It is no secret that the capital markets are volatile. During periods of extended growth, it’s essential to be prepared for sudden market changes. While we cannot predict the market, we know directional changes in markets are accompanied by volatility. The good news is that volatility is not necessarily a bad thing.It’s important to understand True North’s investment philosophy on market volatility. Our financial planning process begins with understanding the client’s goals and risk tolerance. From there, we construct a custom portfolio that allows our clients to reach their long-term financial goals with the least amount of expected/anticipated risk. This is achieved by adopting our mindset, investing in different types of assets, and rebalancing portfolios periodically.
Why Short-Term Market Volatility is Long-Term Opportunity
Long-term growth is our objective. For our clients, the risk is not market volatility but rather the permanent loss of capital. Market volatility is short term – it’s linked to emotions. If the price of a stock were to drop 25% in two months, does that mean the company spontaneously lost a quarter of its value as well? Often, no.
True North’s decision-making process focuses on value in an investment or company, not price charts. This means we invest in companies and assets that we believe have strong potential to grow, especially if they are undervalued by the market. If the asset price suddenly dropped even though its operations remain unchanged, we may want to purchase more of it.
If the price of all BMW cars dropped by 30% one day, what would prospective buyers do? They will likely form a line outside the dealership to take advantage of that discount. On the other hand, if the price of all BMW cars suddenly increased by 30%, buyers will likely find other substitutes. That is normal human behavior. In financial markets, however, rising prices/valuations of stocks lead to more demand for the stock, not less. While buyers were eagerly purchasing stocks of unprofitable companies in March of 2000 due to their rising prices, there were few buyers in January 2009 when the S&P 500 was below 800. The impact of seeing prices change tick-by-tick on the screen has a profound psychological impact on human beings and represents herding behavior, rather than sound decision making.
At True North, we are also susceptible to the emotions that govern others. However, we are able to take emotions out of our decision making by focusing solely on valuations, i.e. - what we are paying for something vs. what we are receiving in terms of earnings and cash flow. Our process may make us seem out of step with the markets sometimes, but has rewarded clients over a long period of time. Even though volatility is not the most important consideration for us, we are cognizant of it because it can cause anxiety for clients. We manage volatility through the following mechanisms.
1. Decreasing Risk through Asset Allocation
“Don’t put all your eggs in one basket” is a cornerstone to lower-risk investing. It’s important to diversify the types of assets you hold. Simply holding domestic stocks and bonds is not enough because they are strongly correlated with US events. At True North, we seek to tap into as many uncorrelated markets as possible so that adverse events in one market do not ripple across and affect other holdings.
True North does this by investing in multiple asset classes, such as global equities, real estate, private equity, and global fixed income. Global exposure means that bad news or an economic downturn in the US has a smaller impact on portfolio value.
We also invest in niche strategies such as reinsurance contracts and litigation finance (buying portfolios of legal cases). These assets have very little correlation with each other and with the markets, meaning it’s almost impossible for all these investments to lose value at the same time.
2. Rebalancing Portfolios to Manage Risk
It’s important to periodically readjust a portfolio’s holdings. If an investment has done exceptionally well and is now a bigger piece of a clients’ portfolio, then trimming the position and allocating those proceeds to an asset that has underperformed automatically leads to “buying low and selling high.” Realizing gains cements profits and reduces the risk that the investment that was trimmed can adversely impact the portfolio if it declines.
At True North, we seek to rebalance our client’s portfolios periodically to manage risk and enhance returns over the long-term. Essentially, we are buying the BMW which is 30% cheaper, and selling the one which is 30% more expensive.
3. Adopt a Long-Term Mindset
The worst-case scenario is the permanent loss of capital. That’s why it’s vital for our clients to recognize that measuring performance against a market benchmark is not a relevant comparison. Lumping all investments into one market or style can result in higher returns over a short period of time, but the approach can also result in intolerable losses which may cause the client to abandon the strategy, thereby leading to permanent capital impairment.
The S&P 500, which reflected the 2000 technology bubble, is a great example of that phenomena. Investors that were in the “market” lost half their money over two years, and it took them over seven years to get back to even. In contrast, managing risk and investing in appropriately valued stocks for the long-term paid off for our clients. We continue to utilize the same time-tested approach today that has led to steady, sustained growth for our client portfolios.