In recent months, the stock market has
experienced unprecedented volatility.
Many jittery investors, fearful of further
declines, have fled to safer havens. While it
can be tempting to convert stocks and
bonds into cash during times of financial
uncertainty, volatility creates opportunities
to buy stocks that are significantly under-valued.
In order to cope with a volatile market, it is
important to stick to your long-term investment strategy, manage risk through diversification and avoid making rash decisions.
“One needs to be patient in one’s decision-making,” says Alan Cole, president of Cedar
Hill Associates. “Maintain your investment
discipline and don’t deviate solely because
the world doesn’t seem the same as it was a
week or month ago. Investment decisions
should be based on an assessment of fundamental information regarding how the
investment climate will be in the future.”
Smart Business spoke with Cole about
the reasons behind the market’s volatility,
how risk can be managed through diversification and the importance of creating a customized investment strategy.
What are some of the underlying reasons for
the market’s recent volatility?
There are two primary causes: fear and deleveraging. Over the past year or so, the element of fear can be broken down into several different phases. Early on, there was a
concern over the impact of the declining
housing market on the stability of the financial system. In September, the failures of
Lehman Brothers, Fannie Mae, Freddie Mac
and AIG led to a genuine concern that the
entire financial system was going to crumble because of the interconnectivity
amongst the major banks. October witnessed governments worldwide stepping in
to allay much of the concern over the financial system crumbling. More recently the
market is sorting out the economic consequences of tight credit markets, rising
unemployment and the worldwide economic environment. Everybody recognizes that
we’re in a severe recession. The question is,
how long will it last and how bad will it be?
The other reason for the volatility is the deleveraging going on in the system. This was initially selling by the banks to help fortify
their balance sheets, followed by institutional selling — primarily at hedge funds —
which caused a lot of the wide swings in the
markets in November and December.
What strategies should be deployed when
investing in a volatile market?
Regardless of what stage of the economic
cycle you are in — whether it’s a good time
or bad — risk management remains an
important continuous process. Part of it is
being prepared through diversification.
Entering a volatile market with the flexibility to take advantage of opportunities is a
preferable position to just riding out the
storm. It’s preferable both from an asset
preservation as well as a psychological perspective. In a volatile market, many
investors experience panic and fear and do
not make sound decisions.
How can one best strike a balance between
risk and return?
We like to focus on risk — and how to
best diversify risk — first and foremost,
rather than just looking at the opportunity
for return. Different investments have different risks. Diversifying investments to
include both traditional and nontraditional
asset classes can help lower overall risk as
measured by volatility. Less risk doesn’t
necessarily mean less return. If you properly diversify your risks, you can both achieve
an attractive return and lower the portfolio
risk at the same time.
How can risk be managed through diversification?
Understanding what diversification really
is and how to achieve diversification is the
first major hurdle. Many firms believe diversification can be accomplished by investing
in different sectors of the equity market, be
it value managers versus growth managers,
large companies versus small companies or
domestic stocks versus international
stocks. Our view is this approach isn’t really
staying true to diversification because each
of these strategies maintains a key common
element: the risk that equity markets move
in tandem and decline.
From our perspective, diversification has
to include other investment strategies.
Typically, people look at bonds as diversification from equities. But for much of 2008,
corporate and municipal bonds declined at
the same time equities were falling. Our
approach is to diversify not only with bonds
and stocks but also, when appropriate, to
incorporate other nontraditional asset classes such as real estate, energy and private
equity.
What are the benefits of creating a customized investment strategy?
Some larger firms focus on allocation
models that classify clients into certain
generic categories such as appreciation-oriented or income-oriented. This approach
might be very efficient for the investment
firm when dealing with a large number of
clients, but it is less likely to meet each
client’s specific needs. A customized
approach, however, better serves each
client’s circumstances, as allocations can be
crafted to address specific income, liquidity
and tax scenarios.
ALAN COLE is president of Cedar Hill Associates. Reach him at (312) 445-2920 or [email protected].
