With the recent market volatility, the average investor may feel paralyzed when it comes to their portfolio. A common question many advisors hear from their clients is “what should we do now?” While the underlying emotional pressures may be at work, for advisors, the answer should be easy…it’s under control. If managed properly, your portfolio should be insulated from the inherent risks a volatile market can pose.
Managing risk in your portfolio should be the cornerstone of a sound long term investment plan. While the term “risk” means many things to people, when used in the context of portfolio management, it should be viewed as a threat to asset value. In our view, proper diversification and strict discipline are major tools utilized when managing portfolio risk.
There are many forms of risk that investors should be aware of. For the purposes of this article, I will touch on a few that we as a group feel are important. Market, Interest Rate and Inflation Risk are three forms in particular that we work to mitigate. While you may never be able to fully deflect these forms of risk from your portfolio, there are many ways you can protect yourself.
Market Risk exists in the equity side of the portfolio. The risk is that the positions in your portfolio will move in tandem with the comparable equity index. While that may be good in a bull market, once the tide changes, having a high correlation to that index can be dangerous. We manage this risk in a number ways. Staying nimble in a volatile market is important. When markets shift wildly, the unrealized gains in a position can erode quickly. Staying disciplined and sticking to designated sale targets can save gains and reduces losses. Hedge the equity exposure with non-traditional asset classes. The use of commodities, real estate or international sectors will help to accomplish this. Another strategy is to employ non-correlated absolute returns in an attempt to diversify away the risk to the equities in the portfolio.
Interest Rate Risk is a problem that many investors are dealing with first hand. Most often associated with the fixed income side of the portfolio, interest rate risk can hurt the investor in a changing rate environment. As rates fall or stay low, the price of fixed income investments rise or stay high. For a bond portfolio the danger includes difficulty investing new or maturing funds without a high premium eroding the benefit of the investment. As rates start to increase, the opportunity cost of holding the bond investment decreases since investors are able move to and realize greater yields. Conservative investors feel the pinch when the ultra low risk money markets, CD’s or cash alternatives no longer provide the income they once did. Manage interest rate risk by keeping the duration in the portfolio low and holding the investments to maturity to avoid loss of principal.
The third type of risk to be aware of is Inflation Risk. The purchasing power of your income is eroded as inflation rises. When reviewing the more conservative assets in the portfolio, the potential damage inflation can do must be considered. As inflation increases, the fixed income on the longer end of the yield curve will be impacted the most. Stretching for yield and not properly diversifying a fixed income portfolio can result in a large part of the assets not being able to keep up with inflation. Holding cash in an attempt to be opportunistic helps to decrease risk. However, holding too much cash in a low rate and rising inflationary environment can have consequences. Taxes on the income from the cash can result in negative returns as well as decreased purchasing power. Common alternatives include the use of inflation-indexed securities, laddering the fixed income allocation, additional commodity exposure, adding stable stocks with predictable and growing dividends and real estate.
While there are many other forms of risk to consider when investing, managing market, interest rate and inflation risk will help to keep your portfolio stable. As first mentioned, if managed properly, your advisor should be helping you through volatile markets by explaining what has already been done to the portfolio in anticipation of changing conditions. By having a strategy in place, staying disciplined and diversifying the portfolio, the answer to your “what should we do” question should be an easy one.
Risk is inherent in investing and as such, so should managing it. If your advisor is not managing the risk in your portfolio, they are taking the biggest risk of all…losing you as a client.
Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk, including loss of principal. An investment cannot be made directly in an index.