Market volatility, this year notwithstanding, tends to unnerve even the calmest of clients. When the market is dropping, investors like holding assets that maintain their value. Nobody likes seeing red on their statements. In turn, when the market is going up, they prefer assets that are going up, not just holding steady. Green is good! So how do we get the best of both worlds? How do we know what to hold and how much to hold at any particular time? That’s a crucial question, but how we arrive at the answer does not need to be complicated.  

The amount of portfolio assets an investor holds in cash/bonds (aka fixed income) should be determined by cash flow needs. Think of it as your client’s lifeboat. If the ship is going down amidst a storm, some form of flotation device is critical. Similarly, if the market is tanking, they may want something to grab hold of to keep them above water. The last thing they want to do to create cash, if necessary, is to liquidate stock during or after a steep decline. Ideally, those growth assets would be given time to recover. Buy low, sell high, not the other way around. Investors must be able to remain invested through some difficult market downturns to achieve better long-term results. The market as a whole has proven resilient, going up more than it goes down. Nevertheless, volatility and irrational, emotional responses are directly correlated, and, at times, we have to play counselor as much as advisor! Preservation assets, like bonds, help buffer these near-term bumpy roads and reduce investor angst. 

So, does everyone need a lifeboat, and what exactly are “cash flow needs”? Think of someone nearing or in retirement. Income from employment has or will be ceasing. Thus, the portfolio becomes a source for maintaining a desired standard of living. In preparation for this stage of life, individuals should take steps to have enough cash and bonds in their portfolio to cover approximately eight years worth of their distribution needs. Eight years may seem like a lot, but history has something to say about this. The worst market declines, and subsequent recoveries, on record have lasted upward of eight years. As rare as those stretches are, this level of preparation can help your clients feel further at ease when bad news strikes. Keep in mind, these distribution needs are lessened with the presence of cash holdings outside of a portfolio and any other income sources, like social security, real estate, and maybe part-time employment. If stock and/or real estate markets decline, this lifeboat of preservation assets provides ample liquidity to sustain clients while we wait for an expected recovery. 

What if someone does not have any immediate cash flow needs from the portfolio? A client may be early in his or her career and just starting to accumulate assets. Depending on one’s time horizon, it may make sense to have an investment line-up exclusively allocated to the equity markets. If growth is the goal for the foreseeable future and there is an understanding that markets will go up and down (meaning the client won’t lose sleep over potential wild swings in the market), then an all-equity portfolio can be reasonable. Advantages of having some fixed income exposure include having “dry powder” for rebalancing, as well as a degree of diversification for risk management. 

For example, when stock markets declined in late 2018, investors with fixed income in their portfolios were afforded the opportunity to deploy additional capital into those equity markets, in effect, “buying low.” As the market turned upward in 2019, these investors owned more shares purchased at lower prices and expedited their recovery. Simple stuff.

Remember, buy low, sell high. This tactic is not based upon a prediction nor timing effort. That’s fools’ gold. Rather, it is predicated on what percent of one’s portfolio ought to be in the stock market versus out of the stock market. What does your client’s plan suggest the portfolio needs to do to meet their stated goals? From there, they have no need to take more risk than necessary. Build a diversified, low-cost portfolio in accordance with their plan. Plan first, build the portfolio second. Keep the lifeboat intact and stay diversified. Wait, did I already say that?

Ross Polking is a lead advisor of business development at Foster Group.