by Jordan Hucht, CFP®, ChFC®, AIF®
For many investors, the past few weeks have been unsettling.
In times like these, it’s important to remember two of the most fundamental components of investment management – asset allocation and time horizon.
Everyone wants to own stocks when markets go up. Nobody wants to own stocks when markets go down.
That may be a blanket statement, but it resonates in periods of extreme volatility as we’ve seen recently. So let’s take a step back and remember why we own stocks, or more specifically, the role of stocks in a portfolio. The primary role of stocks in a portfolio is to produce high levels of real return – the rate of return in excess of inflation – over long time periods. How does that happen? Stocks are priced based on expectations of future earnings. The “future” part of that sentence is important. By definition, the future is always uncertain, so stocks inherently carry an element of uncertainty, which manifests itself in the form of volatility. And we’ve been served quite the melting pot of uncertainty recently.
During times like these, volatility spikes, and stocks go down as fears mount.
And that’s exactly why asset allocation – the balance in a portfolio between stocks and other asset classes – is fundamental, yet often overlooked or forgotten when stocks are doing well. Bonds, cash, and alternatives serve a much different role in portfolios than stocks. More than anything, in times like these, they are intended to provide stability and reduce volatility. The appropriate asset allocation varies by investor and is determined by good financial planning and an understanding of future withdrawal needs. If we’ve done our job correctly, a portfolio is built to weather storms like these.
Changes in portfolio values are not “real” until they’re realized. In other words, unless you sell an investment, its value will continue to change over time. As a result, time horizon – the length of time we intend to hold an investment – is critical in managing risk. The design of a portfolio for investors with no expected withdrawals for the next 20 years is fundamentally different than the design of a portfolio for an investor who is already taking or will soon begin taking withdrawals.
Obviously, those who are currently or will soon be taking withdrawals are more sensitive to fluctuations in portfolio value. The primary way we protect portfolios for those investors is to understand the expected withdrawal needs and allocate several years’ worth of soon-to-be withdrawn dollars in very conservative assets. The main goal of this process is to avoid having to sell depressed assets – for example, selling stocks in times like these. Remember that a properly allocated portfolio will have the right balance between stable asset classes for near-term needs and riskier asset classes for long-term growth.
When negative headlines abound and financial markets are in turmoil, it can be easy to lose sight of some of the fundamentals of financial planning. Good financial planning dictates appropriate asset allocation. Sometimes we need a reminder to take a step back and keep the bigger picture in perspective.
Remember that in many cases, the right reaction is no reaction. And that’s because the right action was already taken by understanding time horizon and having the appropriate asset allocation before the storm began.
Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser.