The real risk of volatility is in investor overreaction

On the Soundbites podcast this week, Punzo said advisors may not be emphasizing enough to their clients the four big risks related to making a hasty retreat from turbulent markets.

Timing risk

“If clients are moving out of an asset class, it’s easy enough to get out, but the timing to get back in is very difficult,” he said. “If they did move out of the U.S. in April, for instance, they would have missed the big rebound that we saw in May.”

Sequencing risk

Drawing down on investments in a down market will deplete portfolios exponentially faster, he said — a potentially ruinous situation for retirees.

“Clients need to have an understanding of downside protection in their portfolio and what that does,” he said. “You may miss some of the upside, but you’ll have significant downside protection, which is important as clients are decumulating.”

Rather than cashing out, he recommends advisors build multi-asset class portfolios for their clients, and diversify with alternatives.

“The key is not to move to cash,” he said.

Liquidity risk

Punzo pointed out that some investment products are poorly suited to cashing out, with restrictions that can include lockups, gates and complex withdrawal rules.

“Obviously there could be a change in circumstance, an event in their lives, where they need their money,” he said. “When they don’t, that’s when the risk becomes prevalent.”

Concentration risk

“This is a matter of just looking under the hood in a portfolio,” he said, “ensuring that clients have a broadly diversified portfolio, so you’re not overconcentrating in a specific sector or region.”

A review is necessary because clients could have legacy assets or emotional ties to a particular investment, creating an unintended bet within the portfolio.

“If you’re taking too much risk in a specific sector, the downside [risk] and the volatility is increased as well,” he said.

Punzo said there’s a big difference between normal market volatility and structural dislocations.

Normal volatility – prompted by routine changes in investor sentiment, economic data or geopolitical events – tends to be temporary or cyclical and is just part of the landscape of investing.

“Structural dislocation, though, is more of a breakdown in pricing mechanisms,” he said. “It’s policy misalignment or external shocks. It’s deeper and more persistent.”

The best inoculation against structural dislocation is diversification, and the employment of alternative investments like real estate, infrastructure and commodities.

“Alternatives play a key role in mitigating market volatility,” he said. “Depending on what you’re trying to achieve — whether that be downside protection, reduced volatility, return enhancement or income generation — there are different needs that alternatives can address.”

Punzo said the key is to stay invested.

“Maintain a disciplined approach. Have a target allocation. Have a target risk profile that you’re working with,” he said. “You can make changes, if necessary — small tactical changes — but try not to let the noise influence all your decisions.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.