The Volatility Paradox

Investment risks come in many different flavors. Some risks are like biting into a jalapeno pepper—they really grab your attention. Other risks are much more subtle.

Market volatility is a jalapeno kind of risk. It is so compelling that entire cable channels are dedicated to following the minute-by-minute swings in stock prices. However, unless we are careful, focusing on volatility can blind us to other risks that may be even more significant to our long-term economic well-being.

I learned this lesson as a young portfolio manager. My team was asked to help a major New York advertising agency redesign the investment strategy for its pension plan. The agency had gone through an aggressive leveraged buy-out and management worried that market volatility would leave their pension plan underfunded. My job was to reduce that risk by making sure their portfolio could hit its return targets.

To give you a little background, a pension plan is said to be “underfunded” if it doesn’t have enough assets to meet its projected obligations. When a plan is underfunded, the company sponsoring the plan is required to add cash to the plan. Contributions to a pension plan reduce the company’s earnings, so companies generally try to minimize them. This is especially true when companies face other obligations like paying down massive amounts of bank debt.

As we evaluated various portfolio strategies, the managers at the agency kept pushing us to eliminate stocks from the portfolio. Stock market volatility scared them and they felt reducing stock holdings would increase the likelihood that the plan would stay properly funded. Unfortunately, we found that the more we reduced stocks in their portfolio, the more likely they were to have a funding shortfall.

At first our results puzzled me, but then I understood. A portfolio of less-volatile investments like bonds and cash simply couldn’t produce enough return to meet the needs of the pension plan. By reducing their exposure to what the company’s management saw as risky assets, we actually increased the risk the company was trying to avoid.

Some individual investors face a similar dilemma.  As they reduce portfolio volatility by investing in bonds, CDs and cash, they create portfolios that cannot keep up with their needs. Paradoxically, their effort to reduce risk leads to greater risk—just risk of a different flavor.

So how can investors make sure their aversion to volatility isn’t blinding to important, but more subtle risks in their portfolio? The best way is to do some simple financial planning, either on your own or with a professional financial planner. A financial plan can help you better understand your financial goals, including when you expect to accomplish them, how much they will cost and how you will fund them. To the extent you will need to fund them from savings, you will be able to see what kind of return you will need to earn on your savings.

A well-designed financial plan puts your financial life in perspective and helps you see the risks that truly matter. Some of the most important risks you face may be much more subtle than near-term price volatility. Once those risks are identified, a suitable portfolio can be structured to help you accomplish your goals with the least amount of risk necessary.

 

Steven C. MerrellMBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell,   2340 Garden Road Suite 202, Monterey, CA93940 or email them to steve@montereypw.com.