit and sovereign risks. The value of your bonds will rise and fall with the overall bond market, and you have no control over market moves. If the return, interest payments and bond price increases, do not keep up with inflation, the real value of your investment is dropping. Currently these bonds are barely keeping up with the current rate of inflation. If inflation picks up in the future, these losses may be significant.
Interest rate risk is important when considering how bonds will perform. Bond value moves opposite the change in market interest rates. That is, if the prevailing interest rate goes up .5% the value of the bonds you hold will go down. The bond's interest rate and the time left to it matures, affects how much it reacts to market interest rate changes. The lower the bond's interest rate and the longer it is until it matures, the greater the impact. A 30 year Treasury bond with a 4% rate will have a significant loss of value if the market interest rates increase .5%. Shorter term bonds have less interest rate risk, although their overall return is also less.
Of lesser concern are the concerns of repayment due to poor financial condition or the US deciding to default on its obligations. Other bond classes have a greater chance of default than US Treasury issues.
US Treasury bonds are not risk free. For more detail on investment risks and how to match risk to your portfolio, check out this article.
Correlation is a statistic showing how investments perform relative to each other. Different investment asset classes, such as U.S. Government Bonds and International Emerging Stocks, typically react differently to economic conditions. Economic and market changes that may encourage bond values to increase, may tend to push stock prices down. The greater the difference, the lower the correlation. If the investment returns for two asset classes move in lock step with each other, they have a correlation of 1.0. If they move exactly opposite (for example, one class goes up 1% and the other goes down 1%), they have a correlation of -1.0. If they move independently, their correlation will be 0.0.
Correlations can change between asset classes. Sometimes many assets will move together. This means their correlation gets closer to 1.0. This is part of what happened in 2008/2009. Many investments moved down, together.
Why are correlations important? If you have a mix of investments in your portfolio that do not react the same way to economic conditions, you expect their performance to balance each other. If the long term trend for each investment is up, the portfolio as a whole will increase and show less variance. The graph of returns will look less like a violent roller coaster ride.
Duration measures how sensitive the bond or bond fund is to changes in interest rates or quality. It is one measure of the riskiness of a bond or bond fund. Bonds with a longer duration, higher number, will be more volatile. Duration can be calculated and is dependent on the coupon rate, yield to maturity and length of time to the bond matures. Bonds that have a lower coupon rate, longer maturity and higher yield to maturity will have a longer duration and their price will be more volatile. Bond prices are inversely related to market interest rates. That is, for a similar term bond, prices will decrease when interest rates rise. A bond with a duration of 2 would be expected to lose 2% of its value if interest rates were to increase by 1%.
You can find duration data at Morningstar and other bond market providers. Want more information? Check out Investopedia for a more detailed explanation.
As with most investments, that question is best answered by determining if an Alternative Investment matches your goals, time frame and risk profile.
First, let's review what are Alternative Investments, why they might be used and the advantages as well as potential risks involved.
Typically Alternative Investments are identified as those which are not traditional equity or fixed income instruments such as company stock or bonds. Alternatives can include real estate or real estate based investments such as Real Estate Investment Trusts (REITs). Other investments include commodities, currency contracts, Master Limited Partnerships (MLPs), precious metals and a host of other new products such as Collateralized Debt Obligations (CDOs). As their use becomes more common, the "Alternatives" become mainstream investments and newer instruments take their place.