Articles & Interviews

Articles & Interviews

Set Your Portfolio Thermostat for Comfortable Investing

You sometimes hear the comment: "Everyone complains about the weather, but no one does anything about it." It's a cute saying, but it's not really true. We actually do a lot about it. Here in the Midwest, where the temperature can easily touch zero and one-hundred degrees in the same year, we rely on our furnaces, air conditioners, swimsuits and fuzzy slippers to keep us comfortable.

Of course, 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 Indiana thermometer readings, and much less predictable. Markets surge and stumble, rally and tumble. These wild swings in returns take many investors far beyond their personal comfort zones. Investing can be, at times, a scary, stressful journey.

There’s No Such Thing as Average

We know that—over the long run—a typical U.S. stock portfolio, such as the S&P 500, will gain around 10 percent a year. That’s the average, but it’s 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 pretty comfortable and satisfied with that 10 percent annual return. Even a reasonable variation around that average, say a range of 5 to 15 percent, sounds just fine. If investors could lock in a portfolio that averaged a 10 percent annual return without ever venturing beyond the 5 to 15 percent comfort zone, most would do so.

Unfortunately, that’s not how it works. Based on decades of S&P 500 data, we know that actual returns will register many more years outside of the 5 to 15 percent annual return range 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. That’s great strategy for a robot, but people don’t react like robots. 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.

The Portfolio Thermostat™

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.

Of course, the thermostat in your home can only do its magic if it knows the actual inside temperature. The same applies to the Portfolio Thermostat. We need an accurate way to measure the volatility of an entire portfolio and the securities within it. Today’s technology provides that ability in the form of RiskGrades®.

RiskGrades® are clear, current measures of the volatility of almost any security, from individual domestic stocks to international bond issues. Provided by RiskMetrics, an innovative company whose leading shareholders include J.P. Morgan and Reuters, these ratings allow comparisons of risk, enabling institutions and investors to tweak their holdings to maintain a total portfolio risk level that’s within their respective comfort zones.

This is another clear example of information technology allowing investors to rethink so-called "rules" of traditional investing. I encourage you to think about your own investing comfort zone and set your thermostat to stay in within that zone.

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