Content provided by Joe Smith, CFA, CLS Senior Market Strategist
Volatility has gradually picked up this year. This should be no surprise to investors since we have seen exceptionally low volatility over the last few years. Volatility inevitably reverts back to historical trends and should be expected to rise as markets focus on company-specific fundamentals and valuations.
So with that as a backdrop, what should investors keep in mind when thinking about risk and its impact on portfolios? At CLS, we believe in three key principles, which are at the heart of our disciplined investment process. Instead of focusing on asset returns, we start with asset risk.
Principle 1: Understand the Client’s Desired Risk Profile
What is a risk score? For many investors, it goes beyond measuring one’s tolerance for risk. It is a mechanism to determine the level of risk an investor is comfortable with over a stated investment horizon. This is the main principle behind CLS’s Risk Budgeting Methodology. In fact, recent academic research has shown this method is still the preferred way for individuals to make investment decisions.
Principle 2: Managing Volatility Within a Given Range
We all know returns go both ways: positive and negative. What is less discussed is the impact those returns have on aggregate wealth in a portfolio.
Say for instance a portfolio had a starting balance of $100,000 with an accumulation goal over the next 10 years. Assume Portfolio A was down -10% for the first year while Portfolio B was down only -9% that same year. Assuming each portfolio had the same return of 5% thereafter for the next nine years, what would be the difference in total wealth accumulated?
What we find is such a small difference in return in the first year could compound into meaningful differences in return (+1.6%) and ending wealth (Portfolio A would have $139,614 and Portfolio B would have $141,170). The point is simple: keeping more of what you earn matters.
Principle 3: Measure Outcomes Based on Their Probabilities
Investing, just like many things in life, is not a black-and-white activity. It requires understanding that each outcome is part of a greater machine called probabilities. Probabilities help investors translate uncertainty around what can’t be directly observed into expectations that help keep goals and emotions managed.
For example, as we look at 2016 we generally have a lower expectation for U.S. equity returns relative to other equity markets, investors must keep in mind that same baseline expectation has probabilities associated with it. Based on our current outlook, we believe the probability for equity returns to increase by 5-10% to be less than 17%. At the same time, we believe the probability for equity returns to fall in the range of 0-5% to be just above 21%. Such an exercise clearly helps investors focus on their long-term goals while also managing emotions for short-term expectations.