Riding the Investment Roller Coaster
Oct 26, 2011 |
The recent volatility of the market has investors split on what they should do with their money. The markets have too much risk, but other options might not have enough. Having a solid financial plan can help you determine the balance between the two.
The past few months have been some of the most volatile in recent memory, with the S&P 500 suffering its worst quarter since the end of 2008 with a loss of 13.9%. Even with September historically being the weakest month of the year, this past September was the worst since 1950. Of the 500 stocks in the index, 422 declined. Losses also were felt in U.S. small stocks and foreign equities throughout the quarter.
The unpredictability of the markets extended to the fixed income sector, albeit with stronger returns. Somewhat surprisingly, the Barclays U.S. Aggregate Bond Index enjoyed a 3.8% increase. This was despite the downgrade of U.S. debt by Standard & Poor’s in August and credit concerns both in the U.S. and abroad, as investors fled to what they deemed as a “safer” refuge for their wealth.
With such 180-degree shifts in the markets, many investors are wondering if they really have the stomach for investing. To some, the roller coaster rides of the last few years seem to be not worth the cost. Instead, when it comes to their portfolios and risk tolerance, many are asking themselves if a carousel ride — with no peaks and valleys — is more up their speed.
Indeed, opting for a smoother ride with less volatility should always be the aim of long-term investing. However, it’s important to remember that there is embedded risk in taking too little risk. Allocating too large a portion of one’s portfolio to cash or, for example, U.S. Treasuries, which are currently yielding little more than 3%, may well result in being unable to keep up with inflation and losing purchasing power over time.
How do you know if the beating one has taken in the past quarter is necessary to achieve one’s long-term goals, or if it’s better to select a less risky allocation but with less expected return?
Here lies the essence of a financial plan. Long-term financial planning is based on the relationships of risk, return and time. The profiling firm FinaMetrica defines risk tolerance as “the emotional balance between seeking a favorable outcome versus risking an unfavorable outcome.” A second and no less important measuring tool is risk required. This type of risk is associated with the return on investments needed to achieve one’s goals, thereby providing mathematical justification for taking risk.
In my experience, investors are often willing to act on emotion to avoid perceived short-term market risks (or to obtain perceived market opportunities) without regard for the fact that doing so has the resulting effect of increasing their long-term risk of not attaining their required rate of return. Perception of short-term risks often leads to emotionally-driven responses, which in turn can lead to error. With regards to achieving one’s long-term financial goals, the stakes are high when emotion overrides the financial plan.
With this in mind, you should seek a balance between risk tolerance and risk required. Keep your emotions in check by creating and reviewing an individual financial plan designed to take no more risk than required to achieve your goals. By identifying the return you need to achieve over the long-run, you will be able to withstand the short-term ups and downs of the market and be a better position to assess when it’s best to continue on the roller coaster for a bit longer, or when it’s time to opt for another ride.
Disclosure Language for Blog
Tom Orecchio is a principal and wealth manager with Modera Wealth Management, LLC (“Modera”). Nothing contained in this blog should be construed as personalized investment, financial planning or other advice, and there is no guarantee that the views and opinions expressed herein will come to pass. Investing in the stock and bond markets involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be construed as a solicitation to buy or sell any security or engage in any particular investment strategy.
Modera is an SEC registered investment adviser. For more information about Modera, including our registration status, fees and services, please refer to the Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov or visit our website at www.ModeraWealth.com or contact us at (201) 768-4600 to obtain a copy of our Disclosure Brochure.