Personal Finance

Andrew Menachem: Managing risk in times of volatility

Looking ahead, investors can look for fresh opportunities in the stock market as the U.S. economy continues to roll along. Recognizing the strength of the nation's five-year recovery, the Federal Reserve has ended its stimulus policy, called quantitative easing (QE), and may raise its interest rates at some point in 2015.

That means the U.S. stock and bond markets are both returning to more normal conditions, at least in historical terms. While that is clearly a positive trend in the economic climate, investors may be faced with a higher level of volatility in the capital markets in the coming year.

In recent months, the widely watched Dow Jones Industrial Average has jumped up or down by 100 points or more on several days. Falling oil prices, an increase in the national's gross domestic product (GDP) and expectations of corporate profits are among the factors that have led to turbulence in the stock market.

In contrast, the bond markets were fairly quiet in December. However, that may be the calm before the storm. That's because the Fed's QE policy put a damper on the normal volatility of the bond market, since the values of fixed-income securities tend to fall when interest rates rise, and vice versa.

Since interest rates have remained abnormally low by historical standards for the past five years, investors haven't had to worry about bond market volatility, except last May when traders prematurely anticipated a change in Fed policy, driving down bond prices.

If you're like most investors, reducing volatility is an important consideration when constructing your portfolio. Putting most of your assets in stocks (and currently bonds) leaves you vulnerable to a sudden drop in the value of your investments. The answer isn’t to sell your assets when volatility increases.

Instead, you should stay focused on your long-term goals, such as saving for retirement or building a nest-egg to finance your child's education. If your financial goals are many years away, then the daily ups and downs of the markets don't need to affect your investment decisions.

Next, you should reassess your tolerance for risk, which may change as you grow older. If you are in your 60s and considering retirement in the next few years, you may be more concerned about preserving the value of your assets than when you were in your 30s.

Most importantly, you should talk with your financial advisor about constructing a diversified portfolio with many different types of assets as a way to reduce volatility risk, keeping in mind that diversifying may not guarantee against a loss in a down market. For example, income-producing real estate such as apartment complexes, warehouses or office complexes, tends to be most affected by local population trends and business conditions, rather than the global financial markets.

Therefore, holding shares in a real estate investment trust (REIT) may help to stabilize the overall value of your portfolio.

Other potential risk-reducing strategies, which may be suitable for some investors, include allocating a portion of your portfolio to alternative asset classes, such as managed futures, hedge funds or infrastructure investments. These types of investments have also shown a relatively low correlation to stocks and bonds, so they may also be able to counter-balance a downturn on Wall Street.

In addition, you may want to maintain a certain level of non-volatile securities in your portfolio, such as shares in a money market fund, certificates of deposit (CDs) or Treasury bills (T-bills). These are very “safe” assets that hold their value under almost all market conditions.

But these cash-like assets also generate very low returns, and don't keep pace with inflation — another key risk for investors. Over the years, these assets can lose their buying power even if they don't decline in value.

Now is a good time for you to review your portfolio with your advisor. Talk about your goals, and your risk tolerance, and develop a strategy that can help to manage volatility in the financial markets — as well as other investment risks — in the next year.

Andrew Menachem, CIMA, is a Wealth Advisor at the Menachem Wealth Management Group at Morgan Stanley in Aventura. Views expressed are those of the author, not necessarily Morgan Stanley, and are not a solicitation to buy or sell any security. The strategies and/or investments referenced may not be suitable for all investors. Follow Menachem on Twitter @AMenachemMS