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Volatility Can Be A Portfolio’s Greatest Threat

The up-and-down swings of the markets are giving everybody vertigo. Yet most people fail to understand how critical it is to minimize the volatility within their investments. Besides getting a better night’s sleep, there are sound mathematical reasons. Most people are astounded to learn that they can actually earn a lesser rate of return with a portfolio with reduced volatility, and yet end up with more money left to spend. Although some may find this counterintuitive, this is the message financial advisers should be emphasizing to their clients.

It is essential to use strategies that protect your principal, minimize losses and reduce volatility. Did you know that if your investments are down 40 percent, you will have to earn 67 percent to get back to even? Worse yet, if your investments go down 60 percent, you need a return of 150 percent just to break even.

Historically, with previous downturns it has taken years for investors to recover their losses to get back to even. For example, from the start of the downturn in 1929 (which lasted 10 years), it took the stock market 25 years to crawl back to break even. It took seven-and-a-half years from the start of the 1972 bear market, and more than five years from the March 2000 high for values to creep back to break even. The more volatile the investment, the larger the potential problem.

So how can you mitigate risk and reduce volatility in your investments?
Diversification — It’s a time-honored strategy. However, most people are shocked to discover that despite all the various investments and different mutual funds they might own, after doing an “overlap for duplication” analysis, they uncover surprisingly large amounts of investment replication.

Proper asset allocation — This involves placing investments in a mixture of different asset categories, including U.S. and international, large cap and small cap, value and growth, emerging markets, as well as various types of bonds. Typically, a portfolio having 12 to 20 asset classes is considered well positioned. However, following last year’s “perfect storm,” almost every asset class was down, including most types of bonds (typically a safe haven during turbulent times).

Investments with upside potential and principal protection — Structured notes can provide principal protection, while simultaneously providing the upside of a particular index. On a related front, there are “fixed index” annuities. Although an alternative, I generally find the insurance company’s “trust me” position difficult to accept, especially their “black box” philosophies. Although you could always move your funds elsewhere, the high and oftentimes long-term surrender charges tend to lock you in for 10 to 18 years.

Guaranteed growth and income riders — When offered on “variable” and “fixed index” annuities they can provide a safety net to override actual account losses. One needs to be sure to navigate the various rules, understand there may not be a legacy to leave behind, as well as take the oftentimes high and long-term surrender fees into consideration. However, in the right circumstances, this strategy can make sense.

Multiple strategy investments — These did the best over the last 20 months, in addition to having a respectable long-term track record. Investments of this type vary between aggressive to conservative, and include hedge funds, managed futures, commodities, PIPEs (private investment in public entities), private equity, senior debt, etc. The “buy in” on these types of investments can be a drawback, as many are not available unless your investment account is $1 million or larger, as they can require a certain investment minimum or certain investor qualification.

Overlaying an “advance and protect” strategy — This is essential to help preserve principal, as well as help lock in gains. Although there are no perfect systems or guarantees, for most advisers utilizing this type of approach, it has delivered meaningful results and peace of mind for their clients.

We are experiencing what is being described as “a deer-in-the-headlights” market. The questions on many people’s minds today are “What should I do now? Should I stay the course and wait for things to come back? Or should I change strategies or possibly even my adviser?”

One should consider that not all investments come roaring back. Although the S&P 500 got back to even in May 2005, other investments performed less well. For example, the Nasdaq is still 63 percent underwater — more than nine years after reaching its high in March 2000.

A recent article in the Wall Street Journal commented on the results of an investor survey:
81 percent of the investors stated they were contemplating or in the process of changing their financial advisers.

90 percent of the investors with “brand named” firms planned to move some of their money; 70 percent planned to move it all.

86 percent of those planning to change were so upset, they recommended others avoid their current adviser.

No one can control the risk and volatility of the markets, so unless one thinks they can do it themselves, it is crucial to work with an adviser who understands how critical it is to reduce investment volatility in order to lessen a portfolio’s exposure to risk. Done correctly, reducing volatility should provide more consistent returns and dependable growth, and ultimately provide more income and a greater end value in your retirement years.

We are in very interesting times, and many people are now realizing they are in trouble. One does not need just any financial planner, but rather a true, unbiased professional adviser who can help guide them through the treacherous waters investors will undoubtedly have to continue to navigate. The decisions being made today could very well have a lasting impact on the rest of your financial life — so make them wisely.

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