Modern life has many benefits, but the accelerating pace of change and information flow can be a double-edged sword, especially for investors. Market volatility hasn't increased materially in the Age of Twitter, but it certainly feels like it has.
In recent weeks markets have exhibited a pattern that's growing disconcertingly familiar: overreact to a news item, pare losses as investors digest the information, stage a rally, and then react to the next news item. This sequence isn't necessarily new—markets have always climbed a "wall of worry"—but it feels like the pace of market inflections has accelerated dramatically over time, and investors are feeling the g-forces.
When it comes to headline risks like trade negotiations, we strongly recommend managing them methodically, rather than sitting on the sidelines waiting for an "all-clear" signal before putting funds to work.
Four steps to managing risk
In our Bear market guidebook, we outlined four key steps to managing portfolio risk:
While we don't think trade tensions are likely to be a mortal threat to the bull market, this is still a useful series of steps for investors to consider. But it's important to consider them in order, because if you skip a step you can miss out on the most effective risk-management for meeting your financial goals.
With this in mind, we will focus on the first and most important step—"Think structurally"—because this is the step that acknowledges one fundamental and under-appreciated element of investing: time transforms risk.
To illustrate this concept, let's consider how asset classes behave over different time horizons:
* Cash is the safest asset class for meeting short-term spending needs, but it's all but guaranteed to trail inflation over the long term so it's quite risky for meeting other financial goals.
* Stocks can be incredibly risky over the short term—subject to common and severe drawdowns that can persist for years before recovering—but they offer attractive long-term growth that has historically dramatically outpaced inflation.
* Bonds tend to hold their value over time, and perform particularly well during recessions, when stocks do poorly, but they've historically provided limited growth in "real" (inflation-adjusted) terms.
This helps to illustrate why it's fortunate that investors don't have to pick just one asset class! A diversified mix of these components is greater than the sum of its parts, but even so it can be difficult to find a single asset allocation mix to meet all of an investor's short- and long-term goals because shortterm goals tend to be sensitive to sharp capital losses, while long-term goals are at risk if the portfolio doesn't grow enough.
This is where our Liquidity. Longevity. Legacy. (3L) framework comes in. By segmenting capital based on time horizon, we can align an investor's investment strategy with their family's financial plan.
How does the 3L framework manage risks?
When it comes to managing day-to-day risks, the Liquidity strategy plays the most direct role. Well-diversified portfolios have usually recovered fully from even the worst bear markets within a five-year window (see Fig. 1), which is why assigning assets to meet two to five years of cash flow needs is such a powerful tool for mitigating the damage of all short-term risks.
With the Liquidity strategy separated from equity market risk (held in cash and short-term bonds or managed through dedicated borrowing facilities), investors can very effectively manage the risks in their Twitter feed while staying confidently invested for meeting long-term goals.
This balance is crucial, because short-term drawdowns aren't the only risk that investors face. Skipping the "think structurally" step can lead to adopting a too-conservative mix of stocks and bonds, or relying on an excessive use of costly direct hedges, introducing a far more permanent risk: missing out on compounding growth needed to meet long-term needs.
Don't overreact to headlines, but don't ignore them either
No matter your circumstances, it's important not to let your Twitter feed overshadow an otherwise-positive economic backdrop . Our "political flux" simulator demonstrates that geopolitical shocks—even the ones that changed the world—usually leave little lasting impact on financial markets. Investors shouldn't ignore near-term concerns outright, but we would recommend viewing them in the context of meeting financial goals. When adjustments are needed, they should generally be measured and limited, not a wholesale revamp of the investment strategy.
Figure 1 - Adding stocks increases risks, but most portfolios spend less than 5 years "under water"
Maximum bear market losses, and time to next all-time high, for stock/bond portfolio mixes
Morningstar Direct, UBS. Portfolios in this example consist of intermediate-duration US Treasuries and US large-cap stocks.
Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.
Author:
Justin Waring, Investment Strategist Americas, UBS Financial Services Inc. (UBS FS)
This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures at the end of the document.
Appendix
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