As we come to the conclusion of another year’s investing we have a few weeks of down-time to look back and review the past year. At present, this is the second longest equity bull run in history; second only to that which followed the great depression in the 1940’s. Instead of being lulled into complacency by the relatively uninterrupted and linear returns of recent years, our risk management would be better served by looking upon our current market as a “one in a hundred years” event, and planning for a return to more reasonable levels of volatility. Of course, the return of volatility will mean an increase in down months, and likely the addition of down-years to our sequence of returns. Although positive years are nice, as equity investors it is important to acknowledge that it takes both sun, and rain to make the garden grow. The following tips will enable you to fortify your portfolio and your mind for the year to come, ensuring that you are able to withstand a possible return to more ‘normal’ levels of market volatility.
1) Review Your Financial Plan
For you to be aiming in the right direction, you need to know where the target is. For your time based goals like education planning and retirement planning where you know when the beginning of the expenses will be, take a look back to the calculations made by your financial adviser that illustrate how much you need to be saving and investing each year to meet your target. If you have stuck to the plan over the last year then give yourself a pat on the back. If not, you should consider what will be necessary next year to catch-up and plan what areas of spending you will cut back on to produce the extra funds required for investment. If you find that you have been overspending and not committing as much as you should to saving and investment, put together a spending budget and consider setting up separate accounts to manage your expenses.
2) Look At Your Whole Portfolio
Try not to fixate on one part of your finances. Look at the total sum of your financial assets as your “portfolio” and accounts, assets and balances within this as parts of the portfolio. For example, you may have an international self invested private pension, a company (DC) pension, a rental apartment, cash deposits at the bank, a lump sum investment account and a brokerage account. It is likely that the account or asset which is subject to the larges fluctuations in value, or requires the most decisions to be made, will end up being your focus and this can lead to over-scrutinizing- which in turn will often lead to unnecessary changes being made that are seldom profitable. If you take the time to compile a list of all of your assets which have a monetary value, you will note that the values move in different directions at different times. When this is the case it is a lot easier to leave a portfolio or investment alone when it is going through a patch of negative performance, knowing that you have other assets in your total-portfolio that are picking up the slack and making money.
3) Define Your Time Horizon
If you are able to commit to longer investment terms, the affect of negative months, or even negative years becomes unimportant in the total scheme of things. Statistically, equity investors will likely have one down year, every three years. Now, if you are only intending to invest for three years, and at the end of that period you need to spend your money on something with a fixed cost, if your last year of investing turns out to be the “down year” then you may well have a problem. If you are saving for long-term goals, then you will feel less inclined to agonize over short-term performance, which is often mercurial and can swing between gain and loss. Although you should conduct intermittent checks on your portfolio to re-balance, other than these occasions you should resist the temptation to peek, let the market take its course, and have faith that time in the market is superior to ‘timing the market’.
If it seems that investors dedicate a lot of time to discussing diversification, you are probably listening to the right conversations. When building a robust investment portfolio, you will want to ensure that you maintain exposure to different asset classes and different geographic regions. Once you know the purpose of the portfolio (if it is to provide funding for a time specific goal; growth, income or capital preservation) then you can pick the appropriate assets based on their return and volatility profile. Once you have your asset dream-team lined up, then you can drill down further and look to allocate money to each of those assets based on their correlation (relationship) to each other. Some assets will move in the same direction, some the inverse of each other, and some pairs will have zero relationship to each other altogether. Being mindful of your objectives when allocating capital allows you to deliberately increase or decrease the total volatility of the portfolio to secure the desired returns.
5) Budget For, And Buy Risk
If you understand that the ‘risk’ of an asset is its volatility (or its standard deviation), and that you need risk if you want to be rewarded (risk≠reward), then you know that you’ll have to endure the amount of volatility commensurate with the size of the returns you want to see in your portfolio. In investment, there is no such thing as a free lunch and over-sized “low risk” returns are extremely uncommon. With some help from your investment planner you will be able to calculate your annual risk budget and then spend it judiciously across a basket of quality investments. This will ensure that you are statistically likely to meet your goals (if you leave your capital invested) and that you are unlikely to see losses beyond your comfort zone in the bad years.
6) Automate Your Investments Like A Robot: Unit-Cost Averaging
If you have disposable income (and are not burning through 100% of your salary month in, month out), you should be taking advantage of unit cost averaging. By investing monthly, over a medium to long-term you are able to average out the intra-day volatility of the market while still participating in the primary trend (the true, long-term average of the market) which is overwhelmingly positive and has averaged in excess of +8% CAGR while accounting for inflation. Many people in Japan will set one of these up as a proxy private pension account so they are able to manage their own money, and still retain access to it when they need it, even if they need it before Japanese retirement age.
7) Employ Professionals
There is a reason that the wealthy outsource money management to financial planners, despite being smart people themselves. Outsourcing some of the heavy lifting to a financial planner means that you get to focus on your own job, without having to learn a whole new one in your already insufficient free time. Despite the abundance of free information on the internet, professionals have traditionally looked to leverage the specialist knowledge of other professionals to save them time. Medical issues are handled by a doctor, legal issues are handled by a lawyer and financial issues are handled by a financial advisor. DIY is definitely a good way to find your feet in the beginning, but you should ultimately aim to accumulate an asset base which requires its own professional manager.
8) Look At The Big Picture
If you really want to ensure that your sleep is not jeopardized by temporary downturns in the market, take a moment to look at historical returns of the assets that you own, and the markets that you are invested in. Even though a -15% drawdown in a calendar year does not feel good, you would feel a lot better to know that 15% annual volatility is completely normal for somebody investing in US equity, based on over 100 years worth of data. The reward for doing nothing (and staying in your investments) throughout multiple market cycles is an annual compounded growth rate close to, and sometimes in excess of, the long term average.