March 13th 2008

Re: A Lesson on Market Volatility

When seeking an investment strategy, investors have many choices to decide what securities to buy and in what concentrations, with emphasis of income or appreciation, and to determine what exit strategies may be appropriate.

Some clients have lesser investment experience or fewer choices determined predominantly by a company retirement plan. Suddenly, they may find themselves facing college educations or concerns about job security as they approach retirement. Meanwhile, they have accrued more assets which are at greater risk than when they started saving many years ago. Therefore, some have found themselves less confident, perhaps even ill prepared to face the threshold of change. How does one convert assets to cash flow? No longer do the standard rules of thumb apply.

Given these conditions, how does one determine an effective investment strategy? While many investors focus primarily on their investment choices, or the conditions of the economy, one should begin by determining:

  1. How much assets do I need?
  2. When will I need this money?
  3. What assets do I have now?
  4. How much more can I save?
  5. What can I expect for inflation?
  6. What rate of return is required to accomplish these goals?

The final question is a function of the first five and becomes the benchmark for an effective portfolio strategy. While an investor cannot control the financial markets, an investor can determine the relative feasibility of accomplishing their objectives through a sound plan. If the required return is too high and unlikely to occur, the investor may consider postponing the goal or reducing its cost rather than assuming excessive investment risk which may jeopardize their financial security.

What I find most often is that investors who attempt to maximize returns through various market timing techniques are normally the ones who have no idea how much money they need or what their required return should be.

Without this knowledge, one may lack sufficient perspective, implementing any random technique to maximize returns at the risk of a more prudent strategy. If one believes themself accurately able to assess peaks and troughs, your guess may be no better than mine. Reading into past or recent performance is like driving through oncoming traffic while looking at the rear view mirror. Technical analysis cannot be used to predict random human behavior. Triggering events impact the markets immediately. Your likelihood of obtaining a competitive fill becomes less likely at higher volumes. The more the market knows, the less likely you are to profit.

Furthermore, all insider information must be reported to the SEC. Trading restrictions may apply. Not to mention, all open end mutual fund transactions may only be processed at market close.

Investors can become easily misled by intermittent volatility, reading more into daily trading volumes than might be suggested by underlying economic fundamentals. Short term stock market performance is not a measure of economic strength, but a leading indicator, merely a reflection of what investors believe the economy might do next.

However, financial markets become more predictable over a period of economic cycles. That is why asset allocation* is such a highly acknowledged professional technique. Based on the amount and timing of intended distributions, a portfolio can be constructed which provides an opportunity to obtain a targeted return with less risk to the objective.

Nobel Prize winning research has shown that more than 90% of long term investment performance is attributable to asset allocation, that is, the diversification of asset categories within a portfolio rather than market timing. Therefore, why do most investors choose to focus on the 10% which matters least to long term results, yet contributes most greatly to short term failures? Do they know something we dont? According to historical results, apparently not.

However, since economic cycles are usually more discernable than the direction of daily volatility, investors may more effectively emphasize certain asset categories during periods of recession vs. recovery.

Meanwhile, a default portfolio should contain sufficient asset categories whose performances offset one another within an economic cycle to produce a more reliable return regardless of economic conditions. Protecting against loss becomes even more critical when distributions from the portfolio become imminent, especially during retirement. Furthermore, the impact of inflation should be adequately considered.

With these criteria in mind, you can design an investment strategy with greater confidence. While working to achieve your objectives, it pays to work form a position of greater knowledge and control rather than lingering uncertainty.

*Diversification does not guarantee against loss.  It is a method used to help manage investment risk.

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