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The Antidote To Fear And Greed: Risk Management

What does last week’s market slide across most of the major asset classes imply for investing? A lot…or maybe nothing. The decision to adjust a portfolio, or not, depends on the risk-management strategy. Every portfolio needs a clear-eyed plan for dealing with risk – it’s the financial brain that controls the investment body and provides the map for navigating rough financial seas. With that in mind, now’s a good time to review and reaffirm the first principles of enlightened risk management in the care and feeding of conventional investment portfolios. 1. Develop a plan. Yes, that’s obvious, but it’s easily overlooked. Many investors have a general appreciation of the merits for managing risk (as opposed to chasing return) but don’t have a proper plan in place. Vague notions of what you may or may not do don’t pass muster. You needn’t be a slave to rules, but there should be a clear path for traversing periods of chaos as well as calm through time. This includes a methodology for regularly collecting and analyzing relevant data that’s integral to your plan. 2. Recognize that a successful risk-management strategy will be multi-faceted. There are no simple solutions or silver bullets. Instead, there’s a zoo of possibility in terms of risk factors from which you’ll selectively choose for assembling a customized plan. That said, there are two concepts that typically form the backbone of risk management: asset allocation and rebalancing. 3. Notice the limits of asset allocation. Like any one aspect of risk management, this one has flaws. This implies that you should add techniques that compliment AA’s deficiencies. 4. Choose weights for asset allocation that match your goals and risk profile. For what should be obvious reasons, there are no one-size-fits-all solutions here. But there’s an obvious place to start: market-value weights, which offer useful reference points on the customizing journey. 5. Rebalance. Plan on adjusting the portfolio mix on a periodic basis. The details will vary, depending on your specific goals, expectations, and other factors. Unless you’re an institution with an effective time horizon that’s infinite, embrace the practical reality that every allocation requires oversight and tweaking. 6. Design rebalancing rules that are appropriate for you. Any number of inputs will inform your choice. For instance, how much drawdown can you tolerate? Every portfolio needs to be rebalanced on a periodic basis. The details on how and when offer the potential for greatness-and trouble. Proceed cautiously. The standard strategy: systematically return the portfolio to the target weights every year or two. The crucial question: Should you instead deploy an opportunistic plan based on monitoring a set of tactical signals? If so, note the following: 7. Juicing the standard rebalancing rules by adding tactical components to the risk-management plan – integrating moving averages, factors such as value and momentum, etc. into the rebalancing rules – can be productive. But careful planning and oversight are essential. Given the zero-sum reality of markets with respect to benchmark-beating results, most efforts on this front will deliver mediocrity or worse, particularly for return-boosting efforts on an after-tax/cost basis. By contrast, lowering risk is a more reasonable expectation. In either case, a fair amount of R&D is critical. 8. Manage expectations. No risk management plan is perfect and so there will be times when results are disappointing. Meanwhile, align your expectations with the target outcome of your risk-management techniques. A strategy that’s focused on limiting the downside, for instance, may look unimpressive before adjusting for risk.

