Volatility Is Part of Investing. The Question Is How You Prepare for It.

With the recent volatility in markets and interest rates moving higher, I’ve been getting the same question from a number of clients:

What should we be doing with our portfolios?

My answer starts with something very simple. There will always be something to worry about. I’ve been doing this for 26 years. Throughout that entire period, someone could always build a compelling argument for why markets were about to move significantly higher, and someone else could build an equally compelling argument for why they were about to collapse.

Today, the concerns are higher interest rates, oil prices, inflation, geopolitical uncertainty and the possibility of another exogenous shock. Tomorrow, it will be something different. That doesn’t mean we ignore risk. It means we manage it intelligently.

There Are Two Ways to Reduce Equity Risk

Suppose you have a portfolio with 60% invested in equities and decide that you want to reduce your exposure.

The first option is straightforward: sell stocks. You might reduce your equity allocation from 60% to 50%. You have immediately lowered your market exposure. The problem, particularly in a taxable account with significant embedded gains, is that selling appreciated securities can create a capital gains tax liability. You have reduced your market risk, but potentially incurred a meaningful tax cost in the process.

The second option is to hedge a portion of the equity portfolio. Rather than selling stocks, you can purchase downside protection on part of the portfolio. For example, you might hedge approximately one third of your equity exposure.

Hedging isn’t free. Depending on the market environment, duration, strike price and structure of the hedge, protection has a cost. In certain structures, that cost might be approximately 1.5% to 2% of the amount being hedged, although the actual cost can vary significantly.

Think about it the same way you think about insurance. You insure your house. You insure your car. You don’t buy insurance because you expect your house to burn down tomorrow. You buy it because there are certain risks you are unwilling to bear completely on your own.

Portfolio hedging can serve a similar purpose. If interest rates move materially higher, oil prices surge, inflation reaccelerates or an unforeseen shock causes a significant market decline, the hedge is designed to offset some of the losses in the equity portfolio. And unlike simply selling stocks, you maintain your underlying equity ownership and therefore retain participation in the market’s upside, less the cost and effects of the hedge. That can be particularly valuable for investors with large, embedded capital gains who don’t want a short-term concern about markets to force a long-term tax decision.

But Hedging Isn’t the Foundation of Risk Management

The most important risk management decision isn’t whether you buy a put option today. It’s how you built the portfolio in the first place. I believe a properly constructed portfolio starts with true diversification.

Diversification doesn’t simply mean owning a lot of different investments. It means owning investments whose return streams don’t all behave exactly the same way.

When one part of the portfolio zigs, you want something else capable of zagging. That can mean combining public equities with fixed income, private investments, real estate and carefully selected alternative or hedge strategies. The objective isn’t to eliminate risk. That’s impossible. The objective is to avoid having every part of your wealth dependent upon the same economic outcome.

The second component is quality. If you’re going to own risk assets, and long-term investors generally need risk assets to generate meaningful real returns, then own high-quality ones. Whether we’re talking about public equities, private equity, private credit, private real estate or multi strategy alternative managers, we want to own investments that we believe have the financial strength, underlying economics and management necessary to remain durable through difficult periods.

Volatility Is the Price of Admission

This may be the most important thing investors need to understand:

Volatility is part of investing.

There is no way around it. If you’re going to own equities and other risk assets for the next 20, 30 or 40 years, you should expect periods when stocks decline 10%. You should expect bear markets when they decline 20% or more. And over a lifetime of investing, you should expect periods that feel considerably worse than that.

That shouldn’t come as a surprise. It should be incorporated into your financial plan from day one. Before you invest, you should understand your risk tolerance, liquidity requirements, time horizon and the potential drawdowns associated with your portfolio. And then you need to ask yourself a very important question:

Can I live with that?

Because the biggest risk isn’t always the market going down. Sometimes the biggest risk is how the investor reacts when it does. Selling after a significant decline, sitting in cash waiting for the “right time” to get back in, chasing markets after they’ve already recovered. Those decisions can do far more damage to a long-term financial plan than normal market volatility. Your portfolio should therefore be constructed so that you can remain invested through difficult periods without abandoning your strategy at precisely the wrong time.

What About 5% or 6% Treasuries?

When Treasury yields approach 5%, 5.5% or potentially even 6%, I understand why investors look at them and say:

Why should I take any risk?

Treasuries can play an important role in a portfolio. They can provide income, liquidity and diversification, and U.S. Treasury securities have extremely low credit risk. But investors shouldn’t confuse a high nominal yield with a high real, after tax return.

If you earn 5% to 6%, pay taxes on that income and then account for inflation, the increase in your actual purchasing power can be considerably smaller. That’s the number that ultimately matters. For investors with long time horizons, the objective isn’t simply to avoid volatility. It’s to grow purchasing power over decades. Historically, accepting carefully selected investment risk has offered the potential for substantially higher long-term returns than simply holding risk free assets, although those higher returns come with greater volatility and no guarantee of success.

Build the Portfolio Before the Storm

The time to decide how much risk you can tolerate isn’t after markets become volatile. It’s before.

Build a diversified portfolio. Own high-quality investments. Maintain sufficient liquidity. Understand your downside. Use hedging selectively when the economics and circumstances make sense. And most importantly, accept that volatility isn’t evidence that your investment plan has stopped working.

Volatility is part of the plan.

The goal isn’t to build a portfolio that never goes down. The goal is to build a portfolio that allows you to stay invested, protect your long-term objectives and continue compounding wealth through whatever markets throw at you next.

Palumbo Wealth Management (PWM) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where PWM and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at www.palumbowm.com.

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

All information has been obtained from sources believed to be dependable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

All information has been obtained from sources believed to be dependable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.

The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that no such statements are guarantees of any future performance, and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

Past performance is no guarantee of future returns.

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By: Adam