|Discipline:||Decrease the likelihood of making emotional decisions during periods of market turbulence.|
|Recovery:||Minimize the time required to recover from portfolio drawdowns by limiting or eliminating losses during bear markets.|
|Preservation:||Reduce portfolio volatility to lower the risk of a devastating financial loss, one that could derail retirement objectives.|
|Income:||Maintain a sustainable level of portfolio withdrawals for cash flow and retirement income needs.|
J.P. Morgan was once asked for a stock-market forecast and famously replied: “It will fluctuate.” Perhaps no other market prediction has endured the test of time more than the famous banker’s observation. Volatility (or fluctuation) is present in all financial markets; it reflects the uncertainty associated with investor’s expectations over time. Unfortunately the existence of volatility is a double-edged sword – while it can create opportunity it can also create financial tragedy under the wrong circumstances. Managing volatility is especially important for investors that are near retirement or are already depending on their portfolios to generate a sustainable income stream.
One of the standard principles of finance is that risk or volatility is inextricably linked to returns. Presumably, higher risk equals higher reward. From an asset class perspective this is generally true. For example, more volatile assets such as equities have higher long-term returns than bonds. Of course the problem is that equities can have heart-wrenching drawdowns like in 2008. As a consequence, buy and hold investors must accept uncertainty as a fact of life in order to be well-compensated. However, passive investing is not as easy as it sounds – its allure comes from looking at theoretical historical returns that investors cannot seem to ever be able to capture in reality. This is because high levels of volatility can make investors very emotional and cause them to make poor investment decisions. Investors in retirement arguably have even stronger emotional reactions to the markets because they no longer have the cushion of a working salary. The research shows that these behavioral biases cause investors to substantially underperform passive benchmarks (see Dalbar). As a consequence, a passive buy and hold approach is difficult to execute successfully in practice.