What I Do When The Market Tumbles

When stocks take a dive, investors call their financial advisors and ask them what they should do. I received a few of those calls this week. Most advisors respond with some version of “Don’t panic.” Here’s what I do when the market crashes: nothing. To be completely honest, I wasn’t aware that the market had fallen 8% so far in January until my wife told me late this week. I don’t watch business news – life is too short. She picked it up on CNN while she was watching election news. (I don’t follow that, either.) Here’s my theory. If you have such a high allocation to equities that market declines make you anxious, you own too much stock. Find the allocation at which severe bear market losses won’t keep you up at night. In the 2007-2009 bear market, the S&P 500 fell over 50%. My portfolio fell just 15% because I had a 40% equity allocation. As one of my favorite baristas, Mandy, would say, “It didn’t feel totally awesome.” On the other hand, I didn’t lose sleep. William Bernstein addressed this in a couple of his early books, including The Four Pillars of Investing (page 268). He suggests that the initial pass at the correct asset allocation for you be based on how much you can tolerate losing in a bear market. He provided the following table: I can tolerate losing this percent in a bear market Invest this much in stocks 35% 80% 30% 70% 25% 60% 20% 50% 15% 40% 10% 30% 5% 20% 0% 10% Every December I evaluate my finances and plan for the coming year. I calculate my desired asset allocation, which might not be the same as last year’s. If my current allocation is within an absolute 5% or so of my desired allocation, I do nothing. Otherwise, I may trade a few funds or ETFs to implement my new allocation. In reality, this rarely happens because my allocation doesn’t often stray very far. Because I am willing to lose 15% in a severe bear market, I don’t labor over my portfolio value daily. I probably check it four times a year, at most. I retired to enjoy the remainder of my life, not to fret over the stock market. Here’s some advice from other advisors I trust. Wade Pfau suggests reading this piece in the New York Times entitled, ” 6 Tips for Investors When the Stock Market Tumbles. ” It’s a good one. Dana Anspach suggests that if you feel that you must do something, instead of selling stocks, enroll in her free online class on retirement – another great idea. Joe Tomlinson and I provided suggestions in Robert Powell’s USA Today column, ” Advice for investors during crazy stock market volatility .” If you’re retired or plan to be soon, set your asset allocation to a level of equities that you can tolerate. By definition, that means you won’t feel the need to do anything at all when stocks tumble. For young people still accumulating savings for retirement, invest most of your portfolio in stocks and don’t you do anything, either. In fact, do less than nothing. Time will fix this for you. As I recall, the 22% loss on a single day on Black Monday in 1987 didn’t feel totally awesome, either, but now it is barely a blip on the history of the S&P 500. So, here’s my advice: pick an allocation you can stomach and ignore the noise. If you owned too much equity this time, gradually adjust it downward. You’ll know you’re at the right allocation when the market takes a dive and you don’t feel a need to call me. Oh, and don’t panic.

Index Funds Explained

By Jane Leung, CFA, iShares Asset Allocation Strategist Indexing strategies have been around for decades, but many investors still don’t fully understand what a powerful tool they can be when constructing a portfolio. Indexing serves as a cost-effective way to potentially achieve long-term goals. From pensions and defined-contribution plans, to individuals and their financial advisors, all types of investors can gain access to broad market opportunities that indexing offers. The first index funds were created in the 1970s, and their popularity has steadily increased to this day. In fact, investment into index strategies has continued to grow even as actively managed mutual funds have seen outflows. Click to enlarge What is an index? Think about a stock index as “the market.” An equity index provides exposure to a relatively large number of stocks that represent a particular market. And there are different kinds of indexes to choose from. Some broadly cover the markets, for example the S&P 500 or the Russell 2000. An index may represent only large-cap stocks or only small-caps, or both. Some indexes cover international markets or specific sectors, such as financial companies or U.S. technology. The same holds true for bond indexes, if you’re looking for income. In summary, if you are buying an index fund, you are effectively investing in the market. How stock indexes fit in a portfolio When thinking about the mix of assets in your portfolio, consider the risks that you are willing to take over a particular time period to realize your goals. For example, if you’re hoping for an early retirement or are saving to send your young child to college someday, you will likely need to have a core allocation to stocks over the long term. What does core mean? It effectively means long-term “buy and hold” positions in your portfolio. Why stocks? Because the value of money erodes over time as inflation drives prices higher and pushes down the purchasing power of your dollars. To put that in perspective, a dollar earned in 2000 would now be worth 74 cents, and a dollar from 1980 amounts to just 35 cents today, according to the U.S. Bureau of Labor Statistics CPI Inflation Calculator . On their own, stocks historically carry more market risk than cash and bonds. In the short term, stock prices can be volatile. But in return for this increased risk, there is the potential for a higher return. But which stocks are the best to own over a long period of time? It’s difficult even for the pros to know exactly which stocks to buy when. Here’s where the beauty of stock indexes come in. Exchange traded funds (ETFs) and index mutual funds can be an effective way to buy the market in a low-cost, tax efficient manner and help you keep more of what you earn. Portfolio construction is a lot like building a house. You need a strong foundation or else your house will fall over. Index funds can serve as the concrete blocks of your portfolio foundation so that your investment plan can stand the test of time. Questions to ask The quality of the index composition and the fund manager who runs it play crucial roles in determining your overall performance. In addition, the structure of the funds you choose can significantly affect your portfolio’s tax efficiency and ability to sell when you want to. When evaluating index fund managers, consider these questions: What trading strategies do they use to maneuver in changing markets? How tax efficient are these products? What’s the quality of the benchmark the fund seeks to track, and how does it compare to others? There are many tools to consider in portfolio construction and asset allocation, but having a core of index strategies can be instrumental to potentially achieving long-term portfolio growth and the outcomes you desire. This post originally appeared on the BlackRock Blog.