Protection From Volatile Markets

On 04/12/2011, in Investment Strategies, by Jordan Wilson

A potentially legitimate concern about buy and hold investing is that it underperforms active management during fluctuating and bear markets.

Today we will review how to protect your wealth during periods of market volatility when using buy and hold.

A few points come from my general long-term investment philosophy. One that attempts to build such safeguards automatically into one’s portfolio.

A few other thoughts will involve tweaks to the traditional buy and hold methodology. Tweaks that hopefully will improve on its performance. 

Long Time Horizon

One’s investment horizon should be long-term.

Certainly if you look at 3-5 year periods, you can find numerous examples where active management is better. But I think investing should take a longer time frame.

In last post’s NASDAQ example, we saw that it took about 7.5 years for the market to recover from the decreases subsequent to December, 1972.

Active management may have performed better. I say “may” because who knows. Would you have bought and sold at the right times? Or would you have compounded your losses through even worse timed trading?

What I do know is that if you took a longer term perspective, a buy and hold strategy would have shown positive returns. Had you held until April 1990, your annual return would have been 6.8%. Until April 2000, annual returns of 13.0%. Until April 2011, annual returns of about 8.2%.

Perhaps an active approach would have brought better results. Perhaps not.

I prefer avoiding “perhaps.”

Asset Allocation

Now some of you reading this are thinking, “Hey, I don’t have 20 or 30 years to invest. What can I do?”

If you recall our discussions on investor profiles and investment policy statements, you realize that your asset allocation is geared, in part, to the phase in your life cycle.

Over the course of your life cycle and ever evolving investor profile, the amounts that you allocate to cash, fixed income, and common shares will change. As you near retirement, you will be shifting more of your wealth into lower risk (i.e., less volatile) assets.

This will also address problems with general market volatility.

Diversified Portfolios

I have previously recommended investing in diversified portfolios.

A diversified portfolio prevents you from having all your eggs in one basket. Whether that be a specific asset within a market or an individual market within the whole spectrum of investment options.

If you have 50% of your wealth in shares of Credit Suisse, your portfolio returns will reflect the results from Credit Suisse to a significant degree.

Or if you have invested 80% of your assets in the U.S. equity markets, your portfolio will mirror the ups and downs of the U.S. equity markets.

Either of these may generate positive returns during bull markets, but they will create problems during down periods.

However, by diversifying throughout various asset classes, you can spread the risk of any one market throughout multiple asset classes.

Not Just Diversified, But Well-Diversified

A diversified portfolio is a collection of different assets.

A well-diversified portfolio reflects a proper mix of assets, such that you minimize asset correlations.

If you recall our discussions on asset correlations, holding assets with low or negative correlations will provide some built in protection against market volatility. As the value of one asset rises, the value of a negatively correlated asset should decline.

While you may give up some potential return by never being fully invested in rising markets, you will also never be fully exposed to falling markets.

This offers a defence against market downturns.

Dollar Cost Averaging

Another strategy I have espoused is dollar cost averaging (DCA).

I think this also provides some protection against market volatility.

If you believe over the long run that appreciating assets do, in fact, appreciate, then down markets provide buying opportunities.

Yes, it took the NASDAQ until April 1980 to fully recover from the crashes of the 1970s. But it did recover and subsequently thrive in the 1980s. Had you continued to accumulate holdings in the NASDAQ under DCA, you would have done very well over time.

We have covered the above points previously in detail. I reiterate them here to show how we have already take steps to protect our portfolios from legitimate potential problems with employing a buy and hold strategy.

Nest time, we will look at tactics we have not previously discussed.


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