Consider building a Portfolio Reserve to avoid making short-term decisions that could jeopardize long-term goals
Following an extended period of smooth sailing in the global equity markets, the potentially choppy waters ahead have many investors questioning their plan. While it can be difficult to remain committed to your investment plan in the midst of a sharp market dip, it helps to know exactly what your money is working toward. In other words, have a plan that can accommodate market volatility instead of trying to predict how the market is going to behave.
Research shows that when global markets fall 15% or more from their prior peak, returns over the following five year period are above average. But opening a monthly statement only to see the balance drop by that much will make even the most committed investor anxious. There is a natural inclination to do something, but changing course mid-storm may do more damage.
Above average returns often occur after market downturns1
WHAT BEHAVIORAL FINANCE TEACHES US
The field of behavioral finance has shown that investors often behave in ways that are far from rational. These irrational tendencies are called behavioral biases, and they can have a meaningful effect on investment outcomes:
- Recency bias: putting more emphasis on recent events than on long-term trends
- Loss aversion: putting more emphasis on avoiding losses than on acquiring gains
- Herd mentality: if everyone else is doing it, it must be right
The last tendency — to follow the herd — often leads investors to sell low and buy high during times of market turmoil.
A Safety Net for Your Portfolio
So how do you remain calm during periods of market uncertainty? Ultimately, assets serve a purpose, and should be invested very intentionally to that end. A goals-based investing approach provides a framework to make sure this connection is made.
Recognizing the importance of investing with purpose, Northern Trust’s approach to Goals Driven Wealth Management starts with a full review of your balance sheet, both what you have (assets) and what you want to achieve (goals). Portfolio assets are then grouped into two broad classes – Risk and Risk Control – to ensure a lifetime of goals can be met.
Risk assets serve as the portfolio’s return engine to fund future goals and build wealth. They include global equities, real assets and alternatives. Risk Control assets are stable diversifiers, such as high quality fixed income, Treasury Inflation Protected Securities and cash. These assets are earmarked to fund near-term goals and build a Portfolio Reserve – a safety net to support core lifestyle funding during periods of market stress. Having this buffer preserves your overall investment strategy during periods of market stress by drawing your Portfolio Reserve down to maintain lifestyle spending while allowing your risk assets to stay invested. With confidence that your lifestyle needs will be met, your decisions are no longer dictated by emotions or market events.
A More Intuitive Approach to Measuring Risk Tolerance
By knowing what your goals are – and how much money is needed to fund them – your portfolio will more intuitively reflect your risk tolerance. In other words, the returns you need your portfolio to produce are no longer arbitrary, but specifically measured based on what you want to accomplish. In return, the amount of risk you need to take to achieve your goals can be more precisely incorporated into your portfolio.
Your risk tolerance – that is, the degree of confidence you want in your ability to reach your goals – is critical to building your Portfolio Reserve. The size of the reserve you build will depend on your annual spending requirements and how many years of spending you want to protect. Larger portfolio reserves give the equities in your portfolio more time to recover from downturns. But they also lower overall returns, making it important to be sure you have enough money to achieve your goals.
Activating the Portfolio Reserve
The decision to activate the Portfolio Reserve during market distress is not about timing the market, but rather staying the course. At its core, the Portfolio Reserve helps investors resist the urge to sell risk assets during periods of market stress so they can take advantage of potentially higher long-term returns. In fact, the most substantial returns come from just a few days of the year. Since it’s difficult to determine those days in advance, it is best to remain invested rather than jumping in and out of stocks.
The risk of missing the best days in the market for the S&P 500 from 1999-20182
When the Portfolio Reserve is activated, the selling of equities is halted in favor of selling fixed income to fund spending needs and allow time for equities to fully recover. By drawing down the Portfolio Reserve during times of market distress, investors avoid making short-term decisions that might jeopardize long-term goals.
The Case for Goals Driven Wealth Management
As volatility is anticipated to be a lasting characteristic of the financial markets, it is critical to be prepared for it. The Portfolio Reserve provides an important buffer to portfolio drawdowns as well as needed liquidity to avoid selling risk assets at potentially depressed prices.
Goals Driven Wealth Management provides a framework for more informed decision-making, which leads to more rational investing and better investment outcomes. By focusing on the purpose of your assets – to efficiently fund your lifetime goals – you will end up with a dynamic asset allocation aligned with your unique goals, risk preferences and circumstances.
- The Portfolio Reserve is a safety net to support lifestyle funding during periods of market stress. It can help you resist the urge to sell risk assets during periods of volatility knowing that your lifestyle needs are protected.
- Focusing on the purpose of your assets – to efficiently fund your lifetime goals – can help you arrive at an asset allocation truly aligned with your needs and risk preferences.
- Use ‘Risk’ and ‘Risk Control’ assets as the strategic building blocks for your portfolio. Risk assets generate returns and Risk Control assets are diversifiers to fund near-term goals and provide liquidity during market turbulence.
Northern Trust Research and Morningstar. Returns are real (i.e., net of inflation). Past performance is not indicative of or a guarantee of future results, which willl fluctuate as market and economic conditions change.
S&P 500 Index. Past performance is not indicative of or a guarantee of future results, which will fluctuate as market and economic conditions change.