The days get colder and shorter this time of year, and warm memories of the beach can help us get through these cold times. Such thoughts – and anticipation of more beach fun – were on Hank and his wife Dot’s minds when they came to see me recently. Hank and Dot live in West Barnstable. They’re in their late 50’s with grown children, but they look at least a decade younger, thanks to their active lifestyle. They’re both avid surfers, and they try to get away for a few weeks every winter to “the Garden Isle,” the lovely Hawaiian island of Kauai.
Hank and Dot have been investing since their late 20’s and have been using a retail broker in town for years. They admit that they have been riding high on a buy and hold equities-heavy investment portfolio for quite some time. They hope they’ll be able to retire soon to spend more time chasing the perfect wave, and they’re getting closer to their goal of about $1.5 million saved. Hank’s been feeling like the wave will never end, especially as U.S. equities markets have been setting new records.
Dot, on the other hand, is scared.
You see, good surfers catch a wave, then turn and paddle out to get the next one. Some stay on the wave for too long, and they wipe out. Wiping out is okay when you’re on a surfboard, but not when your investments are on the line.
I suggested that they think about how ocean waves move: They go up, then they come down. And when it gets stormy, those waves get bigger and bigger – both the crests (the highs) and the troughs (the lows). Similarly, when the market rises, eventually, there’s a drop. I explained how the financial crisis of 2007-2009 began with just such a wave, and Hank and Dot, both staring at each other, admitted they lost a bundle by the time the market bottomed out. Hank and Dot didn’t want to make the same mistakes as before, especially now that they are a decade closer to their goal.
I explained why certain types of strategies that we may use in our accumulation years, are not always appropriate in our distribution years.
No one has a crystal ball to know exactly when we’re on the crest of the current wave, but vigilant investors keep their eyes on signs of change. The CBOE Volatility Index (VIX) is one such measure. The VIX – sometimes called the “fear index” – measures market volatility, and over the summer it hit an all-time low. Intuitively, you might think that a rallying equities market and a lower VIX number are good. Indeed, some investors, like Hank and Dot are chasing that wave.
But volatility won’t remain low forever. There’s even a Wall Street saying, “VIX is low. Time to go.” That’s because a low VIX reading and major gains in the stock market can indicate that the market is at an extreme. Big corrections often follow these extremes. Our experience has shown us that when unexpected factors hit the market – interest rate changes, changes in currency markets, anything – volatility can change quickly.
Vigilant investors can insulate themselves from potential market volatility by using investment strategies that are diversified and that use downside risk management systems.
Diversification can be achieved by spreading investments between different asset classes – domestic stocks, bonds, short-term investments, alternatives, and international stocks. Risk triggers can help determine when it is best to be invested…and just as importantly, when not to be invested.
Many investors aren’t aware of the volatility of their investments and remain uneducated on how their financial system will behave when the tide goes out, or the wave crashes. The uneducated investor continues to only focus on the upside potential of their investments without analyzing the potential downside risk associated with those gains. They ask questions like, “How much money did I make last year?”
The uneducated investor locks in losses or gives up gains they can’t make back later because they usually sell and buy back at the worst possible times. Hank and Dot’s buy and hold equities-heavy portfolio did not give them the diversification they need to achieve their investment goal. It did not provide appropriate downside risk management, either.
I coached Hank and Dot on how to think and act like an educated investor. I suggested they ask questions like, “Tell me about the losses. Tell me what happened in years like 2008? Tell me about the behavior of my financial system in good times, but more importantly in bad. Tell me about the drawdown of my system.”
Drawdown measures an investment’s decline from high to low over time. Measuring your investment’s drawdown – the distance between its peak and trough – helps you understand your overall risk. We calculated the drawdown in Hank and Dot’s retail buy and hold portfolio. It was 54%.
Folks, that is a 54% swing from a high to a low.
Hmm…the educated investor understands that if you can manage the downside, well, the upside takes care of itself.
Hank and Dot became educated. Once we discussed an acceptable level of drawdown, around which to build their financial system, we went to work. We built their diversified portfolio with strategies that, when back-tested, historically would have resulted in 15% drawdown, or swing in their portfolio, instead of the 54% swing in their buy and hold portfolio. We essentially helped to give them the highest probability of financial success.
Of course, folks, the acceptable level of drawdown and mix of diversification is going to be different for each investor based on individual needs and goals, but the principles should be a constant. Understanding how to manage the downside is to investors what proper foot placement and good balance are to a surfer: Necessary to help you maintain control.
You’ve probably heard surfers say “Hang ten” to each other. “Hang ten” has a literal definition: Great surfers can catch a wave and walk to the end of the board, then literally hang all ten toes off the end while still staying in control. Doing so demonstrates balance, concentration, and a good understanding of how to ride the wave without wiping out.
Understand how to manage downside risk in your investment portfolio, and you too can hang ten. Being an educated investor requires you to be vigilant and stay alert, because you deserve more.
Have a great week.
Jeff Cutter, CPA, PFS is President at Cutter Financial Group, LLC, with offices is Falmouth, Plymouth, and Mansfield. Cutter Financial Group provides private wealth and investment management advice incorporating low risk, low volatility financial strategies. Jeff can be reached at email@example.com.
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