Last summer, I was traveling with my family in central Florida—part business, part pleasure. On one particular day, my wife and I loaded up the kids and headed to Busch Gardens in Tampa. If you have ever visited Busch Gardens then you know there is one particularly ominous roller-coaster that dwarfs all others—SheiKra™ is a red monster of twisting metal and a 200 foot vertical drop that produces speed in excess of 70 mph! Let’s put it this way—not for the faint of heart.
This is all well and good if you love the adrenaline (and stomach discomfort) produced by roller-coasters. But, what if we aren’t talking about roller-coasters; instead the value of your investments? What if that 200 foot drop occurred within earshot of retirement? Not so thrilling. Recent years have produced just such a roller-coaster for Baby Boomers—many on the cusp of retirement.
The investment world equivalent of a “roller-coaster” is price volatility—price swings up and down sometimes in rapid progression. If you are approaching retirement and have specific financial targets, you need to hit its easy to imagine the problems volatility can create. So, the big question becomes—what can we do?
First; I think it’s important to note that some volatility should be expected—markets are not static. Price movement is necessary for investments to grow. And, if history provides any insight this has worked to our advantage over time. So, what we are really talking about here is not the elimination of volatility but perhaps its containment. In other words, we don’t swap the roller-coaster for a stroll on a country road but instead aim to change it into a “kiddie-coaster”. That’s a good conceptual description but let’s get down to brass tacks. In my mind there are several strategies for reducing volatility.
The first concept for managing volatility is good old fashion asset allocation. Or, how many types of investments are held (think stocks, bonds, currency, commodities, domestic, global, etc.) and at what concentration at any given time in the market cycle. Different asset types and even different individual securities have unique volatility measures. By balancing higher volatility asset types with lower volatility asset types, the investor hopes to reduce overall portfolio volatility.
The second strategy has to do with indexing. The idea of index investing (think exchange traded products) has been around for over two decades, but has really come into its own in recent years. There are a number of academics and finance professionals that are working right now to build the proverbial “better mouse trap” when it comes to indexing and volatility. For example, the S&P 500 is an index made up of the 500 largest companies in the US (determined by market capitalization or the value of all outstanding shares of stock). Indexes like the S&P 500 are market weighted—which means that larger market cap companies determine a greater share of the indexes price. While market weighting is neither good nor bad, it does not address the issue of volatility. Why not, instead, build an index whose weightings are determined by the price swings (volatility) of the investments it is measuring? Perhaps you give a greater weighting to less volatile investments. These are the ideas being fleshed out today in the world of finance.
There are additional and vastly more complex strategies for reducing volatility. Many of these strategies are only appropriate for certain investors and in certain circumstances. Because of the complexity, you should review your specific needs with a financial advisor.
Regardless of the approach, I believe it is important to think about measure and aim to reduce big swings in the value of investment portfolios. This is particularly true if you are on approach to retirement. When it comes to investing let’s plan to leave the roller-coasters to family vacation!