Pulling The Trigger

As part of our ongoing process to manage risk in client portfolios, we occasionally use investment “triggers”. The investment “trigger” is a rule or a requirement to take a specific action at a future time based on the outcome or resolution of a potential, identifiable risk. The trigger is usually set in conjunction with reducing clients’ market exposure due to this perceived risk. It allows us a way to rationally consider the probability and impact of a potential event that presents risk and take a deliberate and reasoned approach to dealing with this risk, rather than waiting and reacting emotionally after the fact. We believe actively managing risk in this way is the prudent thing for us as fiduciaries of client wealth.
 
For example, in preparing for our first quarter portfolio re-allocations in December, we considered probabilities of outcomes of the fiscal cliff deliberations then underway, and ways in which those outcomes could impact the stock market. In those discussions, we felt there was a greater than 50/50 probability that there would be a negative outcome with respect to fiscal cliff deliberations which  would most likely result in a decline in the stock market. As a result of this assessment, we reduced equity allocations and set a trigger for putting money back to work once we had greater “clarity” relating to the fiscal cliff.

We got that improved clarity through the announcement of a Congressional compromise on the fiscal cliff on January 2. We got even further clarity on Federal budget policy when the House of Representatives passed legislation to temporarily raise the federal debt ceiling. On January 24, we acted on our trigger to put money back into equities based on several factors: improved clarity relating to federal budget and debt issues, continued positive news on the economy, continued low inflation, and a continued positive outlook for corporate profits. All of these lend support to a more positive environment for stocks.

From a financial planning perspective the most important objective in using triggers is protecting client capital. The process of setting a trigger is one way of managing risk of events that could negatively impact client capital. Some other ways financial planners manage risk include portfolio diversification, security selection, a sound investment process, fundamental analysis, understanding of macro risks, and asset allocation. Each of these play an important role in the risk management process and each involve a high degree of human or intuitive judgment which, at least as of now, computers cannot provide.

Increased volatility in 2013 ?

There has been a fair amount of discussion in the investment industry recently regarding the potential for increased market volatility in 2013. One recent article discussed a mathematical model that implies there is a high potential for an increase in volatility. What may cause this increased market volatility? We think increased investor focus on the debt ceiling debate, which will come more into focus in late February. The U.S. federal debt ceiling needs to be raised again to accommodate additional debt issuance by the U.S. Treasury in March. We think the tone and nature of the debate over the next couple of months could get quite ugly and increase investor anxiety, which could lead to rising market volatility (meaning “downside”).

 

One widely-used indicator that market analysts watch to gauge market volatility is the VIX index. VIX stands for “CBOE Volatility Index”. The VIX measures expectations of near-term market volatility reflected in changes in forward stock index option prices. It is sometimes referred to as the market “fear” index. Large increases in the VIX index have tended to be associated with declines or corrections in the market. Over the past several years, major spikes in the VIX have occurred following periods of 8-12 months of low volatility or quiescence in the index. We have been in one of these “quiescent” periods for about the past 12 months. If history is any guide, the odds of a major increase in volatility may be rising.

 

 

A swing in the VIX may or may not have any long-term investment significance. So what does this all mean for financial planning and investing? As financial planners there are things we can do to protect client assets from increased market volatility. One of the ways is through diversifying investment holdings by asset class. This reduces portfolio volatility because different asset classes behave differently in varying market conditions. Another way to reduce volatility is by holding larger proportions of dividend-paying stocks as they tend to be less sensitive to harsh swings in the market. A disciplined investment process or model can also help to keep investment decisions within rational bounds and help avoid the temptation to make emotionally-based decisions. Finally, having a sound financial plan that incorporates reasonable and reasoned spending, income and investment return assumptions can also greatly help clients remain on course with their financial goals and avoid the temptation to either time the market or make detrimental decisions with regard to portfolio risk and/or risk assumptions. All of these, plus a long-term approach to investing can help to mitigate portfolio risk.