Investor Lessons From the Front Line

While we expect volatility will remain a significant force in 2009, we continue to believe that uncertainty creates opportunity

For many investors, last year’s sudden and severe re-emergence of volatility in the markets was a rude awakening. Even some otherwise stoic investors found the degree of volatility, which was without recent precedent, to be unsettling. Although still well above historically normal levels, the degree of volatility has fallen dramatically since peaking last November. Concurrent with that decline have been signs that the credit markets may be thawing. While we don’t believe that this is a clear signal of a return to normalcy, as we expect that the markets will remain choppy in 2009, this positive downward trend in volatility should not be overlooked or dismissed. The change has been incremental, but positive. 

The Importance of Remaining Anchored

It’s not uncommon for investors to re-evaluate their risk tolerance over the course of time. Changing goals, resources, needs, and unexpected “shocks” necessitate the periodic re-evaluation of one’s investment plan and perhaps some fine tuning as a result. At times, market conditions themselves may spur individuals to consider changes to their portfolios. Turmoil tends to stoke fear and a desire to reduce risk (or perhaps even abandon a strategy altogether), while strong returns tend to contribute to exuberance and a desire to assume more risk, often at the wrong time.

That constant pull between fear and greed over the long term is best addressed by remaining anchored to an investment policy. However, individuals that developed their investment policy during a relatively low volatility period may have overestimated their tolerance for risk. The year 2008 resulted in losses that would have been considered by many professionals as “worst-case scenarios,” as all risk-oriented assets declined significantly in value. Having experienced this firsthand (and not just theoretically), investors may find themselves re-evaluating their personal tolerance for risk.

As there’s no “right” answer to the asset allocation question, we recommend that any investor exercise prudence in the decision-making process. Investors should avoid taking more risk than that with which they’re comfortable. However, thoroughly understanding the impact of significant portfolio changes on the probability of reaching one’s goals is essential. For most investors, finding a reasonable balance between managing risk and maintaining sufficient exposure to generate needed return is a critical decision, but one that must be made and re-evaluated periodically. It’s unlikely that “risk-free” returns currently offered by Treasury bills will ultimately provide an adequate rate of return for most investors, given their desired spending levels. 

Ensure Adequate Liquidity

A second potential takeaway for investors is the reinforcement of the need to maintain adequate liquidity to meet their ongoing cash flow requirements as well as provide a source of funds in the event of an unforeseen emergency. Although bonds rebounded in December as tensions in the credit markets eased somewhat and investors began nibbling at riskier assets again, many areas of the bond market faltered severely during the fourth quarter. During the peak of the crisis, Treasuries (along with Treasury-backed agency mortgages) rallied, while high quality municipals, credits, and non-agency mortgages all stumbled. Even so, these bonds provided a cushion against steeper losses in higher risk assets such as stocks.

While bonds remain solid diversifiers and will generally hold their value better than riskier assets during periods of market turmoil, they’re not an ideal alternative for a traditional cash reserve. Investors should carefully evaluate their cash needs to ensure that they have adequate liquidity to navigate any storm. In doing so, it’s critical that both expected outlays and the potential for unforeseen events be considered. The result may be a need to cover even a year or more of expenses, sufficient to ride out the current market tumult. 

So Much for Crystal Balls

The recent dislocations in the market again reinforced the importance of diversification. Clearly, most investments lost ground in the past year, although the degree of loss was far from uniform. When uncertainty is high, the potential benefits associated with holding a diversified portfolio increase. As the saying goes, “Hindsight is 20/20.” It can be easy to look back and find the few “gems” that performed well, although such bright spots in a gloomy market weren’t likely as obvious before they outperformed. Unfortunately, crystal balls aren’t particularly effective, especially when economic conditions are as murky as they are today. When risk is high and uncertainty reigns, maintaining adequate diversification remains a prudent way to protect against the potentially extreme downside risk that can accompany a concentrated portfolio.

Looking forward, we continue to expect a challenging environment for investors in 2009. Much is yet to be resolved before the U.S. or global economy is likely to rebound. While volatility has subsided to a degree, we believe that significant concerns related to the housing and credit markets remain unsettled. Until these intertwined systemic problems are adequately addressed, we expect that the economy will struggle to return to a positive growth trend. Typically, however, the markets will anticipate this recovery well in advance of its actual arrival. 

Uncertainty Creates Opportunity

While we remain wary of the immediate economic outlook, we continue to believe that uncertainty creates opportunity. The massive sell off in risk assets has resulted in some areas of the market experiencing greater dislocations than others, although these may not be measured solely by relative performance. While it’s difficult to think long term in such an environment, we anticipate that patient investors will be rewarded for investing their capital in areas of the market that provide attractive, long-term return potential. At this stage, we believe there are likely more of these opportunities now than when this bear market began.