Exceptional Investing in Volatile Markets
Stock market volatility recently returned to normal levels after a few years of abnormally low volatility. It’s a good time to remind ourselves how to take advantage of this very natural dynamic of investing rather than be deceived by it.
Here are five important reminders:
1. Volatility is your friend.
The very reason equity markets offer the possibility of higher returns than saving or investment vehicles with less perceived risk, such as U.S. Treasury Bonds or Certificates of Deposits (CDs), is the higher risk and greater volatility associated with such holdings.
This is called the risk premium, something investors as a whole build into liquid, open, transparent financial markets every business day of the year around the world.
For instance, the S&P 500, over the last 90 years returned about 10% per year.* However, there were very few individual years it actually returned that amount. The reality is that in 40 of the 90 years, the index was up more than 20% or down more than 20%.
So, remember, the premium (return over less risky assets) you are seeking to receive in risk assets is precisely for accepting the bumpy ride associated with the investment vehicle.
So long as you genuinely are a long-term investor who can ride out the bumps to the level you have accepted, history demonstrates you can be fine. Exhibit 1 illustrates the long-term historic view of what broad asset classes look like: **
2. Diversification is your friend.
Because investing in one company, industry, class or even geography can be too bumpy a ride for one’s stomach (risk temperament), one historically sound way to reduce and customize the risk/reward tradeoff and mitigate risks that do not have an expected rate of return is to diversify a portfolio across individual holdings, industries, asset classes (large cap, small cap, value, growth, etc.) and geographies (U.S., Developed Non-U.S., Emerging Markets, etc.).
While you give up the chance of benefiting by a concentration in the hottest company, industry, class or geography, you exert a level of control on the volatility that seeks to be more in line with your needs and temperament.
Once you decide diversification is the way to go, DO NOT second guess this decision and DO NOT seriously compare your diversified portfolio to a less diversified index/benchmark (such as the S&P 500, which is just U.S. Large Cap stocks). Doing so will only provide a false reading
High net worth investors typically created wealth in some concentrated Aspirational form (business, real estate or stock option ownership) or via the good ole annual saving habit.
Either way, the aim to protect and grow wealth in the face of uncertainty leads one properly funding three buckets:
Safety bucket–highly liquid holdings that tend to retain their value, even in extreme economic conditions;
Market bucket–a globally diversified portfolio of semi-liquid securities that seeks to participate in capitalism worldwide (what this article is mainly about);
Aspirational bucket–a concentrated, leveraged and/or illiquid position in private business(es), real estate holding(s), fund(s), option)s) or semi-liquid security(ies) that seek to participate in accelerated wealth creation and wealth multiplication opportunities at higher risk/reward ratios.
The Aspirational bucket portion typically increases as one moves into the ultra-high net worth ($20 million+ portfolio) range and may not be pursued, for risk mitigation, simplicity and liquidity purposes, by high net worth investors with portfolios under $10 million. For more on the difference between Safety, Market and Aspirational asset investing, click here.
While investors typically understand why they diversify across individual holdings, they sometimes forget why asset class and geographic diversification can be their friend.
Exhibit 2 illustrates a perfect example. From 2000 to 2009, the S&P 500 had a cumulative return of -9.1%, a period known as the lost decade. During the same period, global index returns fared much better.
The big question is, are there systematic ways of identifying which countries will outperform others in advance? Exhibit 3 illustrates the randomness in country equity market returns in 22 developed countries (from highest to lowest). It conveys the difficulty and complexity involved. Frankly, no reliable evidence exists that such performance can be predicted in advance. Diversification remains the historically reliable way to engineer a portfolio for risk/reward and return variability mitigation.
3. Doing what is in your control is your friend.
While market gyrations are out of any investors control, two things in your control that you can focus on, with our help, are:
- Be a Penalty-Resistant Investor
- Be a Depletion-Resistant Wealth Steward
A penalty-resistant investor remembers volatility and diversification are their friend and mindfully controls their thoughts and actions for success.
In addition to diversifying your portfolio in a thoughtful traditional way tailored to your needs, objectives and risk temperament, we’ve helped (or can help) you incorporate five key strategies (also known as exposures) into your portfolio:
- Conventional Indexing (Lean Exposure)
- Factor Indexing (Smart Exposure)
- Select Active Management (Advantageous Exposure)
- Strategic Rebalancing (Disciplined Exposure)
- Strength Based Wealth Management (Prudent Exposure)
Click on Exhibit 4 for a brief explanation of these exposures. We believe you can confidently rely on them as a handful of solid long-term investment strategies. We have solid academic research, some authored by Nobel Laureates, supporting each technique.
Please Note: Every technique that does not exactly match conventional indexing introduces a variance that could underperform a related benchmark for a period. This is natural and to be expected. However, credible research shows the possibility of a higher expected return over a long period of time utilizing these strategies, so in our best judgment, we engineer these exposures into our portfolios.
4. Investing from a Position of Strength is your friend.
Clients of ours taking advantage of our patented Strength Based Wealth Management® (SBWM) services know we highly recommend all investors measure and build 35 Essential Strengths®. Nine of these strengths are portfolio related and 26 are related to other important aspects of your wealth including building and maintaining a strong balance sheet and cash flow. Having these strengths can make you a more confident and capable investor.
The Elastic Limit Threshold™ is a concept within SBWM that we created to assist you in thinking about and building and measuring financial strength, agility, flexibility and endurance. Utilize it to invest from a position of strength.
5. Trust and confidence are your friends; fear and greed are your enemies.
When it comes down to it, we believe a large penalty is paid when investors fall victim to fear during real or perceived dark times and greed during real or perceived booms.
Seven studies illustrate the hefty cost of the Investor Behavior Penalty.
The antidote, we believe, is levering Evidence-Based Investing and Strength-Based Wealth Management.
This is how to build and maintain trust and confidence and practice the virtues of discipline and prudence.
This is the essence of exceptional investing in volatile times.