Investment Success in Turbulent Times

California CPA magazine: January/February 2009

By David George, CPA

This historic market downturn is instilling in people a fear of volatile markets—and making wealth preservation and recovery key issues. As trusted advisers, what can CPAs say and offer to clients? Plenty.

First, CPAs (or qualified CPA/PFS or CPA/CFP) should determine if a client’s investment assets are in line with their goals and objectives, as well as risk tolerance.
The decision on whether your client needs to take any action might center on:

•    A need to sell assets to raise cash for an intended purpose in the short term;
•    A determination whether, after a significant downturn in markets, circumstances exist for the investment portfolio that were not present when the asset allocation was conceived, making the allocation inappropriate; and
•    Whether the portfolio is invested so significantly different when taking into account goals, investment objectives and risk tolerance, an action to change the portfolio should  be taken.

Keep an investment strategy simple for clients so they can understand and be clear about what risks they are taking. Too often risk is brought up when things do not go well rather than when the investments are made.

Anxious clients need reminding that market fluctuations have been around since the dawn of markets, and markets eventually recover—we just do not know how long it will take.

The following concepts can help clients toward investment success.

1. Diversify
No one knows what will be the next best performer—or major bust. But if you are broadly diversified, you don’t have to make that decision.

Keep the job of investment selection of individual stocks to a professional money manager (either mutual funds or individual stock manager). Humans are generally poorly wired for investing, as emotions often cause investors to do the opposite of what should be done. Use diversification effectively and choose a wide range of broad asset classes and styles that match the client’s objectives.

2. Dissimilar Price Movement Diversification Enhances Returns
To the extent possible, create an investment portfolio with investments that have dissimilar price movements. It’s clear that between two investments with the same average arithmetic rate of return over five years, but with the different volatility, the lower volatile investment will have a higher compound rate of return than the more volatile investment.

Design a portfolio with as little volatility as necessary to achieve the client’s goals.

3. Employ Asset Class Investing
Different asset classes generally have different risk factors and different expected returns. Investment grade fixed income investing, while having lower standard deviations and historical returns than equities, when combined with equities reduces the volatility of a portfolio.

In Figure 1 (reproduced with permission from Dimensional Fund Advisors) investors with long-term time horizons are able to understand the sources, and annualized returns in equity markets when comparisons of volatility (as measured by standard deviation) are presented. An investor must understand that if seeking higher returns, markets present them with the consequence of higher volatility as measured by standard deviation.

Also, pay heed to costs—both mutual fund fees and tax costs. Paying large fees to funds or account managers, or realizing a large tax bill for high turnover strategies, lessens your return and is something an investor can control.

4. Global Diversification Adds Benefits
Don’t ignore the benefits of international diversification. This asset has greater volatility, but historically an investor is rewarded with greater return over significant long-term time horizons, again illustrated in Figure 1.

An investor cannot ignore the fact that, in this age of interconnectivity and global commerce, other world economies are growing faster than the United States.

5. Design Efficient Portfolios
Risk and return are related. Indexing is not the only alternative to stock picking or market timing. The best way to structure a highly diversified portfolio is to diversify around risk, as opposed to around a type of investment.

Among many strategies, short- to intermediate-term, investment grade bonds or bond funds, are common methods by which risk is moderated in the portfolio.

Be sensitive when investing in a particular asset class or specific investment. If a client takes on additional risk, but isn’t rewarded with higher returns, there’s no sense in making the investment.

The patience of every investor is tested during this turbulent period. Now is the time to ensure investments are aligned with long-term objectives and risk tolerance, and away from the emotion of the immediate time period.

David George, CPA/PFS is chair of the AICPA’s Retirement Plan Committee. You can reach him at david.george@cpaplanners.com.