Let’s continue exploring our thoughts on managing one’s surplus capital.

If you have been following our monthly posts, you know I consider one’s time-horizon to be the most crucial factor in our advisory process. A sufficiently long time-horizon is essential for weathering market fluctuations effectively. To me, that means planning for a minimum time horizon of ten years.

In addition, it is important to incorporate contingencies to manage emotions during periods of significant volatility.  Volatility is an inherent part of investing in risk-on assets; we often refer to it as the price of admission. To achieve the potential rewards, you must be willing to pay this price.  Thus, every investor should carefully consider his or her volatility budget.

We all have inherent biases – clients and advisors alike.  Here is one of mine: I do not believe people are nearly as comfortable with volatility as they let on.  What’s more, I believe it is close to impossible to know how you will react when confronted by the full force of a market sell-off. 

Unless you have personally experienced a bout of investment volatility that pulled your portfolio down forty-, fifty-, or sixty percent in value, you will have a hard time convincing me that you have the emotional resilience to wait-through that degree of turmoil.  Further, if you have invested through heightened turbulence before, are you sure you will face the next bout with the same fortitude?  I suspect we are all in a different life space today than we were in 2008.  Generally, age does not lend itself to a more aggressive posture.   In my experience, it is very easy to fool oneself into thinking that it will not be emotionally jarring to log in to your investment account and see that your two-million-dollar portfolio has fallen to one-million dollars.  It is our job to ensure you are not being cavalier about the matter.   

We believe that being diversified across and within asset classes is the best way to temper volatility through time.  This strategy is appropriate when your goal is to earn a return that supports your lifestyle while providing a relatively comfortable investment experience.
 

To clarify, a diversified investment portfolio is not the best option if your primary goal is to maximize returns.  Moreover, I have met very few families who are comfortable with the degree of volatility tied to this objective.  Again, my own bias assumes that most are not.  
 

In an ideal scenario, a well-diversified portfolio includes investments that perform differently at various times. For instance, if your technology stocks are experiencing significant gains, you might be comfortable with your utility holdings being flat or even declining. Similarly, if your bonds are rallying, it is not unusual for your stocks to be underperforming. When making investment decisions for our clients, we always consider these dynamics. However, it is important to note that such relationships have been less predictable in recent years.

More commonly, a diversified portfolio consists of investments with varying return and volatility profiles. For example, technology stocks might have a high expected return with significant declines along the way, while utilities might have a lower expected return but much less downside.  Holding the latter can narrow your range of potential outcomes, both positively and negatively. This means that diversifying usually limits your gains in strong markets and provides some stability during downturns.

In future posts, I will discuss our specific investment positions. For now, it is enough to note that our model portfolio is currently diversified as follows: forty percent in stocks, forty percent in bonds, and twenty percent in commodity-linked securities.  This allocation was put in place last September and has been consistent since.  However, it is not static and will change as needed. We are always striving to provide the right balance for our clients, aiming to meet reasonable performance expectations while managing volatility.  We believe the current mix can do both.

Next month, I will start writing about performance expectations; specifically, the rate of return we are aiming for.  For now, if you want to pursue a more comfortable investment experience – one that focuses as much on volatility as return, we may be a good fit to work together.  Please reach out today to start the conversation.  We would love to hear from you.