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Portfolio Volatility – Do you know how much risk is in your portfolio?

Portfolio Volatility – Do you know how much risk is in your portfolio?

June 09, 2018
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Many times, we are asked to name the biggest issue we find when we review a new portfolio. It is difficult to pinpoint one and label it the “biggest,” but one that frequently appears is downside risk.  While most people know how their portfolio performs when equity markets are rising, they often don’t consider what would happen during a correction or bear market.  Portfolios that are built attempting to match or exceed equity market returns in a bull market can often match or exceed the negative return when the markets turn down.

There are many factors to consider when determining the appropriate amount of risk in a portfolio -- time horizon, age and liquidity, to name a few. Maybe one of the most important is how much return you need to obtain.  By performing a detailed and comprehensive plan, a proper return target can be defined to help determine the appropriate amount of risk for your specific situation.

In addition, I would recommend stress testing a portfolio to see what the expected drawdown could be in an equity market correction. Drawdown is the amount a portfolio would be expected to lose for a particular amount of loss in the equity markets.  For a retired client this is even more critical.  Imagine you had a portfolio that could lose 30% or more in a year while you were also distributing 4% of the assets for living expenses.  That could erode a significant part of the portfolio during a period when you are no longer saving money and using your portfolio for living expenses.  If that is more loss than a person can accept, then the portfolio is too aggressive.

Finally, volatility and the sequence of returns materially affect the value of a portfolio. In most cases, two portfolios with the same average rate of return, but significantly different amounts of volatility/risk, will have different ending values over a given period. Managing volatility and adapting to the sequencing of returns is even more important when approaching or entering a distribution phase such as retirement.

Investing is much easier when markets are cooperating and moving up. The true test of a portfolio is how it holds up when markets aren’t so cooperative.  If you haven’t already, you should consider having both a comprehensive review of your retirement plan and a stress test performed on your portfolio before a correction occurs.