Life Boat Drills
One of the most important things about diversification through asset allocation is how
it protects you during market turn-downs. However, there are times when even
diversification doesn't prevent steep declines in the value of your portfolio.
To understand why this happens, you need to understand the different forms of
risk which can affect your investments. Then you should have a
strategy for what to do in that situation. And finally, be disciplined in
following your strategy.
The different forms of risk -- the first distinction the financial planning world makes is
between systematic risks and
unsystematic risk. Therefore, the type of risk which is associated with a
given asset class should be considered before making an investment decision.
According to College of Financial Planning text books, investment risk is
treated in the following manner.
"Systematic risks affect whole asset
classes of investments. They can be further broken down into more specific
risks, i.e., market, interest rate, purchasing power, and
financial risks. Each of these may impact on the different types of
investments in varying ways. For instance, stocks are sensitive to changes
in price when the overall stock market changes in value. Whereas, bonds
are affected by changes in interest rates and changes in the rate of inflation.
By building an asset allocation of investments that are not affected the same
way, you can moderate the amount of systemic risk your portfolio is exposed to.
Unsystematic risk is business risk,
which can be reduced by diversification of the same types of investment
vehicles. Examples include:
1. diversifying with in the major asset class
of real estate by buying properties in different geographical locations or
diversifying among different types of real estate investment properties, and raw
land; or
2. diversifying by purchasing shares of
stocks in different industries or through buying shares of a mutual fund.
Mutual funds generally represent a major investment class such as stocks and
bonds, but diversified within themselves itself is a mix of holdings of
different stocks and bonds issues. Unsystematic risk
can be reduces by the 'investment strategy' chosen for each financial goal."
It's during these times that one needs to rely on life boat
drills. Such as the perspective presented by Franklin Templeton Investments and
the piece immediately below.
Modern Market Downturns
A Retrospective of U.S. Stock Market Volatility
Tremendous innovations have transformed the ways people live and work in recent decades, and yet the primary emotional drivers in
our lives seem remarkably unchanged. Financial markets—increasingly globalized and continually leveraging computer and
communications breakthroughs—have lost none of their power to provoke
excitement, uncertainty, eagerness and bewilderment. When markets become volatile and economic prospects become clouded, even those of us most familiar with historical stock and bond trends can begin to wonder if the sidelines offer a better view.
The long-term upward trend of U.S. stocks could cause us to believe that
condition is the norm. Our expectations are affected by our most recent
prolonged experience of an up market. So emotionally we are unprepared.
But sometimes sudden downturns have endured. To give you greater insight into those moments,
lets focus on
three events in recent years when U.S. markets were sorely tested:
