We continue the series we introduced last week, Lessons From the Past, with lesson one:
Investments by definition are volatile in nature and always unpredictable.
On September 26, NASA slammed a golf cart-sized satellite traveling 15,000 mph into the near-earth asteroid Dimorphos. This deliberate impact was aimed to test humanity's ability to deflect future asteroids from colliding with Earth. And aside from eliciting flashbacks of the silly late-1990s sci-fi film Armageddon, the mission was a remarkable success (NASA impact video).
Ambitious interplanetary missions like this are made possible by physical laws that ensure the predictable movement of celestial bodies. But as past investors have learned the hard way, no such laws granting predictability exist in the investment world. No, the closest we might come to some universal law is that investments are fundamentally unpredictable.
Consider the misfortune of the inflation-worried investor who bought gold on the same day NASA launched its asteroid bullet (November 24, 2021). Those inflation fears proved valid; over the following months, consumer prices accelerated at their fastest pace in four decades - a seemingly perfect condition for gold to soar. But the quintessential inflation hedge didn't soar. Instead, by the time NASA's bullet hit its target ten short months later, gold had lost more than 10% of its buying power.
So even correctly predicting an investment's key economic determinant doesn't guarantee a correct decision about the investment itself.
Today, everyone is staring down an equity market that has lost a quarter of its value and wondering when the tide will turn. To that end, investors are prognosticating about the outcomes of various issues:
• When will inflation break?
• How well will corporate profits withstand higher interest rates and labor costs?
• How will other investors feel about stocks in the near term?
• How will other central banks respond to slower growth?
• How will Russia escalate the Ukrainian conflict? What will be the West's response?
These questions are worth deliberating in terms of potential scenarios relative to market pricing and fundamentals. But making investment decisions around a predicted outcome is an entirely different matter. That's speculation, and it is how investors tend to decide to "get out of the market." Those same investors typically stay uninvested until volatility subsides and likely miss the recovery.
Trying to predict the market's next move neglects a more profound principle: investment opportunities exist because of unpredictability. Without risk, without the possibility of sharp, unpredictable declines, would investments deserve a return premium over cash? Certainly not. The prospect of losing money, even temporarily, allows investors to require a rate of return on risky opportunities that exceeds the return on safer investments.
We share this dispassionate perspective not to trivialize the current market upset. Again, we are talking about real dollars on which clients' goals depend. But we recognize that realizing investment goals is an exercise not in prediction but risk management.
Our approach to risk management boils down to a simple principle: match portfolio assets (investments) with portfolio liabilities (expected outflows). That is, conservatively invest assets earmarked for short-term withdrawals and use riskier investments to fund longer-term goals. In other words, avoid investing in stocks with money that will be spent within the next 1-5 years. Avoid buying "safe" longer-term bonds to fund withdrawals that will occur within the same 1-5 year period. Instead, hold enough short-term investments to cover at least several years of expected outflows.
By organizing portfolios in this fashion, we avoid having to sell assets in a downturn to fund withdrawals. So then, absent a funding need, shedding assets during a slump becomes an emotional decision (we'll address that in a later lesson).
Honoring clients' multiple investment horizons look like an obvious solution today, given that it biases portfolios toward owning more high-quality, short-term assets. But that certainly is not always the case. A year ago, holding short-term bonds earning almost no yield would have appeared wrong-footed as stocks advanced to record highs. Today, that same decision looks prescient. Go figure.
Risk management is a process borne out of the unpredictability of investments. So, whether short-term assets will under or outperform riskier ones is irrelevant. Short-term outflows call for short-term investments. Once we address near-term liabilities, we can begin adding risk to support longer-term portfolio growth. Through that process, unpredictably becomes a strategic advantage that only long-term investors (which encompasses all clients to some degree) can wield over other market participants.
The key to protecting portfolios in this environment is to render fear-based decisions unnecessary. And executing an asset-liability management approach makes that possible. But just as NASA's satellites can veer off course, markets can become off-kilter relative to their long-term fundamentals. When that happens, investors can take advantage of opportunities before markets course-correct. In our next installment, we will explore some of those potential opportunities.
In the meantime, we encourage interested clients to inquire how we specifically match their portfolio assets against their future liabilities, such as living expenses, or some other future goal.
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