It’s difficult to forget the market events we’ve experienced over the past few years. Market volatility has had a dramatic effect on clients, both emotionally and financially. We have seen trillions of dollars of wealth lost and record outflows from equity mutual funds into cash and fixed investments that are earning close to zero percent. Investors have been making emotional decisions and indiscriminately selling their holdings to try and prevent further losses rather than staying the course. This can play a significant role in reducing the long-term performance of a portfolio.
While the first quarter of 2012 was marked by reduced volatility, and we saw strong equity market returns, investors should not be lulled into a false sense of security. Market volatility will continue to persist, at least in the near future. In this age of instant and constant communication, even positive news can lead investors to make irrational investment decisions. In addition, investors’ confidence is low and they are unsure if this is a good buying opportunity or if they should head for “safer,” more stable investments.
Investor behavior is often illustrated by the Emotional Cycle of Investing1. While the chart below shows how successful investors recognize points of risk and capitalize on these opportunities, many investors follow the path of emotional investing rather closely by buying high and selling low. This is the opposite of what a successful investment strategy should attempt to do. Many investors are currently at the Despondency/Depression parts of the cycle. Unfortunately, many of these same investors are sitting on the sidelines, which is not a viable long-term strategy.
Where do we go from here?
You can help your clients overcome the Emotional Cycle of Investing by working with them to create a portfolio that can help weather the ups and downs of the markets through proper diversification and asset allocation. This helps balance risk and reward, while also focusing on clients’ goals and investment time horizon.
Asset allocation is not new. A core premise is that three main asset classes–equities, fixed income and cash–have different risk and return characteristics, and behave differently from each other over time. By blending them together, you can get the best attributes of each one. The Callan chart below shows the performance of indexes over the past 10 years, and the 10-year average. While you can’t buy into these indexes, it’s important to see how they performed, and how a diversified portfolio produced a better overall result2.
Over the past decade, there has been an important trend in asset allocation–the use of alternative asset classes. Alternative assets have low correlation with traditional asset classes. Combining alternative asset classes with traditional equities and fixed income investments can dampen volatility and help smooth out the ride, giving investors the potential for greater upside and reduced downside. In addition, the level of diversification is increased, and investors gain access to more sophisticated investment styles. Some alternative investments strategies are real return strategies–REITs, TIPS, private equity and natural resources. Others are absolute return strategies–options, futures, derivatives and currency hedges.
Alternative investments are one of the fastest growing asset classes. In particular, endowment portfolios have turned to alternative investments, since they look to avoid volatility due to the need for steady income streams.
Keep in mind, however, that asset allocation does not guarantee a profit or protect against a loss. Application of diversification does not ensure safety of principal or interest. It is possible to lose money by investing in securities.
Risk management with variable annuities
Market volatility has also led to variable annuities playing an increasingly important role in helping individual investors achieve a secure retirement. Due to the increasing want and need for protection, variable annuity assets have grown tremendously over the last decade. The protection is in the form of a guaranteed living benefit that, for an additional fee, provides clients with income they cannot outlive. In addition, clients gain access to professionally managed investment portfolios. This helps investors resist the urge to buy high and sell low, while also addressing a need.
There are risks associated with these guarantees that the insurance company must manage. One of the most common ways is to require that a minimum amount be allocated to fixed income investments. As a variation, some companies require that contract holders invest in asset allocation models. However, as the asset management industry evolves, insurance companies are transitioning to methods of volatility management that are embedded within the asset allocation model. One method involves establishing a target volatility for the portfolio. The asset allocator will shift money out of equities during times of heightened volatility and back into equities when volatility falls. However, it can also lead to challenges with accurately timing the markets. And it does not allow for a customizable experience for each contract holder. All investors will experience the exact same ups and downs, regardless of their unique circumstances.
Another method uses a predetermined mathematical formula to manage volatility at the individual account value. With this method, assets are still moved out of equities during market downturns. However, there is no emotion involved with the decisions to transfer assets. It is based on the difference between the actual account value and the guaranteed value. When the gap reaches certain trigger points, funds are transferred from variable investments to a more conservative fixed income portfolio. When that gap narrows, the transfers go back into the variable investments. This approach aims to help protect account values in adverse markets, while still enabling participation in market gains, thus offering a distinctive and sustainable value proposition for both clients and shareholders.
A final note: As annuity companies also continue to try to strive for innovation, many have begun to offer alternative asset allocation portfolios as investment options. Examples would include:
- A combination of traditional equities and fixed income, ETFs and real return strategies;
- A range of absolute return-oriented investments, with a focus on innovative fixed income strategies; and
- An endowment-like strategy, including exposure to commodities, global infrastructure and currencies.
As mentioned above, alternative assets give clients exposure to investments they may not be able to access on their own…inside their variable annuity.
Volatility is here to stay. You can help manage it by crafting a well-diversified portfolio, potentially including alternative investments. You can also consider a variable annuity as a way to provide guaranteed retirement income. This helps clients manage risk, as they are transferring that risk to the insurance company.
1Russell Investments, 2008
2Asset classes represented in diversified portfolio chart:
International – MSCI EAFE Index
Large Cap Growth – Russell 1000 Growth Index
Large Cap Value – Russell 1000 Value Index
Small/Mid-Cap – Russell 2500 Index
Bonds – Barclays Capital U.S. Aggregate Bond Index
Global Bonds – JP Morgan Global Government Bond Index
REITs – FTSE NAREIT All REITs Index