One of the most important lessons learned over the last few years in the stock market is that volatility kills a poorly managed portfolio. How? Let’s do the math:
Examplele 1: Fred invested $100,000 in Investment A that earned 50% in the first year and then subsequently lost 50% the next year. At the end of the second year he has $75,000 left from his initial investment.
Example 2: June invested $100,000 in Investment B that earned 25% in the first year and then subsequently lost 25% the next year. At the end of the second year she has $93,750 left from her initial investment.
Example 3: Bill and Judy invested $100,000 in Investment C. The portfolio earned 10% the first year and then subsequently lost 10%. At the end of the second year they have $99,000 left from their initial investment.
The point of the above scenarios is to convey the importance of risk management in a portfolio. An investor may think he or she has made a smart investment, but things don’t always turn out well for those who make big bets with their money in the stock market. I do not believe anyone can consistently predict a stock’s return unless he or she has access to accurate unknown information. Trading stocks and bonds on accurate unknown information is ILLEGAL (ask Martha Stewart about this) so we have to look elsewhere to find a way to minimize risk while maximizing returns.
One way to manage volatility is to try and remove it from your portfolio entirely, but eliminating all risk is impossible. One of the safer investments I know of are short term US Treasury bonds. If interest rates go up Treasury bond values on the open market will decrease thus exposing investors to interest rate risk. Inflation has been rising since August of last year, and according to the Consumer Price Index (CPI) was about 2.63% in January of 2010. Inflation significantly erodes the buying power of low risk/low yield investments. My point is: you cannot remove market risk without exposing yourself to other significant risk factors like interest rate risk, inflation risk, and default risk.
If we can’t remove risk, then how do we reduce volatility? Grandma knew the answer when she said “don’t put all your eggs in one basket”. Diversification and asset allocation spread an investors risk over several stock and bond positions and broad sectors of the market. Over time a broad and diverse array of stock and bond positions will provide the best defense against market volatility. Exchange Traded Funds (ETF’s) have been one of my favorite tools for broad diversification for years. When inserted into the right allocation strategy, these low cost broadly diversified instruments provide the best defense against volatility while providing a return that allows you to achieve your long term financial goals.
Rob Schulz, CFP®
The views expressed are not necessarily the opinion of Cambridge Investment Research, and should not be construed directly or indirectly, as an offer to buy or sell securities mentioned here. Investing is subject to risks including loss of principal invested. No strategy can assure a profit nor protect against loss.
Rob Schulz, CFP® is a Principal with First Texas Financial Services, Corp., and a Registered Representative through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. He is also an Investment Advisor Representative through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Cambridge and FTFS are not affiliated. These are the views of Rob Schulz and not those of Cambridge, FTFS, or any of their affiliates.
By Rob Schulz