Your Answer May be Detrimental to Your Future Wealth July 2008
by Cathy Pareto, MBA, CFP®, AIF®
Oil prices are high, real estate is down, the dollar is flat, unemployment is high, your investments are down, and no one really knows what’s going to happen with the elections in November. The future is uncertain to say the least, and for many the fear of uncertainty can lead them to make poor investment decisions that will have a rippling effect into their future. It is times like these that separate the well prepared investor from the panic stricken speculator. Let’s explore the difference between the two and the consequences.
An investor is someone who invests using a consistent, long-term strategy to secure their financial future using well diversified investments. Generally the focus is on minimizing risk while maximizing return.
A speculator or market timer is someone who is less concerned about consistency and who switches investments on an emotional whim.
During a bull market most people would say that they are investors, but when the stock markets are jittery investors get tested, revealing many closeted speculators. This may include you, if you liquidated your investments and are waiting for the markets to recover to get back in.
Why This Strategy Does Not Work
You simply cannot predict when the markets will rally and when the markets will hit rock bottom. And missing the upswings of the market can be very damaging to your long term returns as seen in the following graph.
Investing in the stock market is not risk free. You should understand and feel comfortable with the level of risk in your portfolio so that when the market goes through its cycles you are well prepared. Let’s explore this further. Let’s use a hypothetical portfolio ABC with the following risk and return criteria:
Standard deviation = 10% (Standard deviation is a statistical measurement that sheds light on historical volatility. This is a good measure of the portfolio’s risk. The higher the standard deviation, the riskier the portfolio.)
Expected return = 12%
If you own portfolio ABC what can you expect going forward? To answer this question we must go back to statistics. If you are a long term investor you expect that the average return will be 12%. This does not mean that you will earn 12% every year. After all, there is market risk to consider. For example, one year you may earn 6% another year 25% or anywhere in between, and so forth.
At any given period you can be 68% confident that your portfolio’s return will fall within a range of 2% to 22%. And you can be almost certain that your portfolio’s return may fall anywhere from -18% to 42%. Can you deal with this? Most investors enjoy the up side of risk, but seldom enjoy the downside. Case in point, an investor that earns 32% on a portfolio whose long term expected return is 12% is a happy camper. But, is that same investor happy when the same portfolio (whose expected return is 12%) earns a crummy -8%?
The point of this example is to understand that returns will vary from year to year. Depending on the standard deviation of your portfolio, those figures will fluctuate within a given range and you must be willing to live with that volatility. Just like you will not get 12% returns every year, you will also not get negative returns every year. Long term investors must understand and accept this risk if they want to be appropriately compensated.
Remember you are a long term investor. It’s the long term strategy that matters. Over the long run when you average the positive and negative returns your portfolio’s total return will approximate 12%. All the bumps in between are just part of the investment process.
Quoting Warren Buffet “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
The Importance of Diversification
As investors, we must understand that markets are cyclical and that there is risk involved in investing in the stock market. While that risk never completely goes away, we can do a lot to minimize the portfolio risk to the best extent possible. The best way to do this is to diversify our investments across different asset classes (or categories of the stock market) The key here is to identify investments in segments that perform opposite to one another under different market conditions (known as negative correlation), or at least have low correlations to each other. The result is higher returns and lower risk over time.
One common example that simplifies this concept is that of suntan lotion and umbrellas:
If you own a store that sells suntan lotion in Florida, more than likely you will do very well when it’s sunny out and people are going to the beach or outdoors. However, we all know that it rains in Florida, so on rainy days your store may not do so well. To diversify the risk of not selling any suntan lotion on rainy days you could consider also stocking up on umbrellas. That way you will make money whether it rains or it’s sunny out. This is the concept of diversification. Market conditions that cause one asset category to perform well, often cause another asset category to have average or poor returns. If properly executed, diversification will smooth out the unsystematic (market) risk events in your portfolio.
What About Asset Allocation?
Asset allocation describes how you choose to distribute your investments among investment vehicles such as stocks, fixed income, alternative assets, cash etc. According to Roger G. Ibbotson’s The True Impact of Asset Allocation on Returns “for the long-term individual investor who maintains a consistent asset allocation and leans toward index funds, asset allocation determines about 100 percent of performance—regardless of whether one is measuring return variability across time, return variation between funds, or return amount.”
How you decide to distribute your assets among investments is a personal choice that needs to be looked at very carefully. In making this decision you should take the following into consideration:
- Time horizon: how long will it be before you need to start withdrawing money from your portfolio? You don’t want to find yourself in a position where you need the money and you have to sell part, or your entire portfolio at a loss. The longer your time horizon the more risk you may be able to accept. The closer you get to your investment goal i.e. retirement; you can reduce the level of risk by reducing your equity exposure and increasing your fixed incomelevels.
- Risk tolerance: You may want higher returns, but when your ABC portfolio is negative you feel like you’re going to be sick. You may be taking on more risk than you can stomach. You have to be realistic with yourself and face the fact that you need a portfolio that will not deliver huge returns but will help you outpace inflation.
When it comes to investing and life in general, it always pays to do your homework and have a plan. As a long term investor your goal is to diversify your investments to reduce risk and maximize your long term results. This involves the careful selection and distribution of assets among investment vehicles that support your risk tolerance, time horizon and individual needs, as well as the appropriate mix of negatively correlated asset categories.
There is no denying the sexy allure of timing the market, or the fact that speculators can make money, and do get lucky investing in what’s “hot”. However, the reality is that they can’t consistently beat the market. More times than not, speculators end up buying high and selling low in a panic. You will always hear how much money a speculator made on one or two investments, but you will rarely hear how much money they have lost on their other not-so-“hot” investments. It is wiser to develop a long term strategy and remain consistent even when the market misbehaves. After all, if we do our homework we would know what to expect in the long run and this includes expecting, that at some point or another, our portfolios will experience a few bad periods. What matters is the long term performance of our investments and most of all our peace of mind.