Volatility can affect portfolios

Three years ago I embarked on an adventure and rowed across the Atlantic with my girlfriend. There were times when we were literally on the crest of huge waves having the time of our lives, but there were also times when we endured great hardships as we battled tropical storms and some very low moments. After almost a decade as a financial advisor, the past two years presented similar ups and downs as all of us in the financial advisory world battled one of the worst financial storms since the Great Depression.

With that in mind, a recent meeting with a prospective new client (let’s call her Tara) highlighted a point I feel many investors don’t entirely understand.

When I asked Tara how her investment portfolio performed in 2008, she told me she thought is was down about 50%, but promptly added she was up close to 50% so far in 2009 – “so I’m nearly back to where I was at the beginning of the crash.” In Tara’s case, a $600,000 investment portfolio had fallen to $300,000 by the beginning of March 2009 and had since recovered to approximately $450,000. In fact, she was still considerably worse off (by 25% to be exact) since early 2008.

Many investors share Tara’s sentiments that 50% down followed by 50% up gets you back to where you were. As advisors, we know this is far from true and that a 50% drop in value will require a 100% gain on the reduced portfolio to get back to where it was before the drop.

However impressive it might sound, informing Tara that my average client’s portfolio was down only 6.5% in 2008 and up over 11% in to September 2009 probably didn’t make her feel any better. I wanted to emphasize to her that she will go through bear markets again in the future to stress the importance of protecting her wealth in bad times rather than just focusing on growing it in better markets.

Investors need to stay mindful of the long-term effects of volatility on their portfolios. Here are some steps financial advisors can take to reduce their clients’ volatility and improve long-term investment results, while also touching on some behavioural finance issues.

Future Volatility

Tara is young (40 years old), so let’s consider the effect future volatility might have on her portfolio. Let’s assume Tara’s portfolio finishes 2009 up 40% for the year. Now let’s also assume that over the next 20 years we go through four five-year investment cycles that give Tara an 11% return in the four good years of each cycle and a bear market drop of 20% in the one bad year of each cycle. From 2008 to 2030 (when Tara will be 60 years old), her portfolio would have gone from $600,000 in value to $978,904.

Now let’s change the structure of Tara’s portfolio and tailor it to produce cash flow as well as less equity exposure. Additionally, let’s add more alternative asset class exposure such as real estate, mortgages and hedge funds. Using this more diversified and less volatile approach, we’ll assume only a 7% return in the good years and a -7% return in the bad years.

We’ll also assume that this approach saw Tara’s portfolio drop by 7% in 2008 and recover by 10% in 2009. Using these assumptions over the same time period, by age 60 Tara’s portfolio would have grown from $600,000 to $1,355,499. A strategy that focuses on cash flow and a wider asset class diversification would produce a portfolio 38% larger than the first approach – with much less volatility along the way.

Losing a large portion of a client’s capital in bear markets makes it extremely difficult to recover, even over a long time period such as 20 years.

1) Pay attention to cash flow

Investment portfolios that generate cash flow (which is reinvested) benefit from an extremely powerful tool that Albert Einstein described as the eighth wonder of the world – compound interest. Its potential has been proven over the years. Let’s look at an example using help from Globe Hysales. If you had invested $10,000 in the S&P 500 Index in 1950, you would have had $511,000 by 2008, based on an annual compounded return of 7% over this 58 year period – decent numbers.

However, if you had invested the same $10,000 in 1950 in the S&P 500 Index, which reinvests dividends, then by 2008 your investment portfolio would have been worth $3.6 million! This equates to an annual return of 10.7%, which would have produced a portfolio over 700% more than what you would have made based on the price increase alone.

2) Consider using a wide range of asset classes

One of the main reasons why many investors’ portfolios dropped by 30% to 50% in 2008 and might be up 10% to 30% year-to-date in 2009 is because of a heavy focus on equity markets. Most new clients I meet have investment portfolios that typically consist of about 60% to 80% equities and 20% to 40% bonds. The investment industry commonly refers to this asset mix as “balanced.” To me, a portfolio that consists of 70% of one asset class is about as close to balanced as I am to being an NHL hockey player (I am 33 years old, come from Ireland and cannot skate, let alone skate and use a stick at the same time).

A balanced investment portfolio should include other asset classes in addition to bonds and equities. History shows 80% of investors’ total returns come from their asset class mix and only about 20% comes from the actual security selection. Unfortunately, many investors focus most of their time and energy on something that is only responsible for 20% of their investment return.

3) Recognize and manage clients’ emotions

The speed with which information travels today is truly amazing, but has facilitated another way for our emotions to interfere with our investing habits. We have access to and are bombarded with infinitely more information on a daily basis then we were 10 years ago. Today, one week’s worth of reading The Wall Street Journal is the equivalent to a lifetime of information 30 years ago (source: Did You Know? Fisch, McLeod & Bronman). Having access to such a large amount and variety of information can be enormously positive, but it can also fuel clients’ emotions when it comes to their investing decisions, which is especially relevant given the fact that we can buy and sell stocks and funds with the click of a mouse.

We’re all emotional beings and when it comes to our hard-earned money, we’re naturally emotionally attached to it – I know I am. That’s exactly why professional advisors must guide their clients through their financial decisions and ensure they make well-informed choices and get the long-term financial results they desire.

The next five years will be challenging. Managing our clients’ wealth is as much about protecting it in bad times as it is about growing it in better markets. Based on the last two years, I believe now more than ever that this is true.