We want to start with something most investment firms are reluctant to say out loud.

We do not know what markets will do next year, neither does anyone else. The history of professional forecasting is not encouraging, and we have no reason to believe we are the exception. This page explains what that means in practice, and why our portfolios include two types of investments that are less common in traditional stock-and-bond portfolios: risk-parity strategies and trend-following strategies.

What history actually tells us

There is a large body of research—from academic economists and from central banks—studying how financial trouble develops. It spans many countries and, in places, more than a century of data. A few findings come up again and again:

• Borrowing tends to build up before trouble arrives. Across long historical samples, rapid growth in private credit has been one of the more useful statistical warning signs of banking crises. It is not a reliable predictor. But it carries real information.

• Credit-driven downturns are different. Research by economists at the Bank for International Settlements found that recessions coinciding with a contraction in credit and property prices were associated with declines in output roughly 50% larger than other recessions, in a study of seven advanced economies from 1960 to 2011.

• Recovery takes years, not quarters. When households and businesses are repairing their balance sheets, they pay down debt rather than spend and invest. Economies in that condition have historically taken a long time to heal, and have responded poorly to the usual remedies.

None of this is controversial. It is the accumulated finding of a great deal of careful work.

And what it does not tell us

It cannot tell you when. The economists say so themselves. A lead researcher at the Bank for International Settlements has written that the financial cycle "should not be considered a recurrent, regular feature of the economy, which inevitably unfolds in a specific way." The patterns are real. The timing is not knowable.

What you can do instead

If you cannot know exactly when stress will arrive, you can still decide in advance not to be dependent on any single outcome. That is a design question, not a prediction, and it is one you can answer today.

A conventional portfolio of stocks and bonds is a bet—usually an unstated one—that the future resembles the recent past: moderate growth, contained inflation, and stocks and bonds that do not fall together. That bet has paid off for long stretches. It has also failed, sometimes for years at a time, and the failures have tended to cluster in exactly the credit-driven episodes the research describes.

At times we may hold two additional types of strategy because each is built to depend on a different set of conditions than a stock-and-bond portfolio does. Not because either is better, but because they are different, and because we cannot know in advance which environment we are about to get.

The two strategies, plainly described

Risk-parity strategies

A "50/50" portfolio is named for how the money is divided: half in stocks, half in bonds. That sounds balanced, and in dollars it is exactly balanced. But stocks move much more sharply than bonds do, so nearly all of the portfolio's ups and downs still come from the stock side. It's a seesaw with an adult on one end and a child on the other — both are sitting on it, but only one decides which way it tips.

Risk-parity strategies balance by how much risk each piece contributes rather than how many dollars it holds, spreading that risk across investments that behave differently across growth, slowdown, inflation and disinflation. The aim is a portfolio less dependent on any one of those arriving.

The equity-driven declines of 2000–2002 and 2008 are the kind of environment this is designed for. In both, stocks fell over an extended period while high-quality bonds rose as interest rates came down. A conventional portfolio did own the asset that helped—but even with half its money in bonds, the bond side made up only a small share of its risk, so the stocks still decided the outcome. Balancing by risk rather than by dollars is meant to address that imbalance directly.

What you are accepting:

• Leverage: which magnifies gains and losses.

• Poor performance when rates rise sharply, or when stocks and bonds fall together, which happens.

• More complexity and cost than an index fund.

• In a strong stock market, a very likely lag, possibly large and possibly for years.

Trend-following strategies (managed futures)

These invest across equity indices, bonds, currencies and commodities, and can position for a rise or a decline. The rules are systematic: position with a persistent trend, reverse when it turns.

We hold them not because they predict anything, but because they don't need to. A strategy able to position for decline doesn't have to know decline is coming, it responds to what is already happening. Historically that has meant a low long-term correlation to stocks and bonds, which is the property we are actually buying.

2022 is the kind of environment this is designed for. Stocks and bonds fell together, so the usual balance between them offered little protection, and the major moves—in interest rates, currencies and commodities—ran in one direction for months rather than days. That is the type of market a trend-responsive approach has something to work with, though no strategy is assured of benefiting in any particular period.

What you are accepting:

• Losses when markets move sideways or reverse sharply—repeatedly caught as the trend breaks, an experience called whipsaw.

• They can lose money in years when stocks rise, and have had multi-year stretches of poor returns.

• They use derivatives and short positions.

• They trade frequently, with tax consequences in taxable accounts.

• They cost more than index funds, and results vary widely by manager.

How this shows up in portfolios

These strategies are one component of a diversified portfolio, not a replacement for stocks and bonds. How much of each is appropriate—or whether either is appropriate at all—depends on your objectives, your time horizon, your tolerance for risk, your tax situation, and the types of accounts you hold. Some clients hold a meaningful allocation. Some hold none.

What to expect — including the uncomfortable part

Frequently, these strategies will look like a mistake.

That isn't a flaw in the approach, it's the design. Owning things that don't move together means something you own is always lagging, and in a rising market, which is most years, it will likely be these. Also, these strategies can lose money, including in years when stocks and bonds do well or they may fail to help in the next downturn. The fair question in your mind will be why you own them at all.

The answer is that we are not trying to maximize any single holding. Our objective in holding them is a better balance of return and risk over a full market cycle, not higher returns in any given year. The balance of evidence favors diversifying this way.

Research referenced

The findings described on this page draw on published academic and central-bank research, including:

Drehmann, M., Borio, C. & Tsatsaronis, K. (2012), "Characterising the financial cycle: don’t lose sight of the medium term!", BIS Working Paper No. 380  ·  Borio, C. (2012), "The financial cycle and macroeconomics: What have we learnt?", BIS Working Paper No. 395  ·  Schularick, M. & Taylor, A. (2012), "Credit Booms Gone Bust", American Economic Review 102(2)  ·  Reinhart, C. & Rogoff, K. (2009), "The Aftermath of Financial Crises", American Economic Review 99(2)  ·  Romer, C. & Romer, D. (2017), "New Evidence on the Aftermath of Financial Crises", American Economic Review 107(10)  ·  Koo, R. (2010), "The world in balance sheet recession", real-world economics review 58.

These are independent works of research. Their authors have no relationship with PlanWiser and have not reviewed or endorsed this page or our investment approach.