Being on a boat on the ocean during a storm doesn't feel very good. You can be jolted around, sometimes violently, the wind blows and you are likely cold and wet. Fear, regret (for stepping on the boat) and discomfort are natural emotions during these times.
During the third quarter of 2011 (June - September) many of us felt like we were revisiting the storms of 2008. Stock markets around the world gave back some of the gains we experienced since March 2009. Each day it felt like we were being tossed about, up and down, as the waves pounded our boat and it didn’t feel good. Fear, regret and discomfort reared their ugly heads, as they always do when stock market volatility increases. Things are still quite unsettled, fraying the nerves of even the longest of long-term investors.
Investment Maxim: "High Risk, High Returns"
It's a funny thing: When stock markets are good and we see our account balances increase over a few months or quarters, we tend to forget how we feel when account balances go in the opposite direction. We like getting good returns and many of us build our financial plans around the hope that stock markets will, over time and on average, provide returns that are significantly in excess of inflation and taxes. You may be disappointed as you review recent statements, but remember that given enough time stock markets recover and do provide the returns we need to meet our objectives.
There is a long held belief that in order to achieve these high market returns, investors must accept an equivalent amount of market risk. The higher the return, the greater the risk. With that in mind, many investors allocate a large portion of their portfolios to the stock market. But as we have experienced, the stock market has swung violently over the last decade and riskier assets have not always provided investors higher returns. Investors feel cheated by the high risk, high return maxim of the stock market and they are looking for alternatives.
The perception that the stock market provides higher risk and lower returns has many investors fleeing equity markets, moving assets to so-called safe havens, like cash or bonds. Unfortunately, these assets aren’t really safe either, especially when you consider inflation and taxes. Investors sitting on the sidelines risk missing market upswings, fail to recoup their losses and jeopardize their life goals. Emotional decision-making isn’t usually a good long-term strategy for stock market investors.
Some investors believe the markets will eventually calm down and become "normal". But how will they know when it's the best time to get back into the stock market? Will they miss a significant increase in value while waiting to "feel good" about the markets and the economy? For example, the markets dropped 37% in 2008 and increased 26% in 2009 and 15% in 2010. Based on a review of net redemptions from stock mutual funds during these periods, it appears that many investors sold around the bottom of the market and missed the rebounds of 2009 and 2010. Not participating in these market recoveries may make it difficult for them to achieve their investment goals.
As this was written in Mid-October, stock markets have rebounded significantly since the end of September. Investors that reduced their exposure to stocks in September may have missed some of the recovery. While returns may turn negative soon again, this is just another example of how difficult it is to time markets.
Limit Your Losses
Since timing markets isn't a viable long-term strategy, most investors should stay fully invested even during tumultuous periods and focus on limiting losses. Limiting losses is important because it can be tough to make them up. The rate of return required to recoup a loss is always greater than the loss itself. What’s worse, larger losses require even greater gains to reach breakeven. For example, you'll need an 11% gain to fully recover a 10% loss, but a 100% gain to recoup a 50% loss. That's why volatility can be so painful. The message is clear: Limiting losses, even by one or two percentage points, can make a meaningful difference in the ultimate value of your portfolio. For that reason, we believe the potential downside of a stock portfolio is as important, if not more important, than its potential upside.
What can you do to manage risk? Utilize "rowing" strategies that attempt to manage volatility. Some managers will tactically position portfolios into less volatile, higher quality, dividend-paying stocks. Other managers will reduce stock exposures when trends are negative. Another example would include managers that "hedge" positions in order to reduce portfolio risk.
Because success is measured differently in managed volatility portfolios, investors need to adjust their mind-set. The focus is on lowering absolute risk rather than beating a benchmark. For that reason, performance can differ significantly from the broader market, especially in the short-term. For example, when stock prices climb steeply, managed volatility strategies will likely under perform. Long-term however, these strategies are designed to make up ground in down markets and potentially produce longer term returns comparable to the broader market.
How can managed volatility strategies help you meet your goals? Recently, an anxious client called very concerned about stock markets around the world. His portfolio was approximately 50% in stocks and 50% in bonds. But now he wanted to reduce his stock holdings down to 15% until the world became "normal" again. We discussed the historical reality that 15% stocks and 85% bonds wasn't probably going to provide the returns he needed to meet his goals and that he didn't really know what would have to happen to the world economy and markets for him to feel comfortable with a greater allocation to stocks. He was also surprised to hear that despite the news reports, his account was actually doing better than he thought. The solution was to reduce his stock allocation to 40% and transfer some of his stocks to a managed volatility strategy. This approach kept him invested in stocks and somewhat reduced his feelings of fear and discomfort.
Most importantly, long term investors need to keep the logical side of their brain in charge. Recognize when emotions begin to creep into your decision-making. Keep focused on your short and long-term goals and confirm that you are on the right path by updating your financial plan. Seek counsel from a professional financial planner. By giving context to your investment plan, you can reduce those emotions of fear, regret and discomfort. Markets do recover and as it does, you will regain confidence that you have a sound and manageable financial plan.
* Source: www.ewealthmanager.com/cmsdocs/sinfo/pdf/gfwm_1300_stratfactshtevtuforq2_flr_2011_06.pdf
By Peter Raskin