Whether it’s pandemic infections or U.S. presidential elections, investors have been enduring at least the usual, if not higher levels of market uncertainty lately. As the daily news plays out, I’ve been fielding at least the usual level of questions about how to manage the related market risks.
Two sides to risks and returns
In recent posts, such as going defensive in uncertain times and the vital importance of rebalancing, I’ve reminded readers why investors seeking long-term returns must hunker down during uncertain times and let near-term market volatility have its way as part of their well-planned portfolio. Because:
Higher investment risk (including market uncertainty) = higher expected returns
I believe most investors intuitively understand this. And yet, the question keeps coming. It might help if we think about the same thing, in reverse:
Lower investment risk (including market uncertainty) = lower expected returns
The price of uncertainty
In other words, viewing the same point from a different angle shows us we pay a price either way for the two reasons we invest to begin with:
- Accumulating Wealth: If you’re still building lifetime wealth, you may be best served by taking on more market risks and pursuing higher expected returns. The price you pay for investing more aggressively is being more uncertain whether you’ll achieve your ambitious goals. As long as you stay put and have time on your side, odds are you will ultimately prevail. But there is no free lunch in investing, so you never know for sure.
- Preserving Wealth: If you’re at or near your lifetime financial goals, you may be best off avoiding market risks and the wider range of uncertain outcomes they create. Here, you pay a different price. In exchange for having more certainty about your investment outcomes, you must expect lower returns, and slower portfolio growth.
By the way, whether you’re accumulating or preserving wealth isn’t necessarily based just on your age. It also depends on your goals. For example, even if you’re in your 20s or 30s, with decades before you retire, you still might focus on preserving some of your wealth to purchase a house within a few years. Conversely, even if you’re retired, you still might have wealth accumulation goals if you wish to leave a substantial legacy or charitable bequest.
Throughout your financial journey, there may be different “price points” you’re willing to pay to accumulate more wealth while preserving what you’ve already got. Identifying and maintaining the right exchange for you and your personal financial goals is where the art and science of financial planning and investment management come in.
Planning to manage your emotions
Once you’ve determined the right mix, the next (and arguably harder) step is to manage your emotions when the time comes for you to accept the required tradeoffs. We humans only have so many lines of defence against fear, doubt, regret, and similar emotions that eat away at our investment resolve. Planning is among your most important fortifications.
Here’s how Dimensional Fund Advisors’ David Booth described it in a recent piece:
“I want people to have an investment philosophy they can stick with. If they focus on controlling what they can control, and taking the right amount of risk, they can make it through the tough times, and capture the rewards of the good ones.”
In short, it’s best to prepare for market uncertainty as a near-certain event within your greater investment plans:
- Establish your near- and long-term personal financial goals.
- As you save and invest toward your goals, consider the tradeoffs you’re willing and able to make to manage the uncertainty involved.
- Incorporate the risk/reward prices paid into your plans.
In so doing, market surprises can hopefully come as less of a surprise whenever you encounter them.