Key Takeaways
It’s easy to deviate from your plan when markets are volatile and headlines are tapping into your fears.
You may not be as diversified as you think even if you own lots of stocks and funds.
Advanced strategies like exchange funds and options, combined with emotional discipline, protect wealth during turbulent times.
Market volatility is an inevitable part of investing. While it can be unsettling, it also presents opportunities for those who remain prepared and disciplined. Protecting your wealth during turbulent times requires more than just a reactive approach. It demands a well-thought-out strategy grounded in science. Fortunately, we have proven strategies for helping our clients protect their wealth in volatile times.
Strategic Asset Allocation
Strategic asset allocation is about setting target allocations for various asset classes that are consistent with your goals and risk tolerance. For instance, if your plan calls for a 60/40 stock-to-bond portfolio and the stock market rises significantly like it has over the past two years, then you might find your allocation closer to 65/35 or even 70/30. When that happens, we help you sell the right stocks and buy the right bonds to get your allocation back to the original target.
The benefit of strategic asset allocation is that you are not trying to time a stock or a certain segment of the market when you think it’s the right time to get in or out. Instead, you're setting an allocation that is properly diversified – one that's going to provide the return you need to stay ahead of inflation, so you can achieve your goals without taking on unnecessary risk. With a systematic, rules-based strategy in place for trading and investment selection, you’re not relying on guesswork or luck for success.
Proper Diversification
Everyone talks about diversification, but often they’re not as diversified as they think. This is especially true when it comes to 401(k)s where investment selection can be limited. Just because you own lots of different stocks or funds from different companies, or just because you have your accounts in multiple custodians, doesn’t mean you’re sufficiently diversified.
When people first start working with us, we analyze their portfolio and often find they have dozens of stock funds, but those funds are focused in only one area of the market, usually U.S. large stocks. Proper diversification -- having a mix of investments that go up and down at different points in time -- allows you to manage your risk effectively and enables you to earn a better return over time.
Another diversification challenge is for people who have large chunks of their wealth tied up in their employer’s stock. That’s common in the pharmaceutical and technology industries, for instance. People are often reluctant to sell their company stock or trim their position because it makes them feel like they’re not being loyal to their employer. You don't have to sell your entire position. But, taking a portion of your gains every year and using that money to buy something else – in a different industry or sector -- will ultimately lead to a better investment experience. Just because you are highly familiar with an industry, doesn’t mean it’s less risky. We call that familiarity bias.
Disciplined Rebalancing
When it comes to reducing a concentrated stock position, it doesn’t have to be all or nothing. Take some gains every year, pay the tax on it because you’ll be paying at the capital gains rate (not the ordinary income rate), and the amount of tax is likely to be much smaller than holding on to the stock and watching it drop sharply in price.
Advanced Strategies
Another way to protect your wealth during volatile markets is through advanced strategies such as exchange funds or options, including protective puts and collars. During volatile times, if you have a concentrated stock position, you can utilize “protective” put options which give you the right to sell your stock at a pre-determined price, even if the stock price goes down. Further, we can install a “collar” option around the stock to protect against large losses while reducing the costs of the protection. You’re giving up some upside if the stock takes off, but at least your downside is protected, and you’ll be able to sleep at night when the markets get cranky. We will use collar strategies if we need to protect a stock from decline for a shorter period of time. That way, we can sell and reduce the risk in the near future.
We find that options are best used for short-term risk reduction. If you have a concentrated position of stock and you need to hold this stock for an indefinite period of time, then an exchange fund may be a good way to reduce your risk.
An exchange fund, aka “swap fund,” is essentially a limited partnership that allows you to transfer your appreciated stock into the fund without incurring any taxes. The limited partners each bring a unique stock to the fund and the limited partners own the fund collectively for a set period of time, typically seven years. At the end of the term, you are free to leave the fund or leave the fund and receive your pro-rata share of all the stocks in the fund. You maintain the cost basis (what you paid for the stock you are attempting to diversify). So, an exchange fund won’t reduce your taxes, but it will help reduce your risk by providing additional diversification and avoiding the potential need for an immediate sale to diversify.
Control Emotional Decision-Making
Nothing can derail a financial plan faster than making hasty, irrational decisions during times of extreme market volatility. We realize it’s hard to avoid the headlines and social media these days, but our behavioral coaching techniques can help you avoid panic-driven decisions. Proactive communication with our clients builds trust and helps prevent their “lizard brain” from taking over during times of stress so they can continue to make sound decisions about their long-term financial future.
Conclusion
If you’re a Novi client, you have a carefully designed plan in place so you can just tune out the noise when the headlines and social media are making everyone else anxious. If you’re thinking about working with us and you have money scattered in multiple places or you’re unsure about your investment decision-making, working with an advisor such as Novi can help. We can offer an expert financial perspective, keep you on track and help you maximize your wealth.
RYAN M. VOGEL, CFP® is the CHIEF PLANNING OFFICER, PARTNER at Novi Wealth
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