Standing Strong: Investing in Today’s Volatile Market
Following the recent market pullback, uncertainty is a common concern shared among the majority of investors.
The second half of 2010 and the first half of 2011 saw a slow and steady climb in the S&P 500, and may have lulled some into a false sense of security. Borrowing costs remained low, many corporations increased (or regained) profitability, and the consumer confidence index gradually moved higher. It appeared to many that the days of bank failures and flash crashes were in the rearview mirror. However, following the considerable pullback in the major indices throughout July and the early part of August, it may be an especially prudent time to review the basics of asset allocation, dollar-cost-averaging and manager selection.
Most investors are aware of the importance of diversifying an investment portfolio, but may not understand just how meaningful it is. Seminal studies indicated that over 90% of investor returns are derived from strategic policy decisions (1986, Brinson, Hood & Beebower), highlighting the critical need to allocate your portfolio among an appropriate mix of asset classes based on your personal risk tolerance and time horizon. After developing an asset allocation strategy, it should be reviewed regularly to ensure it is well suited to your individual needs and preferences. It is essential to ensure that an asset allocation remains within a range of the assigned asset classes, which is achieved through a periodic rebalancing of the portfolio. Disciplined rebalancing during volatile markets can produce the favorable outcome of harvesting gains during times of relatively strong performance while mitigating losses during weaker periods.
While developing an asset allocation strategy, investors must consider the role of liquidity in their portfolio, with specific attention paid to the magnitude and timing of the liquidity requirements. While it is generally recommended that an asset allocation policy be managed within finite bounds to maintain objectivity within the investor’s constraints, it should also be flexible enough to accommodate changes in the “economic reality” of the time, often placing liquidity at the forefront of the investment process. Structuring liquidity into tiers, to facilitate current and future liquidity demands, distinguishes the amounts dedicated to capital-preservation from the yield-enhancing liquidity segments.
Attempts to time the market rarely work, and in many cases, fear and greed can often lead investors to rely upon instinctual judgment. A dollar-cost-averaging timetable is recommended for investors who strive to make the investing process less susceptible to timing risk and emotional reaction.
After determining an appropriate asset allocation and dollar-cost-averaging schedule, the next step is to implement the plan with appropriate investment vehicles. Selecting the right portfolio manager, mutual fund, or separately managed account is a much more detailed process than simply comparing the performances and choosing the fund with the highest return. Items such as expense ratios, manager tenure and turnover ratios should also be examined closely. An expense ratio is an embedded cost that can erode returns, and an investor should adequately review the prospectus to understand how it is calculated. Unlike most fees that are separately broken out, a mutual fund’s expense ratio is directly built into the performance, and some funds will have relatively higher expense ratios than others.
A manager’s tenure is also very important, because a manager that has been in place at a particular fund or company for a longer period of time tends not only to be more experienced, but also to have a track record that can be more accurately assessed. Manager tenure can be easily researched using an independent mutual fund evaluation service (e.g., Morningstar) or on the money manager’s own website.
Finally, an investment’s turnover ratio refers to the period of time in which investments are held in the portfolio, which can have a direct impact on an investment’s after-tax return. Today, long-term capital gains are taxed at a historically low rate of 15% or less. Conversely, securities bought and sold within a one-year period are treated as a short-term capital gain and taxed at the investor’s ordinary income tax rate. To put this into perspective, an investor in a 35% marginal tax bracket would need to earn over 13% in a portfolio with a 100% turnover ratio to earn the same after-tax rate of return as a portfolio that yields 10% with no turnover.
The highest quality equities and bonds should be at the core of one’s investment portfolio during periods of volatility. Companies with strong balance sheets, free cash flows, and top and bottom line earnings growth should lead their peers, since they should be able to expand earnings organically rather than being forced to rely on financing. Investors should be well served by retaining holdings of well capitalized, high dividend-yielding institutions in recession-resistant sectors that still offer relative value.
Properly diversifying a portfolio is not an easy accomplishment, and doing so in a volatile market is even more difficult. However, keeping the basics in mind while working with a knowledgeable advisor should help you protect your portfolio during volatile times, allowing you to accomplish your financial goals without losing (more) sleep.
