Four Things Affluent Investors Must Know About Risk Management

risk management

Sophisticated investors pay attention when someone brings up the topic of portfolio risk management. Affluent investors are often the most risk averse, perhaps because they have already accumulated enough money during their lifetime to achieve their financial planning objectives. Having reached their accumulation goals, they don’t want to lose their hard-earned gains because the financial markets misbehave. But affluent investors often misperceive some of the most important rules for managing portfolio risk, mainly because the investment industry doesn’t promote the bad news that the portfolio risk management “status quo” probably won’t help them in the next bear market. Here are four facts for you to keep in mind when the financial markets do the next deep dive.

1. Diversification May Not Be Enough

Building a diversified portfolio based on past performance, using long-term average returns and volatility measures, probably isn’t going to help you forecast future portfolio volatility if asset classes are expensive. In fact, long-term average volatility, correlation (asset classes zigging and zagging at different times), and returns are pretty much useless when investors have bid up the prices of stocks and bonds after a historically long bull market like we are experiencing right now. If you think that you’ve managed risk by building a diversified portfolio with multiple asset classes, and think you understand how the asset classes will perform once investors begin to panic…think again. Owning a portfolio of overvalued asset classes could lead to disastrous results, regardless of what has happened on average in the past. The worst-case scenarios for investors determined to hold on to their current holdings could be much worse than they think.

In fact, bear markets tend to be influenced by new and unexpected events that demand a thoughtful response by investors trained to respond unemotionally to news. The 2007-2009 bear market was created by a series of unprecedented events. Over a two-year period, the U.S. housing market crumbled due to banks lending to unqualified borrowers and then bundling the loans into highly leveraged derivatives that ended up bankrupting a series of Wall Street investment banks. The result was unexpected and catastrophic declines in traditionally diversified portfolios as well as non-traditional portfolios that owned asset classes like hedge funds and private equity. And while we don’t pretend to know what will cause the next bear market, we think it wise to allow our investors the benefit of our experience and common sense when the next one occurs. Affluent investors might consider that mindlessly buying and holding isn’t likely to be a winning strategy.

2. Buy And Hold Is Dead

The notion of “buying and holding” and then rebalancing to a fixed mix of asset classes in your portfolio is held out to be the behavior of educated investors who believe that trying to predict the future performance of asset classes is a fool’s game. But the most sophisticated investors understand that there may be times when it is actually more dangerous to hold on to over-loved and overbought securities than it is to sell them and find different and more fairly valued investment ideas.

Investors who insist that they shouldn’t make educated forecasts of future returns when markets are obviously expensive could cost themselves a fortune. Professional investment managers who are active make forecasts based on a variety of time-tested techniques that allow them to assess the highest probability of future market behavior. No one can guarantee the future, but changing the asset allocation of a managed portfolio is far from the behavior of an unsophisticated and panicky investor. Instead, holding on to expensive securities with the mistaken notion that “no one has a crystal ball” may not be a viable strategy during the next bear market.

3. Don’t Rest On The Bull

Bull markets always create a false sense of security for investors who’ve watched risk assets appreciate in value over many years. This bull market is no different, and today the very concept of managing risk is becoming unpopular. Once again investment managers who are tasked with risk management are often trailing the popular indexes. Risk and volatility once again are becoming undervalued as investors look at past performance and realize that the risk takers—and not the risk managers—are winning the game.

The herd is likely to forget about risk management just as markets are becoming the most dangerous. Alas, this cycle of investor behavior is unchanging. Greed overcomes fear in bull markets. This particular bull is becoming reminiscent of the bull market that peaked in the year 2000 when everyone’s friends, family, and business acquaintances were touting their favorite dot.com stocks. Today the darlings of the market are the FANG stocks; Facebook, Apple, Amazon, Netflix, and Google. They represent a huge and disproportionate share of the gains in the S&P 500 Index over the past nine years. Those investors who sleepily trust that their diversified portfolio strategy will protect them from outsized losses in the next bear market should understand that diversification didn’t work in the last bear market of 2007-2009, and buying and holding a fixed mix of asset classes may be just as ineffective in the next bear market. Don’t let the bull lull you into complacency.

4. You Must Understand Sequence Risk

Affluent investors should understand the concept of sequence risk. It isn’t the average return of your portfolio that matters during your retirement years. It is the order that you earn your returns that will have the most telling impact on your ability to retire and achieve your financial objectives. If we experience a bear market early in your retirement and you are taking withdrawals from your portfolio to maintain your lifestyle, then you could find that withdrawing money while your portfolio values are declining in a bear market will be devastating to your plans. And while patience is the portfolio strategy that is most frequently recommended by those advocating buying, holding, and waiting for average returns, you might find that time has run out and an unwanted lifestyle change is in your future. Risk management is more than an emotional decision based on your personal willingness to accept portfolio volatility in bear markets. It’s a necessity for those who are approaching retirement or who have already retired. The logical, data-driven strategy of defending portfolio values in bear markets by changing the asset allocation of client portfolios shouldn’t be overlooked by those who want to have the highest probability of achieving their financial planning goals.

About the Author

Ken Solow

Ken SolowKenneth R. Solow, CFP®, ChFC is a founding partner and serves as the Investment Committee Chair of Pinnacle Advisory Group, Inc. As a founding Partner, he was instrumental in creating the tactical asset allocation strategy currently used by Pinnacle to manage $2.2 billion in assets. Solow is nationally known for his views on active portfolio management, and his 2009 book, Buy and Hold is Dead (Again): The Case for Active Portfolio Management in Dangerous Markets, is considered the definitive work on Tactical Asset Allocation. Solow appears regularly at events sponsored by the Financial Planning Association, National Association of Financial Planners, the Investment Management Consultants Association, and the AICPA, and has been published in The Journal of Financial Planning, Smart Money, Financial Planning Magazine, The Baltimore Sun, the Globe & Mail, and the Wall Street Journal.View all posts by Ken Solow →

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