Month: June 2011

Protection in Volatile Markets

Over the last few years investors have navigated through arguably one of the worst financial storms since the Great Depression. At the peak of the volatility it seemed like a day didn’t pass without some big financial news and it was unusually bad. Markets either reaped big gains or got clobbered with steep losses. The level of volatility made investors more anxious and in many cases frustrated.  The 50% drop in major markets in 2008 challenged the ability of the traditional buy and hold strategy to produce consistent returns while controlling downside risk.

The buy and hold investment approach had worked in the past. However it is noteworthy that the nature of investing has changed dramatically over the past 20 years. Certainly technology has advanced with developments such as rapid trading programs, quantitative investment management, as well as new structures such as hedge funds and ETFs which focus more on the short to mid-term or on momentum. These changes have created monumental challenges to long term investing in terms of stability of returns. Due to the extreme bear market of the last two years investors have acknowledged the limit of long term investing. Thus investors now have more of an appetite for strategies that produce comfortable or even opportunistic returns while protecting their assets on the downside.

One important way of dealing with this is to first identify the client’s lifestyle goals and incorporate them into a well-designed asset allocation. There is no shortage of empirical evidence that have proven over the years the importance of asset allocation decisions which can account for more 90% of investment returns. On that note 2008 clearly demonstrated the impact of asset allocation decisions as most classes dropped substantially in value, however some fared much better. For example most equities dropped almost 50% while bonds preserved much of their value.

Another important way to mitigate volatility is to find some common ground between the long term horizon and the short term one. Clients need to have their portfolios designed with a long term view to “stay the course” while carving out a reasonable portion to short term strategies which would take advantage of market momentum and opportunities. For a very long time many advisors have been inclined to believe that tactical shifts are market timing decisions and not appropriate for client portfolios. Contrary to that opinion, tactical strategies should be viewed rather as proactive investment management which can complement the core asset allocation and is effective in taking advantage of bullish markets while preserving capital in bearish ones.

Finally it is critical for clients to acknowledging that their investment portfolios are not infallible but rather a system that maximizes the outcome on the positive side and minimizes it on the negative side. Through this approach clients can expect realistic results and prevent themselves from living in perpetual fear of a financial calamity.