Record breaking is the only way to describe this wild ride! Did you make it back or did you get off along the way?
Market volatility – risk – is a way to describe the ups and downs of the market. Market uncertainty is the emotional measure. Significant market uncertainty has put “risk” in a personal context …one that every investor has taken measure of.
The million dollar question is; “Did you react to market uncertainty and change your investment holdings?”
If you did, you weren’t alone. New York Stock Exchange daily share volume – number of shares that are traded – not only broke the four billion share record, it also broke the five billion share record. This means a whole lot of decisions were made during market uncertainty.
Investors need to think about investing as a process over time. Not a decision that needs to be made at some moment in time. A mistake that most investors make is in reaction to volatility. They think it creates an investment “to-do” item.
The best way to avoid hasty decisions is with a highly diversified investment approach. We call this approach smart asset allocation. It is constructing a portfolio that gives you the highest return with the least risk. It can be done with a technique called mean variance optimization, which is close enough to rocket science to have won its creator, Harry Markowitz, a Nobel Prize in 1990.
The basic concept of Mr. Markowitz’s study was to combine assets with low correlation – when one asset is up, the other is down – into an investment portfolio. Treasury bonds – fixed income – are considered less risky than stock – equity. Yet equity has the potential for higher gain.
The result of the basic concept is not so intuitive. Combining a little equity with fixed income, results in the potential for higher return with less risk. However, as equity becomes a greater percentage of the investment, the risk is higher and the potential return higher.
Mean variance optimization is the process of combining asset classes – equities and fixed income – in an optimal amount to achieve an expected return for a mathematically measured level of risk – standard deviation. The resulting optimal investment portfolios are defined along a risk/reward curve – efficient frontier.
We have developed portfolios that represent this knowledge – AB Building Block Portfolios. Building Block Portfolio 6 has 66% fixed income and would be at the “low risk/low return” end of the efficient frontier. Building Block 14 has 92% equity and would be at the “high risk/high return” end of the efficient frontier.
One of the key benefits of this method is the investor determines the “ride”. Since we have experienced a high degree of market uncertainty this year, it has brought more focus on risk. We have a tool which provides a historical perspective and is a great pictorial of the “ride”. AB Building Block Portfolio 6 is very smooth, as opposed to AB Building Block Portfolio 14 which is more volatile. http://assetbuilder.com/swf/growthofwealth/assetbuildergrowthofwealth.html
NO REACTIVE DECISIONS REQUIRED is the label for this smart buy-and-hold investment method.
The graphs are not sufficient to formulate an investment decision.
The AssetBuilder (AB) Building Blocks constructed portfolios have been developed based on historical performance of the standard asset classes (stocks, bonds and cash) and of representative index fund products,including Dimensional Fund Advisors (DFA) funds, as well as other concepts of Modern Portfolio Theory.
The graphs above are representative of a compilation of DFA funds to achieve a probabilistic return for a measured level of risk.