Volatility reduction is essential to wealth maintenance and growth
Spring has officially arrived, flowers are blooming, and our 2012 investment returns have everyone in a good mood. In fact, the investment returns this year are far better than we had expected. Stocks are making four-year highs. Our worries about the financial markets can be put to rest and we can enjoy a carefree balance of the year, right? Maybe not. While it is easy to sit back and enjoy the good results the investment markets have delivered, it is not prudent to ignore the future.
Some investors believe that having a very aggressive portfolio increases their ability to grow their wealth and capture the highest returns possible. Many of these aggressive investors also believe that they possess the ability to forecast market corrections and avoid their negative impacts. Sadly, there is little historical evidence to suggest that anyone is able to forecast future market directions. In addition, the most aggressively invested portfolios rarely deliver the best results.
So the question becomes what does a prudent investor do in the face of a recovery that has delivered multiple years of positive returns? Further, what is the appropriate reaction when investment returns from stocks and stock mutual funds are in double-digit territory just 10 weeks into the new year?
Fortunately for investors who develop and implement an investment policy, the answers about how to react to these situations are established in advance. The Investment Policy Statement (IPS) is tailored for each investor and provides the guidelines and details for adjusting the portfolio following long-term growth and short term spikes in the investment markets.
The IPS features target asset allocations and ranges within which the portfolio is allowed to vary from the target allocations. After a long bull market, or even a short-term significant movement in a single asset class, the IPS recommends that you rebalance back toward the target asset class weightings. Essentially, you are buying low and selling high every time you rebalance your portfolio. This discipline helps to ensure that the volatility of the portfolio, also known as the risk in the portfolio, is maintained at acceptable levels. The benefits of decreasing and managing the risk in the portfolio can be seen in the following example.
Compound Return Impact on a $1,000,000 Portfolio
In this example, there are two portfolios that each start with $1 million dollars. The only difference between the two portfolios is the amount of risk they have. Portfolio #1 has less risk and less volatile returns than Portfolio #2. In each portfolio, we will assume that the returns achieved in the first year are offset by returns in the second year of exactly the same magnitude, but in the opposite direction. Thus, you have a positive return in the first year followed by a negative return in the second year. In both cases, your average return is the same. Someone who is told that the two portfolios have the same average return is likely indifferent between owning Portfolio #1 or Portfolio #2.
The difference in compounded returns is staggering. The less volatile returns of Portfolio #1 delivered far superior results. Now imagine compounding returns for ten, twenty, or fifty years.
It is not enough to evaluate investments in terms of average returns. Reducing portfolio volatility can have a tremendous impact on the value of the portfolio in the future.
Staying focused on the guidelines in the IPS will help to keep the portfolio risk within a reasonable range. To decrease the level of risk and volatility in a portfolio and achieve similar returns requires the addition of investments with little or no correlation to the existing investments. Additional diversification from new uncorrelated investments should smooth the future returns and decrease the level of risk in the portfolio.
The financial services industry is constantly creating new products with claims of higher expected returns, better risk control, and access to niche investment markets. The vast majority of the new products, however, offer little more than a new wrapper on an old approach. Some new strategies, while potentially enticing, are so expensive that the only people likely to profit from them are the people selling them. Other new products are so burdensome from an income tax perspective that their attractiveness is lost unless they can be placed in a tax deferred account. The evaluation of new products needs to focus on whether or not they can improve the risk/return characteristics of the portfolio at a reasonable cost.
One of the joys of managing a wealth management firm is having access to many of the new investment theories, strategies, and products. Despite my high level of cynicism regarding new investments, I am always seeking new opportunities to improve the expected future returns for clients while maintaining or decreasing the level of risk to which they are exposed. Over the past three years, I have found a few new products that possess these diversification characteristics. They have attractive risk and return histories, are unlike the core holdings in portfolios, are inexpensive relative to similar strategies, and have the liquidity and transparency that we demand of all investments for client portfolios.
Over the course of 2012, I anticipate increasing exposure to these complimentary alternative mutual funds as portfolios are rebalanced and cash is added to accounts. We have had a nice run with stock mutual funds generating very good results and real estate and commodity focused mutual funds also performing very well. Bond investments through 2011 had returns that were fantastic. The key going forward is to decrease the risks from rising interest rates, rising inflation, and slowing economic growth on a global level. It is also critical to decrease the volatility in portfolios by increasing the number of different investments and decreasing the level of exposure to the riskiest of the asset classes.
Only time will tell if the portfolio adjustments made in 2012 will be the right ones. We can be certain that a disciplined approach, utilizing broad diversification, and strict adherence to asset allocation ranges, gives us the best chance to limit the negative impacts from unavoidable market risks.
The problem with this thinking is that the money does not come out of the portfolios at the end of the first year and we do not start with $1 million in each portfolio on the first day of the second year. Instead, the portfolios, like real-world accounts, get the benefit of having the first year’s gains included at the start of the second year.