Risk Management
Many investment advisors believe that the stock market is efficient. They believe that because you don't know which asset classes will outperform or when the "best days" in the market will be, that you should allocate your portfolio to a variety of asset classes that performed well together in the past and continue to hold these asset classes, no matter how expensive they get or how high market risk is. They hope some of these asset classes will go up in value when other asset classes go down in value to protect your portfolio from large losses. This is often referred to as Modern Portfolio Theory.
HOW HAS THAT WORKED OUT FOR YOU?
Unfortunately, investing isn't that simple.
The stock market is not efficient and Modern Portfolio Theory doesn't reflect the reality of how the market actually behaves.
People don't always act rationally and never have. During a financial crisis, margin calls cause stock prices to plunge. Investors panic and want out of everything. Diversification doesn't protect you when this happens.
As more and more investors have followed Modern Portfolio Theory and are all investing in the same asset classes, this has caused most asset classes to move together and go down together during periods of high financial stress. Buy and hold investing doesn't work well in all markets.
During secular bear markets, like the one we are in now, stocks prices are very volatile and can go sideways in value for a period of up to 20 years. "Buy and Hope" doesn't work for people nearing retirement who don't have a 20+ year time horizon.
Buying and selling investments based on their long term trends makes more sense. It allows you to invest more in stocks when they are cheap once their long term trend turns up and less in stocks when they are expensive after their long term trend turns down. Markets tend to go down a lot faster than they go up. However, they don't go straight down. They go down in stages. Using disciplined buy/sell rules helps us avoid a lot of the damage and know when it is reasonably safe to get more invested.
People who invested in AIG, GE, Bank of America or GM didn't expect them to drop so much in price during the last bear market. If instead of buying and holding them, they had monitored the long term trend of these stocks and sold them towards the end of 2007 when their long term trend turned down, they would have been a lot better off.
What is Active Risk Management?
1. Active risk management uses disciplined buy/sell rules to help you avoid letting the fear of missing the best days in the market cause large portfolio losses that you can't afford.
- "Fear of missing out" and the unwillingness to recognize losses are both emotional.
- Emotions lose you money.
- We use disciplined rules that attempt to keep us invested through a bull market but get us out of stocks before we incur large losses. This, plus counseling, helps our clients stay the course. The goal is to take profits so that you have cash to go "sale shopping" once stocks get cheap and the longer term trend turns back up.
2. Active risk management involves using judgment and avoiding asset classes when the upside potential isn't enough to justify the risk - no matter what type of market we are in.
We don't invest in all asset classes during all periods. Why continue to allocate 50% or more of your portfolio to bonds once we enter the next bear market for bonds and their prices start to fall? Why stay invested in funds with large allocations to Europe when risk of a European sovereign debt crisis is so high? Why stay invested in internet stocks near the height of the internet bubble when their values bore no relationship to reality? Why stay invested in gold and commodities long term when they can plunge in price and go nowhere for periods of up to 20 years?
Does that really make sense?
Managing risk requires flexibility, judgment, and discipline especially when there are major bubbles or unsustainable levels of debt. Continuing to allocate money to all the major asset classes no matter what market conditions are or where we are in the economic cycle costs you returns and sleepless nights.
3. We employ Risk Budgeting. We create "buckets" or ladders of investments appropriate to your goals and the time frame over which the income is needed. The goal of these retirement buckets is to keep the money you need over the next 5 years very conservatively invested, the money needed in years 6 through 10 invested with moderate risk, and the money you don't need for 10 years or more invested in high return investments with more risk to help maintain your purchasing power and retirement lifestyle.
- This helps our clients sleep better at night and avoid taking risks they can't afford, but also helps them avoid not taking enough risk.
No one can perfectly time the market. You don't need to. If we are able to miss a good portion of a bear market decline and have cash available to buy high quality dividend stocks and asset classes that protect your purchasing power when their long term trends head up, it can make a big difference in your compound returns over time and significantly increase the dividend income you earn going forward.
To us, the logic is simple. No one can guarantee you won't have significant losses. However,using active risk management gives us a better chance of protecting both your principal and your purchasing power. It makes a lot more sense than watching your stocks go sideways in value for 14 to 20 years or drop so far in value that you panic and sell near the bottom.