It doesn’t happen with our clients too frequently, but during periods of market volatility (like we just experienced this past fall and winter) I am often approached by acquaintances or friends who ask me my thoughts on selling out of stocks during the market turbulence in an effort to avoid the risk of a market downturn. This strategy is sometimes called “de-risking” in the investment world.
But when an investor sells off equities during periods of market volatility are they really reducing or avoiding risk? I would argue that these investors are not reducing their risk at all, but merely trading types of risk. And in many cases, these investors may unwittingly be increasing their overall exposure to risk. Let’s look at what happens when investors attempt to “de-risk” in order to get a little better understanding of what actually occurs and examine the types of risk associated with de-risking activity.
The Dash to Cash
When an investor sells all or a portion of the equities in his or her portfolio the investor frequently sits in cash or money markets while waiting out the period of market volatility. While cash is viewed as a safe haven by most investors for stability purposes, cash is arguably the worst asset class for protection from an insidious destroyer of wealth: inflation risk. Looking at historical data, investment returns on cash and money market funds have significantly underperformed inflation rates. So the investor who sells off equities and moves to cash has traded market risk for inflation risk.
But the investor who intends to move back into the market later has also added an additional element of risk: market timing risk. With market timing risk the investor must now successfully pick the correct time to exit and re-enter equity markets. Market timing is no easy task as anyone who has followed the market for any considerable amount of time can attest to. Perhaps the flight to cash isn’t as safe as some investors think it is.
Another favored technique for avoiding market volatility risk is to move into fixed income investments, which are generally more stable investments than equities are. But there are risks associated with fixed income investments that investors may not be focused on. First, fixed income is another investment that does not protect adequately from inflation risk. While bonds do generally produce a higher investment return than cash or money markets, they do not keep pace with inflationary rates in the long term.
A second risk, and perhaps a bigger concern today than at other times, is interest rate risk. With interest rates more likely to go up than any other direction in the short term, investors who purchase the wrong types of bonds could expose themselves to volatility as great as they would see in equity markets. And if investors ignore quality investment grade bonds and reach for higher yields by investing in high-yield (also known as junk bonds) they could expose themselves to default risk if they aren’t careful.
Finally, choosing the incorrect kind of fixed income investment can expose the investor to liquidity risk. Certificates of deposit and many annuity contracts impose penalties and/or surrender charges that can make it costly to extract yourself from those investments, even if market conditions turn more favorable for other investment options.
We’ve just covered four additional risks that investors may expose themselves to if they “de-risk” from market volatility risk associated with equities and move into fixed income assets. There are other strategies that investors could potentially pursue: alternative investments, commodities, hedging, etc. But each of these other strategies involves variations of the same types of risk the investor is trying to avoid: market volatility risk.
A Better Solution
In reality, there are dozens of different types of risks that investors are exposed to. Some risks can be eliminated with the appropriate strategies, while some risks can only be managed. But as the examples above illustrated, attempts to “de-risk” your investment portfolio really only end up in “re-risking” your portfolio, or swapping the types of risk faced. A far better strategy, yet one that requires discipline, patience and faith in the efficiency of markets, is to ride out volatility and keep your investment allocation consistent with what you and your adviser have determined is necessary to reach your financial goals.