Tuesday, January 29, 2013

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.

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