Sometimes the best, most rigorously developed financial advice is so obvious, it seems cliché. And yet, investors often end up abandoning this same advice when the markets turn volatile. Why the disconnect? Let’s take a look at five general truths for thriving in volatile markets, and why they’re often much easier said than done.
If You Fail to Plan, You Plan to Fail.
Almost everyone would agree: It makes sense to plan how and why you want to invest before you actually do it. And yet, few investors come to us with robust plans already in place. That’s why detailed planning is one of the first things we do when welcoming a new client, including:
- A Discovery, or “Master Map” Meeting – To understand everything about you, including your goals and interests, your personal and professional relationships, your values and beliefs, how you’d prefer to work with us … and anything else that may be on your mind. At AMDG Financial, we liken the process to orienteering, the sport of navigation in which participants use a compass and a map to find their way to various checkpoints. In our discovery meetings with clients, we work together with you to create the “master map” for your journey to financial well-being. This includes organizing your existing assets and liabilities, define your near-, mid-, and long-range goals, and ensure your financial means align as effectively as possible with your most meaningful aspirations.
- An Investment Policy Statement (IPS) – To bring order to your investment universe. Your IPS is both your plan and your pledge to yourself on how your investments will be structured to best align with your greater goals. It describes your preferred asset allocations (such as your percentage of stocks vs. bonds), and is further shaped by your willingness, ability, and need to tolerate market risks in pursuit of desired returns. In orienteering terms, this would be akin to “orienting the map.” That’s where a navigator would use a compass to position the map according to the surroundings. In our process, we’re orienting your investment policy according to what you’ve told us about your risk tolerance, your goals, and your other investment preferences.
- Integrating Tax, Financial and Investment Strategies – To chart a course for aligning your range of wealth interests with your financial logistics: insurance, estate planning, tax planning, business succession, philanthropic intent and more. We take a holistic view of your financial well-being and understand that change in one area may affect another area in a way you didn’t plan, so we’re careful to examine each action we take in the context of the whole.
- No Risk, No Reward.
In many respects, the relationship between risk and reward serves as the wellspring from which a steady stream of financial economic theory flows. Simply put, we expect that exposing your portfolio to market risk should generate higher returns over time. Reduce your exposure to market risk, and you also lower expected returns.
We typically build a measure of stock market exposure into our clients’ portfolios accordingly, with specific allocations guided by individual goals and risk tolerances. But here’s the thing: Once you have accepted the evidence describing how market risks and expected returns are related, it’s critical that you remain invested as planned.
There’s ample evidence that periodic market downturns ranging from “ripples” to “rapids” are part of the ride. As a February 2018 Vanguard report described, from 1980–2017, the MSCI World Index recorded 11 market corrections of 10 percent or more, and eight bear markets with at least 20-percent declines lasting at least two months. Such risks ultimately shape the stream that is expected to carry you to your desired destination. Consider them part of your journey.
- Don’t Put All Your Eggs in One Basket.
At the same time, “risk” is not a mythical unicorn, and this is where diversification comes in. In 1990, Harry Markowitz was co-recipient of a Nobel prize for his work on what became known as Modern Portfolio Theory. Markowitz analyzed (emphasis ours) “how wealth can be optimally invested in assets which differ in regard to their expected return and risk, and thereby also how risks can be reduced.” In other words, according to Markowitz’s work, first published in 1952, investors should employ diversification to manage portfolio risks.
This leads to an intriguing, evidence-based understanding. By combining widely diverse sources of risk, it’s possible to build more efficient portfolios. You can:
- EITHER lower a portfolio’s overall risk exposure while maintaining similar expected returns
- OR maintain similar levels of portfolio risk exposure while improving overall expected returns
Rarely, evolving evidence helps us identify additional or shifting sources of expected return worth blending into your existing plans. When this occurs, and only after extensive due diligence, we may advise you to do so, if practical (and cost-effective) solutions exist.
The details of how these risk/return “levers” work is beyond the scope of this blog. But come what may, the desire and necessity to DIVERSIFY your portfolio remains as important as ever – not only between stocks and bonds, but across multiple, global sources of expected returns.
- Buy Low, Sell High.
Of course, every investor hopes to sell their investments for more than they paid for them. Here are two best practices to help you succeed where so many fall short: time and rebalancing.
By building a low-cost, broadly diversified portfolio, and letting it ride the waves of time, all evidence suggests you can expect to earn long-term returns that roughly reflect your built-in risk exposure. But “success” often takes a great deal more time than most investors allow for.
In a recent article, financial author Larry Swedroe looked at performance persistence among six different sources of expected return as well as three model portfolios built from them. He found, “In each case, the longer the horizon, the lower the odds of underperformance.” However, he also observed, “one of the greatest problems preventing investors from achieving their financial goals is that, when it comes to judging the performance of an investment strategy, they believe that three years is a long time, five years is a very long time and 10 years is an eternity.”
In the market, 10 years is not long. You must be prepared to remain true to your carefully structured portfolio for years if not decades, so we typically ensure that an appropriate portion is sheltered from market risks and is relatively accessible (liquid). The riskier portion can then be left to ebb, flow and expectedly grow over expanses of time, without the need to tap into it in the near-term. In short, time is only expected to be your friend if you give it room to run.
Another way to buy low and sell high is through disciplined portfolio rebalancing. As we create a new portfolio, we prescribe how much weight to allocate to each holding. Over time, these holdings tend to stray from their original allocations, until the portfolio is no longer invested according to plan. By periodically selling some of the holdings that have overshot their ideal allocation, and buying more of the ones that have become underrepresented, we can accomplish two goals: Returning the portfolio closer to its intended allocations, AND naturally buying low (recent underperformers) and selling high (recent outperformers).
- Stay the Course.
So, yes, planning and maintaining an evidence-based investment portfolio is important. But even the best-laid plans will fail you, if you fail to follow them. Here, we get to the heart of why even “obvious” advice is often easier said than done. Our rational self may know better – but our instincts, emotions and behavioral biases get in the way.
If you think back to our orienteering example, deciding to change course during a short-term market adjustment is a bit like throwing away your master map and trudging along without knowing where you’re headed. In this scenario, you would likely end up lost in the woods wondering which direction you should follow! Best to stick to your master map for an increased opportunity to arrive at your destination. `
Simple, But Not Easy
Blame your behavioral biases. They make simple advice deceptively difficult to follow. We all have them, including blind spot bias. That is, we can easily tell when someone else is succumbing to a behavioral bias, but we routinely fail to recognize when it’s happening to us.
This is one reason it’s essential to have an objective adviser (and/or a spouse or solid friend) who is willing and able to let you know when you’re falling victim to a bias you cannot see in the mirror. That’s exactly what we’re here for! Let us know if we can help you reflect on these or any other challenges that stand between you and your greatest financial goals.