By Robert Toomey, Special to the Reporter
Much of what we do as financial planners involves forward-looking assumptions. The assumptions encompass many areas: inflation, the economy, interest rates, financial market performance, and assessments pertaining to financial market and geopolitical risk. Add to that list increasing risks around health care/pandemics and more recently, domestic unrest. It conjures up a recipe for a high degree of turbulence and uncertainty.
One might question how, as planners, we can have any real confidence in making forward projections in the face of such uncertainty. A couple of observations on this. First, there is always uncertainty, it is nothing new. Investors and financial planners have been dealing with uncertainty for centuries, really. We have over 150 years of history to look back on as a guide. By studying historic financial metrics over long periods and combining that with logical assessments of the forward environment, we believe we can make reasonable projections with a fairly high degree of confidence.
Second, we’ve been here before. If one looks back, really over millenia, there have always been risks and uncertainties with which humans have had to deal in order to survive: wars, pestilence, pandemics, natural disasters and the like. Humans have survived these events and economies have continued to grow. The good news around something like COVID-19 is we have means to deal with it. As planners, we have a fairly high degree of certainty we will get through this event and the economy will get back on its feet and yes, grow and prosper once again. This lends confidence that returns on investments such as stocks, in which all of our clients invest for growth, can and should return to long-term mean returns.
Third, there are ways to mitigate these risks. One way is through diversification. When we invest client assets, we do so in a way in which their assets are allocated across several different asset classes, such as stocks, bonds, real estate, commodities, etc. Investing in this way allows us to reduce or mitigate the risk of material declines in one or two asset classes and thereby reduce the risk (volatility) within the portfolio. As an example of the effectiveness of diversification, a recent study by Morningstar showed that a portfolio allocated 60% to stocks and 40% to bonds actually outperformed an all stock (S&P500) portfolio on a total cumulative return basis for the period March 31, 2000 through March 31, 2020. Why? Because the diversification reduced portfolio volatility.
Despite the current problems we are facing including COVID and civil unrest, history has shown there is every reason to believe things will get better. They always have. As I have said before, no one can predict the future. But we can look back at historic performance of the financial markets and combine that with probabilistic assessments of the future and portfolio risk mitigation, all of which allow us to have a fairly high degree of confidence in making planning and investment recommendations to our clients.
Robert Toomey, CFA/CFP, is Vice President of Research for S. R. Schill & Associates on Mercer Island.