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Riding the volatility wave

Feb 15 2017 14:11
Nic Horn

(iStock)

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The only constant is change”, “the future will surprise” and “investments should never be based on forecasts”. These phrases attempt to describe the world we live in. 

Brexit was a prime example of how the opinion pollsters got it wrong in the UK. And this was followed in quick succession by the pollsters getting it wrong again in the US presidential election. Both these events impacted global bond and equity markets, as well as exchange rates. What’s more, we have a number of significant elections and referendums coming up in Europe in 2017, including the Dutch general election (March) the French presidential election (April/May) and the German federal election (September). With multiculturalism dominating the debate, there is the potential for additional electoral surprises and market instability. 

This uncertainty and volatility keep many investors up at night. But in times like these, it is always worth reminding ourselves of the two key aspects of successful investing: 

Managing our investments – The strategic and tactical measures taken to invest in a variety of assets in order to produce long-term returns in line with one’s goals; and 

Managing our behaviour – The way investors react to a changing investment environment and the decisions they make. Significantly, there is much evidence to suggest that investors are not always as rational as they think they are! 

One of the biggest destroyers of wealth is not the markets, but rather the way in which investors behave during times of uncertainty. While we cannot control investment markets, we can certainly control how we react to them. 

This raises the question of how investors deal with this uncertainty and the resulting market volatility. The answer is relatively simple. Rather than getting carried away, along with all the news channels and “experts” commenting on these markets, it starts with diligent financial planning and, to borrow from Rudyard Kipling, to “keep your head when all about you are losing theirs”. 

By constructing a financial plan that is designed to adapt to volatile markets, implementing it and then actively reviewing but not deviating from that plan midstream, investors can dynamically match their assets and anticipated drawing requirements, thus managing the two critical risks they face, namely volatility and inflation. 

If done correctly, an investor’s exposure to volatility risk can be reduced by including a pool of funds (within a well-diversified portfolio of local and global assets) that is not exposed to market volatility or the exchange rate to provide for their short- and medium-term monthly needs. 

While a strategy incorporating a non-volatile pool of funds reduces the risk of short-term volatility, it unfortunately does not solve the objective of protecting the purchasing power of an investor’s hard-earned savings. It also means that assets that have come under volatility pressure do not have to be sold to provide for immediate income needs. In this way you can protect the growth portion of the portfolio. One of the drawbacks of holding traditional mixed asset type unit trust funds (e.g. balanced funds) is that while they include these non-volatile assets, in drawing from them the fund sells across all asset classes regardless. This does not protect the growth assets.

To guard against inflation, investors need to embrace the opportunities that arise from volatile markets. Therefore, investors will require a second pool of funds through which they can protect the purchasing power of their savings by investing in asset classes that can reliably outpace inflation over time. These growth assets, such as inflation-linked bonds, hedge funds, property and equities, combined in local and global portfolios, will protect investors against inflation. 

However, these investments are inherently volatile and, in order to realise the growth potential, investors need to stay in these markets despite the volatility. This is where investors’ behaviour (response) is critical. 

By following a well-constructed financial plan, investors will know when they will need money from the different fund pools and this gives their asset management team a clear mandate to manage volatility – both as a risk in the short term and to embrace the opportunities it provides to outperform inflation in the longer term with an inflation-plus strategy. In the end volatility is not risk; it is, well, just volatility. 

Although investment principles remain constant, technological breakthroughs and ongoing research enable investment managers to discover additional key principles of wealth management. When better ways of managing money and risks are uncovered and proven to work, it is desirable to adopt those practices leading to enhanced wealth management. This will ultimately ensure that portfolios have the highest probability of achieving investment goals within acceptable levels of risk, in accordance with a financial plan. 

Nic Horn is a certified financial planner and regional head at Citadel. 

This article originally appeared in the 9 February edition of finweek. Buy and download the magazine here.

investment  |  portfolio  |  market risk

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