In order to understand how to manage volatility, I first need to explain what a majority of the financial industry preaches about it.
First, it’s based on something called Modern Portfolio Theory, which is based on some very good research. The problem is that the findings of that research are grossly misinterpreted and misapplied throughout the financial industry.
Second, it’s assumptions are based on historical data from the past 70 to 100 years of investment returns. This is problematic because most people don’t have 70-100 years before they will need to access their money, and anything can happen over any given, shorter period of time.
Third, it has two main components: Asset Allocation & Diversification
Asset allocation is what kinds of assets you have – stocks, bonds, and cash. Diversification is how many different investments of each kind you have; not having all your eggs in one basket.
Fourth is the idea that managing volatility is largely a passive activity. Active management is limited to the following: Regularly rebalancing back to the agreed upon asset allocation. Occasionally selling one or more investments of a certain type (stocks, bonds, or cash) and buying another of the same type, but keeping the overall asset allocation intact.
Fifth is an extension of #4: the idea of never responding/reacting to what’s going on in the market. This is why whenever extreme volatility occurs, you’re told to ignore it because investing is a long-term process, and everything eventually recovers. Sound familiar?
You’ve been told that Asset Allocation and Diversification are all you need to manage volatility. Based on the past twenty years, I simply don’t believe that’s true. Both asset allocation and diversification are important, but they are simply not enough – especially when it comes to retirement.
Three of the most common allocations I have seen retirees have who are either working with an advisor, or trying to do things on their own, resulted in losses anywhere from 22% to 34% in 2008. In order to get back to even, these portfolios would have had to earn anywhere from 28% to 54% – not including any income they might have needed along the way.
The status quo doesn’t work. So then how SHOULD you manage volatility? Well, just like you manage all the other types of risk in your life – with a combination of guarantees and expertise.
Take driving your car, for instance. Let’s face it, driving a car is risky business. 1.25 million people die in traffic accidents each year.
So we manage that risk in two ways: The first way is with guarantees.
Your automobile and medical insurance provide guarantees that if something does go wrong, the insurance company will cover the cost of fixing your vehicle and/or your physical body. You basically transfer that risk to a third party for some relatively small cost.
The second way is with some level of expertise.
You try your best to drive safely, right? This means wearing a seatbelt, staying focused, not being distracted or driving too fast or recklessly, etc. Driving safely is an example of using your expertise of driving a car to manage risk.
So you should do the exact same thing with your retirement income.
Use strategies at the bottom level of your cash flow pyramid to provide income stability. In fact, part of my process is to ask every one of my clients how much of their retirement income they would like to see guaranteed.
Then, for the remainder of your retirement income needs, you should seek out an expert to take a very “hands on” approach to managing volatility when things turn ugly. I refer to these highly skilled managers as our “Sullys”.
Sully, or Captain Sullivan, was the pilot who landed the aircraft in the Hudson river when both engines died, saving everyone on board. He didn’t have training in that specific scenario, nor was he able to predict it. Instead, he relied on his decades of experience, assessed the situation and used his expertise to respond wisely.
The outcome wasn’t guaranteed, but it was greatly enhanced by having him behind the stick rather than some brand new pilot with virtually no experience or track record. The problem, of course, is that you can’t change pilots in the middle of a crisis situation. So you better have a Sully in the cockpit at all times – because you never know when you’ll need him.
When it comes to asset management, the key is to employ an experienced team of experts with a proven track record of managing volatility when times get tough, rather than simply closing your eyes when things get ugly and hoping everything will work out in the long run.
So why have you always been told the opposite? The financial industry understandably wants you 100% invested all the time. It’s never in their best interest to encourage you to sell your stocks and bonds, for instance, and go to cash. Also, most people, quite honestly, don’t have the expertise. Just like most pilots couldn’t have done what Sully did.
But the truth is that the Sullys of the world do exist. And so do great, defensively-minded managers. You just have to find them. That’s what we’ve spent the last 20 years doing.
So in the end, managing the risk associated with your retirement income is no different than any other risk in your life. You use a combination of guarantees and expertise to reduce your exposure.