Building a Portfolio in Today’s Volatile Market

Jul 04, 2016

Pennsylvania CPA JournalA volatile stock market is a sure bet to fray your clients’ nerves. It may require a significant amount of hand-holding on your part as clients fret over protecting their nest egg. It doesn’t have to be like that. There are ways to devise a portfolio that meets the client’s financial goals while also attempting to manage volatility and minimize the risk of running out of money.

One strategy includes segregating portfolios between near-term and long-term goals, and having an investment strategy for each. This tactic is analogous to the bucket approach attributed to Harold Evensky, who wrote extensively about the topic.

Near-Term Goals

In periods of high market volatility, consider maintaining enough liquidity to meet near-term goals for the next five years. This can be accomplished by holding funds in principal-stable investments, such as money market funds or short-term CDs. These investments will not be subject to capricious stock or bond market swings and will ensure that funds are available for client goals. The liquidity bucket should be refreshed periodically by rebalancing the client portfolio or sweeping dividend and interest payments from other investments into the liquidity account. Preserving this bucket for near-term goals discourages investors from making investment decisions in the short term when market volatility may negatively impact their results.

To further protect client distributions for near-term retirement goals, you can consider additional strategies. The purchase of an immediate fixed-income annuity will deliver a predictable and steady stream of income undisturbed by stock market volatility while also providing the client with longevity insurance. Or consider having the client secure a home equity conversion mortgage (HECM) that could be used during periods of market distress to provide ready income, which is then paid back when markets have recovered. This is an especially effective strategy in lower-interest-rate environments that usually accompany market downturns during recessions. Also, bond ladders may be considered to ensure protection of invested principal with maturity dates synced to client goals. However, contrary to popular belief, this strategy does not insulate the portfolio against interest rate risk.

Long-Term Goals

Domestic and international stocks should be a core holding to fund long-term client goals. Investments in these asset classes historically deliver a real (inflation adjusted) average annual return of almost 7 percent. Risk and return are always linked, of course, so advisers must prepare clients for significant market volatility (crashes and corrections) along the way.

To buffer some of this volatility, certain investments should be added to client portfolios to serve as a shock absorber against severe downturns. As mentioned earlier, cash holdings provide liquidity but holding too much cash can act as an anchor to client portfolio performance. (Have you seen what money market funds are paying lately?) Investment-grade, short-term bonds can be recommended for modest income with a fairly stable principal. Intermediate-term, investment-grade bonds will provide more income but a higher degree of principal volatility. Pensions and Social Security benefits will also provide stability as their cash flows are disconnected from market gyrations.

Adding Treasury inflation-protected securities (TIPS) to client portfolios can also help protect against inflation. The TIPS principal adjusts to the Consumer Price Index (CPI) and pays a fixed rate of interest on the inflation-adjusted bond principal, which ensures a real rate of return. Although the real return of TIPS is less than stocks, owning TIPS is a less risky way to achieve some degree of real inflation-adjusted returns.

For clients who are drawing down portfolios, a systematic and forced rebalancing of their portfolios will help blunt the impact of market volatility. This will force the client to sell when markets are high and buy when markets are low, a basic tenet for long-term portfolio growth.

After having your clients complete a risk-tolerance questionnaire, take the time to discuss volatility in the markets and the history of crashes and corrections, reminding them that similar events will occur again. Remember, risk and reward are always linked, and the adviser cannot stress this too often or strongly enough with clients. A thoughtful approach that includes near-term and long-term portfolios based on your client’s risk tolerance, time horizon, and cash needs specific to their goals should help them weather the expected volatility in an efficient manner.

Kevin P. Brosious, CPA, PFS, CFP, is president of Wealth Management Inc. in Allentown. He can be reached at kevin@wealthmanagement1.com.
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Disclaimer:
The responses are based on the limited information provided by the questioner and apply the laws and regulations at the time of posting. Other options could arise as rules and regulations may change over time, including but not limited to the passage of the Tax Cuts and Jobs Act of 2017. They are intended to provide general information, not specific accounting or tax advice; they are not intended or written to be used and cannot be used for the purpose of avoiding or evading taxes or penalties under the IRS code or regulations. Views expressed do not imply an opinion of the PICPA, its officers, directors, employees, or members.