With the Standard and Poorâ€™s 500 Index rising more than 20% since last June, some people are reluctant to invest now, fearful that stocks are poised to tumble again. By focusing on their long-term investment objectives rather than short-term market fluctuations, however, investors can plan for a sound financial future. In this post youâ€™ll find strategies for building a portfolio that helps to limit market risks and increases the likelihood of achieving your long-term goals.
Think like an investor, not a trader.
Traders attempt to take advantage of short-term market fluctuations by timing their trades just right. History shows, however, that it is very difficult to time markets consistently, and even if you make a good call about when to sell, knowing when to get back in is equally important.
Rather than timing markets, our goal as wealth managers is to help clients identify their investment objectives, preferences and constraints. We then use that information to develop a sound investment strategy that mitigates risk. By doing so, we are able to build portfolios that meet client objectives, such as generating spendable income over the next several decades, without the stress that comes with daily market fluctuations.
Valuation levels still matter.
Although we think long-term and encourage our clients to do the same, we are still disciplined about our investment decisions. For instance, when a new client comes to us with cash to invest, it may take us up to six months to deploy this capital fully. Each position we purchase has a price target, but we do not buy unless the return potential is justified by the risk taken. Since our focus is on the individual securities we own, we do not worry as much about general market movement.
Return potential is not as important as downside risk.
When we evaluate securities, we actually place more emphasis on the risk of being wrong, rather than how much an investment can return if we are right. We select investments with appropriate risk/reward ratios to help protect portfolios from major losses, which is extremely important to long-term investment returns. After an investment declines 25%, it takes a 33% return to get back to even; after a 50% decline, it takes a 100% return to get back to even. By worrying about possible downside risk, we are able to preserve client funds when markets turn downward while still positioning portfolios to take advantage of market rebounds.
Achieve true diversification by focusing on investments with low correlations to one another.
Another way we mitigate portfolio drawdown is through what we call true diversification. A cookie-cutter approach to asset allocation is to divide capital among large cap, mid cap, and small cap stocks, potentially with both value and growth investment styles. While this approach is simple to explain and may work well for someone with limited funds to invest, these groups of stocks typically rise and fall in a similar manner, particularly when volatility increases.
We believe there are smarter ways to achieve true diversification. Our clients deserve a more nuanced approach, and because they are investing more than the typical investor, they have more options available for diversification.
Two unique ways we may achieve true diversification in client portfolios are through our Equity Income strategy and, where appropriate, by investing in hedge funds.
Equity Income: Unlike traditional equity income approaches featuring stocks that offer a yield 1% to 2% higher than the S&P 500â€™s 2.1% yield, our Equity Income approach focuses on business development companies, master limited partnerships and other securities. These investments yield 6% to 10% and may offer additional capital appreciation potential. Equity Incomeâ€™s total return potential, calculated by adding dividend income and capital appreciation, is similar to traditional equities, but most of the return comes from a dividend instead of capital appreciation. The strategy is a good complement to a traditional stock portfolio because the securitiesâ€™ prices generally donâ€™t fluctuate as much. These securities are also often quicker to rebound from declines than traditional stocks, since investors value the elevated income they produce, though past performance is not a guarantee of future results.
Hedge Funds: For qualified investors, another strategy we use to achieve more consistent returns for our clients is to invest with a select group of regulated hedge fund managers. These investments may also be a good complement to equities in a portfolio, since the factors that drive stock market performance differ from those that affect hedge fund performance. Though past performance is not a guarantee of future results, hedge funds have traditionally provided steadier returns than stocks and decline less than equities when markets fall. Investors must meet certain qualifications to participate in hedge funds, however, and these investments offer limited liquidity, so they wonâ€™t work for investors who need immediate access to funds.
While all investing carries some risk, developing an investment strategy based on your personal goals can greatly mitigate those risks. By working with you to help determine your individual needs and taking a long-term approach to investing, Cedar Hill can help you manage your wealth successfully in any environment.
Chris Engelman is a Managing Director at Cedar Hill Associates, LLC, a $1 Billion wealth management firm. At Cedar Hill, Chris works with clients to design customized investment strategies and is responsible for selecting and monitoring the firmâ€™s hedge fund, private equity and real estate investments. Prior to joining Cedar Hill in 2003, Chris worked at Asset Consulting Group, assisting family offices in developing asset allocation strategies and evaluating traditional and alternative investment managers. Chris earned a Bachelor of Arts from Gettysburg College and his MBA in finance from Washington University in St. Louis. Chris is a CFA charterholder and member of the CFA Society of Chicago. Contact Chris directly at Chris.Engelman@cedhill.com.