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Three Reasons to Diversify Now

While 2017 seemed an easy year for investors to make money, this year is likely to be a lot more challenging.

Looking back, 2017 looks like a cake walk for investors. Stocks and bonds rose broadly with only one major asset class ending the year in the red (energy-focused master limited partnerships). Most global stock markets posted double-digit gains and the S&P 500 climbed 20%.

Next year is poised to be much more challenging. Instead of the “goldilocks” scenario of low volatility and rising global growth, markets are likely to get a lot more choppy and individual stock performance could become more idiosyncratic.

Below are three catalysts for more challenging markets in 2018:

  1. Global economic growth may disappoint. The U.S. economy as well as the economies of most developed nations were surprisingly strong through much of 2017. Now, however, I believe expectations for growth in 2018 are a little too rosy. I already see signs that consumer confidence is weakening. I think investors could be disappointed with economic growth in 2018.
  2. U.S. interest rates are poised to rise. As I wrote in December, (See, “Get Ready for Rising Rates”), I believe there is potential for higher inflation and a more hawkish Federal Reserve. If rates rise as much as I expect, that is likely to put pressure on both stock and bond prices. I believe volatility could rise sharply.
  3. Corporate results could vary widely. Most stocks rose in 2017, but results will be far less uniform in 2018. There will be new winners and losers based on tax law changes. Plus, the potential for higher prices and rising rates could impact individual companies in different ways.

Scaling back on risk seems appropriate. With most markets “priced for perfection” (i.e. failing to discount risks), it’s likely that we will see more negative surprises going forward than positive ones. Picking winners will be much more difficult and higher valuations suggest more downside for companies that disappoint. Rising interest rates could mean that even bonds perform poorly, since bond prices move inversely to rates.

My advice is to diversify across asset classes and sectors while raising more cash. I also suggest using more active managers, not index funds. Professional fund managers can identify securities that offer both value and quality, which should hold up well even as markets become tougher to navigate this year.

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Morgan Stanley Access Investing