Reaching your life goals: Managing risk and volatility for successful outcomes

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How do you measure success in managing your investments? Many people think they are successful if their portfolios produce returns that “beat” market benchmarks such as the Standard & Poor’s 500. But what really matters is your portfolio’s ability to generate sufficient growth and income to help you achieve your goals, such as enjoying a comfortable retirement or leaving money to heirs.

Successfully navigating risk and volatility are two of the most critical factors in whether an investor can reach financial targets. But can the individual investor, working alone, manage an investment portfolio through these inevitable ups and downs?

Understanding risk and volatility

Investment risk and return are intertwined. Generally, the greater a return you expect to reap from an investment, the greater amount of risk, or potential loss from the investment, you will be assuming. However, you must assume some risk for your funds to increase in value enough to meet future financial needs, such as retirement.

Investors encounter many types of risk in managing their portfolios, including inflation risk, longevity risk, risk in “drawing down” a portfolio in retirement, and interest rate risk. For younger investors, there is also the risk of investing too conservatively, which may lead to reaching retirement age with too little saved. Though these risks can never be totally eliminated, it’s important to keep the level of risk in your portfolio to a degree with which you are comfortable and to modulate your goals/spending relative to the amount of risk you are willing to assume.

Is volatility a form of risk? It can be. Volatility describes the degree to which a security, portfolio or whole market rises or falls relative to its price. It becomes a risk to you if market gyrations cause you to sell assets after they fall in value. Volatility is also a risk for assets that you are drawing down, such as a retiree living off a nest egg. Volatility becomes less of a risk the longer your time horizon is for an investment.

Keeping a rein on your emotions

Risk and volatility are not inherently bad for investors; it’s when investors react badly to risk and volatility that problems crop up. Periods of high volatility can often cause investors to sell and buy securities in an effort to navigate these ups and downs, as when dips in the equity market can cause investors to act against their own interest by selling. But by moving into and out of different markets and securities, investors are likely to miss some of the best trading days and end up performing below market averages.

For example, in 2011, a year of considerable volatility, the average equity mutual fund investor had a return of -5.73%, compared to the gain of 2.12% in the Standard & Poor’s 500 Index, research firm Dalbar found. That result turns up over longer periods as well. Over 20 years, the average equity investor generated a return of 3.49%, compared with the 7.81% return of the S&P 500. Investors similarly lagged the index over periods of three, five and ten years, Dalbar found.1

Long-term investors should ignore volatility and focus on buying good assets at reasonable prices. Investors who struggle to manage their emotions may even want to consider investing in an asset allocation/portfolio that may underperform other assets, yet exhibits lower volatility; this could help control the impulse to panic and sell during market downturns.

Portfolio construction can also help investors avoid wild market swings that may lead to rash behavior. Constructing a portfolio that manages both downside risk and volatility, while striving for strong investment returns, can lead to a higher total return, as shown in the chart below.

Reaching your life goals Managing risk and volatility

A consistent, long-term asset allocation strategy can help manage the risk you bring to your portfolio if you have a tendency to react to short-term market movements. A rise in equities, for example, can help offset a simultaneous decline in bonds. That balance helps keep a portfolio’s overall performance in line with risk and return objectives.

By investing in a variety of different types of investments, you are betting that some will do well when others are lagging and vice versa. But it also assumes that asset classes tend to react differently under different market conditions — which is known as correlation. Including different asset classes that have low correlation with each other can help to balance your portfolio.

Proper asset allocation could have cushioned the effects of the steep market decline from 2007 to 2008. For example, let’s say John was invested 90% in equities through the S&P 500 Index and 10% in bonds through the Barclays Capital U.S. Aggregate Bond Index, while Sally was invested in a well-diversified portfolio of 60% equities, 30% bonds and 10% real estate through the FTSE NAREIT Equity REITs Index.2 Please note that one cannot invest in an index.

By the end of 2008, John’s portfolio would have suffered substantial losses of -23.7%, dragged down by the nearly 39% drop in the S&P 500 Index. Meanwhile, Sally’s more balanced and diverse mix of assets would have offset that drop, trimming her losses to only -14.1%.3

Volatility and retirement withdrawals

Successfully managing volatility remains critical for an investor who is already retired and drawing down money from a portfolio. These investors face withdrawal risk, which occurs when an investor must take money from an account during a period of market declines. To mitigate that risk, a lower volatility portfolio that makes steady payouts will generally leave a retiree with more money relative to a portfolio experiencing choppier returns.

For example, if in retirement you plan to draw down 5% of your nest egg annually, market volatility can force you to sell a larger portion of your account when market returns are negative. If you started 2008 with $1 million in the S&P 500 and withdrew $50,000 (5%) at the end of the year, you would actually have realized a withdrawal rate of 7.9% on the $630,000 in funds available to you on December 31, 2008, since the S&P declined by 37% that year.

For a higher payout strategy (4% or more) diversification has historically led to better results. Maintaining a 4% inflation-adjusted payout is difficult if you encounter periods of market stress early in your investment program, especially if you don’t have the flexibility to lower your payout in response to falling markets. Highly aggressive strategies such as a 100% equity strategy can quickly result in drawing down your capital to zero. With high payouts, the most conservative strategies, such as corporate and government bonds, virtually guarantee you will eat into your capital over time, but they can give you a window of 15+ years, which could be appropriate for some investors with shorter investment windows. The best course in these cases is a middle ground that offers the best chance of achieving goals while insuring against a rapid decline in your nest egg.

Seeking help to reach your financial goals

Many investors could benefit from professional help in managing their portfolios, given their often poor reaction to market volatility and tendency to chase returns. Such help should incorporate individual investor goals and appetite for risk to build a suitable portfolio and manage it going forward. Professional guidance can also help in providing tax management and efficiency when needed.

Help with finances, through an advisor relationship or managed account, can benefit investors in all stages of life. For those still working and putting away money, a trusted advisor can steer an investor away from the tendency to be too conservative with investments and generate inadequate returns to reach future goals. For others nearing retirement age or already out of the workforce, an advisor can help create an income or asset drawdown strategy that seeks to provide steady returns even during periods of market volatility.

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