Tailoring downside portfolio risk to an investor’s risk tolerance, goals/objectives, and future cash flows can help reduce the probability the investor will experience a catastrophic loss.I last wrote (way too long ago) that hope isn’t an investment strategy when the markets start moving against you, but I failed to give a solution. A client then wisely asked me to elaborate on the plan we have in place for him, so I walked him through it.
Below is an abridged version of my response. It outlines his, as well as other clients, portfolio risk management strategy. Nothing is full-proof, but what this strategy does attempt to do is prevent losses from becoming catastrophic. This is where panic selling often takes place, compounding the losses.
By focusing on the client, their risk tolerance, goals/objectives, and future cash flow we can put together a plan that helps reduce the probability of a loss that would have drastic implications for the client moving forward:
- Diversification. By utilizing bonds we can help reduce the downside if equity markets fall. This smooths returns over the long-run and helps balance the account when stock returns get ugly. Still, even with diversification returns can be much lower than would be expected given historic returns and volatility…
- Quality. We keep the bulk of our assets in Large Cap equities and also allocate more to blue chips in that space. This minimizes exposure to some of the riskier equity asset classes out there. So while we may have a muted upside, we believe the downside should also be muted. Still, the baby can get thrown out with the bath water when the market tanks, so we aren’t done…
- De-Risk. We are still bullish on equities now, but what if that changes or we are wrong? We look for market signals to tell us when we should de-risk the portfolio (e.g. sell equities). These signals tell us if the market is at a greater risk of a large loss and happen as the market moves down, so we aren’t trying to pick the top, but rather avoid much of the bottom(ing). These signals have been very good in the past, we have custom models that illustrate this, but there is a chance they could not work…
- Custom Waterline. We put together a bespoke cash flow model for our clients, which maps their inflows and outflows moving forward. From this we can develop a “waterline” – the minimum portfolio value a client can have and may still reach their long-term financial goals. What this means is that if all the above risk metrics fail we can move to cash on the equity side when this value is met. Using the waterline allows us to manage specifically to THE CLIENT’S needs and helps increase the probability we keep them financially stable over the long-run.
Ultimately these strategies are in place to protect the downside for the
client, and subsequently help give them some clarity. If we can do that
by minimizing the downside risks, the returns should take care of themselves.
The views and opinions
expressed herein are those of the author(s) noted and may or may not represent
the views of Capital Analysts, Inc. or Lincoln Investment. The material presented is provided for
informational purposes only. Nothing contained herein should be construed as a
recommendation to buy or sell any securities. As with all investments, past
performance is no guarantee of future results. No person or system can predict
the market. All investments are subject to risk, including the risk of principal
loss.
While there
is no assurance that a diversified portfolio will produce better returns than
an undiversified portfolio, and it does not assure against market loss, a
diversified portfolio can reduce a portfolio’s volatility and potential loss.
Large cap stocks typically
have at least $5 billion in outstanding market value.
