Riding the Market Roller Coaster
As often as the stock market tumbles and recovers, it’s easy for investors to feel like they’re on a never-ending roller coaster ride. Minute by minute, the market adjusts in real time to information and to investors’ emotional state. When confidence is high, the market rises accordingly to reflect investor optimism; conversely, when fear takes over, we typically experience a market downturn, reflecting investors’ growing sense of uncertainty.
Ups and downs seem even more drastic when viewed through the traditional wealth management lens, which can be at odds with how investors actually view risk and their investment objectives.
“Continued market volatility is a constant reminder to investors that there can be a fairly wide berth around what we expect will happen and what actually happens regarding short-term equity market returns,” says Katherine Nixon, chief investment officer for Personal Financial Services at Northern Trust. “The wealth management business tends to define risk as volatility, or standard deviation. It is industry standard to look at an investor’s assets using a portfolio view, from the top down, with dollars assumed to be fungible across asset classes.”
A new solution, dubbed Goals Driven Investing at Northern Trust, turns this long-held view on its head. This approach to investment management matches life goals with the appropriate asset allocation based on the goal’s time horizon and risk preference. Goals Driven Investing is part of the Life Driven Wealth Management strategy that helps clients prioritize goals around maintaining a current lifestyle, preparing for future expenditures, protecting their family’s financial future and creating a philanthropic legacy.
“Goals Driven Investing is a much more intuitive approach, and one where we can have higher confidence in meeting clients’ goals,” Nixon says.
Redefining Risk and Success
Market volatility throughout 2011 and 2012 has underscored the need for a goals-based investment approach in several ways, says Scott Dille, senior vice president and director of client solutions for Personal Financial Services at Northern Trust.
First, the industry-standard definition of risk isn’t consistent with the way investors actually think about risk. Rather than viewing risk as a range of possible outcomes relative to an expected return, investors tend to frame risk around the likelihood of meeting their specific goals. Those goals can range from maintaining their lifestyle to passing along wealth to future generations to engaging in philanthropy.
“Clients think of risk in terms of, ‘Am I going to be able to fund my children’s education? Am I going to be able to fund a large purchase I have in mind? Will I be able to support the causes I care about?’” Dille says.
Similarly, ongoing market volatility highlighted a glaring disconnect between the conventional definitions of success and investors’ unique and personal benchmarks. While broad market benchmarks may be important from an informational standpoint, they do not reflect how investors view success or failure.
“During market downturns in particular, short-term relative investment performance is irrelevant to longer-term goal achievement. It not only can be a difficult distraction but also can exacerbate emotional behavior,” Nixon says.
Dille puts it into perspective: “If the market goes down 15% and your portfolio goes down 10%, that is a positive outcome if you are using a relative benchmark. But if it’s your portfolio that goes down 10%, it doesn’t feel like a positive outcome.”
With Goals Driven Investing, however, portfolio success is determined by whether clients’ objectives are realized.
Avoiding the Pitfalls of Market Volatility
Many investors, caught off-guard when the market tumbled in 2008, made emotionally based portfolio decisions that weren’t aligned with their long-term investment objectives. That’s a common pitfall during times of excessive market volatility.
As a result, many investors attempt to time trades, selling when the market falls and trying to get back in when it stabilizes. This often results in perfect bad timing: selling low and buying high. “Investors [typically] modify their investment plan at the most inopportune times,” Nixon says.
She points out that true skill around short-term market timing is extremely rare. Plus, it’s a pricey strategy, as round-turn transaction costs can be as high as 1%, and the tax impact of these short-term trades can add up.
In addition, asset class correlation rises during periods of market volatility – meaning assets that once appeared to have low correlations to one another, and hence were expected to behave differently, now have higher correlations and perform more in sync with other assets in the portfolio. This renders ineffective the common risk-management tool of constructing diversified portfolios of assets with low correlations. Unfortunately, asset class diversification can fail as a risk-management tool just when investors need it most.
One solution is Goals Driven Investing, or properly aligning assets with specific objectives. “We have found that clients who stay the course – a well-charted course – fare the best,” Nixon says. “To the extent that assets are properly aligned with investor goals and aspirations, and that they are matched appropriately in terms of character and duration, investors can stay invested and still sleep at night.”
Investors should have a variety of near-, intermediate- and long-term goals, and align investment strategies appropriately. Near-term goals should match with assets that are safe and liquid, such as high-quality bonds. Investors should assign equity risk only to intermediate- and long-term goals. Doing so provides time for assets to recover value after a market decline so investors do not feel they must sell into market weakness.
Comfort Among Uncertainty
Through the Goals Driven Investing process, the advisor and investor gain clarity around the purpose behind each asset in the portfolio.
“Really understanding why the portfolio is structured as it is and being able to tie assets to a particular and well-articulated goal is extremely comforting during volatile market periods and reduces the desire to react to these periods,” Nixon says. “That enables investors to stick to their plans.”
“Zeroing in on Wealth Management Goals” offers additional information on how investors can set very specific financial and personal goals through Life Driven Wealth Management.