by Andrew Sivertsen, CFP®
There are several key principles to having a sound investment philosophy, and one of the most important is being able to deal with volatility risk.
Volatility risk is accepting that fact that your investment portfolio can undergo large and unexpected swings both up and down. I think of volatility like flying in an airplane. If you fly long enough and often enough, you accept the reality that at some point you will experience turbulence.
Most of my flights are calm and I barely remember them. On the other hand, I remember one flight to Atlanta where, out of nowhere, the biggest bump I’ve ever felt in my life jolted my seatmate’s in-flight beverage to the ceiling of the plane. Our eyes locked with the same fear and question: are we going down? The next 10-15 minutes were some of the scariest moments I’ve ever experienced, but eventually the plane reached an altitude where things settled down, and my heart rate was able to return to normal.
I also vividly recall another turbulent flight to Anchorage, though it was not nearly as scary. Traveling from Chicago, the entire 8+ hour flight was a constant, steady stream of turbulence. I consider myself to have a strong stomach, but even I felt like reaching for the complementary airsickness bag and wishing I had taken a Dramamine.
Investing in the stock market is much like these three flight scenarios. Much of the time it’s a steady, calm experience and most passengers pay little attention. Other times, like on my flight to Atlanta, a big shock can come out of nowhere to quickly terrify us—before recovering just as quickly. Or, as happened on my flight to Anchorage, the volatility can go on and on leaving us sick wondering if it will ever end. Fortunately, there are systems that we can use to help deal with volatility risk.
One of the most efficient ways to travel from point A to point B is flying, though obviously every flight risks unexpected turbulence. The same is true of your long-term financial goals. Investing can and should be a part of a prudent strategy. The key to managing long-term volatility is to make sure that you’re not investing too aggressively or too conservatively for your personal situation.
This is done in two ways. The first is understanding your risk tolerance, because every investor has their own financial DNA that dictates how they will react to various financial scenarios. The second is understanding your risk capacity, which is driven by your age and goals. This means that most investors will have a higher percentage of their funds in the stock markets in their 20s/30s, but then lower that percentage as they get closer to retirement. Your advisor at The Planning Center can help you assess and understand your risk tolerance and risk capacity to help you make more informed choices around how much volatility risk to take on in your portfolio.
During my flight to Atlanta, the pilot was able to climb out of the irregular air currents, which helped address the unexpected turbulence. At The Planning Center, we utilize what is called volatility-based re-balancing to help prepare for short-term volatility. For example, your investment portfolio contains several different funds. Each fund represents a different type of investment that is important to own for diversification purposes, and each fund is a different percentage of the portfolio depending on its function.
As time goes on, each of these funds moves at its own pace, with some growing much faster while others rise and fall in price. Re-balancing simply means that from time to time we need to look at the portfolio and sell what has gone up and buy into what has gone down. Since the goal of investing is to buy low and sell high, re-balancing over time helps us accomplish this goal.
Every week the algorithms on our trading software are looking for opportunities to do just that by setting a volatility “band” on each fund, allowing it float up or down until it crosses the threshold triggering either a buy or a sell. This doesn’t happen every week, but usually these triggers occur several times throughout the year. For example, looking back at the last year and a half, stock markets hit all-time highs in August of 2018. In most cases, this would trigger selling stock funds in the portfolio and buying into the safer bond funds. Then, the following four months contained a sharp correction in the stock market, which bottomed out on Christmas Eve. This most likely triggered selling some bonds and moving them back into the stock funds.
The markets then recovered quickly in the first couple months of 2019 resuming all-time highs and thus more stock sales. Re-balancing helps keep a portfolio from drifting too aggressively as the stock market is going up. This, in turn, reduces downside risk for the next market fall, and, conversely, enables us to invest more client funds back into the market and generate more upside potential for when stocks eventually go back up.
Finally, like my flight to Anchorage, there are broad market swings that last much longer. The tech boom of the late 90s ended in 2000 with the tech crash, followed by 9/11, which lasted through 2002. Then the housing boom propelled markets until 2007, which fizzled and eventually crashed when Lehman Brothers went under in October of 2008. Markets have now been expanding for the most part since March of 2009.
There is a quote by famous investor Warren Buffett that states, “Be fearful when others are greedy and greedy when others are fearful.” Our human emotions lead us to get caught up in the euphoria and excitement around abnormally large financial gains like the tech and housing booms. Nonetheless there are certain “ratios” (a measure of a stock’s valuation that helps determine its performance and risk as an investment) that we can look at that show when investors are paying much more for a stock than they should when compared to its “book value.” (Book value is the total value of a company’s assets minus its liabilities, which is how an accountant would value the company).
When the market pricing is high, we typically begin reducing the amount of stock exposure in a portfolio. Likewise, when fear drives prices down, the ratios indicate when it could be time to start increasing exposure back into the stock market. The ratios are not a predictor of short-term market performance but do give us insight into the longer-term return expectations.
Currently ratios are particularly high in the US, indicating that now would be time to be more defensive. For example, someone with a long-term portfolio of 60% stocks and 40% bonds might consider temporarily investing at a 50/50 split instead. If you are a Planning Center client with a signed Investment Policy Statement, these adjustments happen automatically unless you’ve opted out for one reason or another. Check with your advisor at The Planning Center if you would like to further understand how making portfolio adjustments based on the pricing of markets works.
Next time you think about markets, whether they are calm, wildly turbulent, or consist of never-ending bumps, think of the three strategies that we are using to deal with volatility risk in your portfolio. Most importantly, keep flying! Despite the inevitability of some turbulence, clear skies are ahead.
Andrew Sivertsen, CFP®, is a Sr. Financial Planner in the Quad Cities office of The Planning Center, a fee-only financial planning and wealth management firm. Email him at: firstname.lastname@example.org.