Volatility has returned to the markets in recent months and with this comes the feeling of uncertainty. When the market takes a downturn our emotions can take hold of our decision-making ability, but it is crucial to focus on the long-term. It is not possible for anyone to accurately forecast market fluctuations and, despite what the media would lead us to believe, trying to second guess market outcomes really just leads to an unhealthy approach. There are specialist magazines and every major newspaper has a money section. There are radio shows and, of course, entire television channels devoted to the latest on the markets and where the so-called ‘experts’ think they’re heading. But is it futile?
The author Dan Gardner says it very well: “No one can foresee the consequences of trivia and accident, and for that reason alone, the future will forever be filled with surprises”. My role as a financial adviser is not to predict the future, rather it is to manage risk. That is why knowing your tolerance to risk is foremost to choosing the right portfolio structure.
What is your tolerance to risk?
There are two areas of risk that people need to take into account. The first is emotional tolerance to risk and how you feel when things go wrong. The second is your capacity for loss. You may feel like you can take more risk than your capacity. Lifetime cash-flow modelling should be a vital part of your financial planning process. We use this tool to see into your future, removing guesswork and allowing you to make informed decisions. It will also identify how much risk you can tolerate and afford to take.
Investments are never certain. But knowing your tolerance to risk and building a portfolio that spreads this risk through diversification is the key to generating successful returns. If the two are not carefully aligned there is a strong possibility of disappointment at some stage in the future because either your goals will not be met, because you have taken insufficient risk, or you will have taken too much risk and will be perturbed by market events.
How do we mitigate risk?
Diversification is the best defence against market volatility. It is more than just investing in a number of funds – you need to own assets that behave differently. This is why well-structured portfolios include widely diversified exposure to geographical regions and non-equity assets such as bonds and property.
However, markets are continually going up and down which means that the asset mix originally created inevitably changes due to differing returns among various securities and asset classes. As a result, the percentage that was allocated will change over time. This change may increase or decrease the risk of your portfolio. The real danger of facing market turbulence happens when investors have failed to rebalance their portfolio to regularly avoid excessive risk.
What is Rebalancing?
Here is a good definition from Investopedia:
“Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each asset class back to its original state. In addition, if an investor’s investment strategy or tolerance for risk has changed, rebalancing can lead to readjusting the weightings of each security or asset class in the portfolio to fulfil a newly devised asset allocation.”
By and large, riskier assets will deliver greater growth over time and portfolios will become skewed towards these assets. Often this is well beyond the tolerance set for volatility and the potential of further gains will backfire instead towards greater losses.
It is sometimes difficult to persuade investors that rebalancing must be implemented to the original allocation on a regular basis. This discipline forces the sale of assets that have done well and reinvests assets that have done less well, which keeps a portfolio’s exposure to risk reasonably constant over time.
This can feel counterintuitive but it is the most significant contributor to achieving a sell high and buy low strategy which results in beneficial returns. When markets are on the up, investors often resist rebalancing because they become focused on the short-term gains but when the markets have taken a downturn investors can overreact and become focused on the fear of short-term losses. This drives novice investors to head for the hills at the first sign of distress. These past months have been no exception. During July and August investors have been withdrawing money from both stocks and bonds, which of course, has not happened in consecutive months since the last financial crisis in 2008.
A successful investment strategy must be based foremost on the level of risk you’re prepared to take. Once you understand your financial goals, choose a portfolio that fits and then regularly (but no more than twice per year) rebalance your portfolio to realign it with your risk tolerance. Don’t worry about the stock market. You can’t control it. But you can control how you structure your wealth to work for you.
This article does not constitute financial advice. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner to take into account your particular investment objectives, financial situation and individual needs. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections.