Volatility: Opportunity or Risk?
Paul Tarins, RICP®,WMCP®,CSRIC™
As 2020 wrapped up, the signing of a long-awaited second stimulus package resulted in all three major equity indexes breaking records. The Dow Jones Industrial Average, the S&P 500 and the Nasdaq all surged on the news. This isn’t the first time that’s happened – we’ve seen repeated instances where dire headlines brought markets down, only to see good news, such as on vaccine development, push markets higher again. Since the market hit bottom in March, it has recovered and then some. So are individual portfolios back on track? It depends.
The journey to a positive result saw a market that bounced up and down every month, sometimes by very large amounts. To compound matters, the tech sector that had seen a historic run earlier this year cooled off in the third quarter, and megacaps declined somewhat as value stocks and small cap stocks were favored. Overall, the pandemic has created a whole new set of winners and losers, as our lives changed, and in some cases these changes may be permanent. If investors were realigning portfolios, or attempting to reduce risk, they may have missed out on recovery – and the chance for gains.
Balancing Return and Risk
One strategy for investors that are attempting to mitigate risk is to invest in the broad market. By spreading investments amongst many stocks, the theory is that investors will participate in the overall progress of the market when the economy is strong and will mitigate downturns by not being overly exposed to any one company or sector. The problem is that megacap companies have grown to such predominance that they influence indexes in different ways. For example, the S&P 500 has become overly concentrated in just a few megacap stocks.
As of this writing (December 27th), by market capitalization 12.3% of the S&P 500 index is in just four stocks: Facebook, Amazon, Netflix and Google (the so-called “FANG” stocks). With a concentration in so few companies, the index isn’t really providing exposure to the broader economy. Investors that are tracking the index with a passive ETF will certainly be exposed to more volatility. If the index is being used as a benchmark in an active mutual fund, it will be difficult for a portfolio manager to lower risk and still match or beat the index’s return.
Diversification Is Good, But Not Everything
Another strategy investors often deploy is to diversify across asset classes, capitalization size, and geographies. The theory is that different asset classes and regions will respond differently to market events, such that one may be increasing in value as others are decreasing. This works well and is a fundamental principle of building a long-term investment portfolio. However, one thing it does not take into consideration is the effect of market cycles. Over time, the economy expands and contracts as growth increases and then slows. Monetary policy on lending, governmental policies affecting foreign markets and relationships, and technological advances and changes all play a part in this cycle.
An asset allocation that is not flexible enough – and is not consistently monitored – will struggle to provide maximum returns. And this does not consider one of the most important elements of building and maintaining an investment portfolio: It should be built around one’s progress towards a goal. If the goal is retirement income, the portfolio should change the closer the investor gets to retirement.
The Bottom Line
If an investor just looked at the headlines – record breaking market returns – they might think that the long bull market had returned with a vengeance. And it may have – that remains to be seen as events play out in 2021. But if this year has taught us anything, it’s that volatility may bring opportunity – but it always brings risk.
Paul Tarins is an investment adviser representative of and offers investment and advisory services through Portfolio Medics,a registered investment adviser. Nothing contained herein should be construed as a solicitation for investment advisory services. Sovereign Retirement Solutions and Portfolio Medics are not affiliated.
