A Good Night's Sleep... Priceless

October 18, 2011

 

It seems like up 200-point days and down 200-point days have become normal for this market. However, what might be normal doesn’t mean it’s easy to get used to. During periods of high volatility, there are not too many places to hide. With that said, there are ways volatility can be reduced, but, it comes at a price.

 

To understand how to tame volatility, we first have to understand what is the current Risk-Free Rate of Return? The financial industry defines the Risk-Free Rate of Return as the return an investor expects from an absolutely risk-free investment over a very short period of time. The common example of this would be the 3-month treasury bill. However, let’s bend this definition just a bit and stretch it out to a one-year CD, which currently yields about 1.1%.

 

For retirees wanting to enjoy cash flow from their nest egg, producing a sufficient amount of income is crucial. If income needs are greater than the income produced by the capital, then principal deterioration could occur at a faster than prudent pace. On the flip side, if the portfolio is invested in ultra-high-yielding securities, the investor must understand the risk and volatility they are assuming.

 

The old saying goes, “you should accept volatility when you get paid for volatility.” For every percentage point you expect your portfolio to earn over the Risk-Free Rate of Return, you should expect increased volatility. If your portfolio yields 5%, then a certain degree of the “ups” and “downs” of the market should be expected. The goal is to find the right level of “sleep tolerance” equal to that of the acceptance of expected volatility. For those with equity market exposure, the same rule applies. However, the risk of uncertain returns in the equity market should only be assumed once cash flow needs are taken care of and a needs analysis examined. The goal is to enjoy your cash flow……..but not lose sleep worrying about it.

 

 

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