Our number-one tool in the battle against the meteorologist is the thermostat. The temperature outside may be 14, 50 or 98 degrees, but this magical control panel lets us live in a perpetual comfort zone of 68 to 72; not too hot and not too cold.
What does the weather have to do with investing? Well, investment returns are just as volatile as temperatures and are much less predictable. Wild swings in returns take many investors far beyond their personal comfort zones. Over the long run a typical U.S. stock index, such as the S&P 500, will gain around 10 percent a year, an average reached by weaving together many years of big gains and agonizing losses as well as considerable periods of little or no change.
Most of us are comfortable and satisfied with that 10 percent annual return. Based on decades of S&P 500 data, actual returns register many more years outside of a 5 to 15 percent annual return range, which would be a reasonable comfort zone, than within it. And often we will be far beyond the comfort boundaries; about one-third of the time the actual annual return has been a gain of more than 30 percent or a loss of more than 10 percent. That's a lot of discomfort just to reach the average.
How does traditional investing address this problem? It doesn't. It says buy and hold and don't worry about the annual fluctuations, even big declines. Under the stress of uncertainty, we become not just uneasy but also more likely to make hasty or irrational decisions. We abandon long-term strategies. During sharp pullbacks, we give up on getting back to the average. We sell low and retreat.
If only we could regulate volatility like we regulate the temperature of our home or office. Well, thanks to newly available tools, we can. We call our comfort-seeking method the Portfolio Thermostat. The Portfolio Thermostat approach responds to a reality that traditional investing tends to ignore—that market volatility varies considerably over time. When the markets act like a careening roller coaster, the thermostat directs us to reduce the inherent volatility of our portfolio; to turn down the temperature—by moving some assets to cash or other low-volatility vehicles. At other times, when the ride is smooth, the thermostat guides us to add more volatile elements to the portfolio. At all times, the goal is to keep volatility within a predictable, and personal, comfort zone.