Like other daily newspapers, the Baltimore Sun has seen shrinking revenue and print circulation as more people turn to digital news
Like other daily newspapers, the Baltimore Sun has seen shrinking revenue and print circulation as more people turn to digital news AFP / JIM WATSON

Inflation! Rising interest rates! Armies on the move in Ukraine! Growth stocks stumbling! All these factors made for a volatile start to 2022. Novice investors often confuse volatility with risk and go to cash in times like these.

Experienced investors recognize that volatility is a fact of life in financial markets. Volatility makes certain investments pay off. There is no volatility risk in U.S. Treasury bills, which yield 0.05%. The S&P 500 is volatile, but the expected return for the next 20 years is in the range of 7% to 9% per year.

When we work with clients, we explain that risk is the chance money won’t be there when you need it. If the client wants to close on a home purchase in three months, we reserve the cash for the down payment now. If a client wants to enjoy their retirement 20 years from now, we must build a nest egg large enough to sustain an annual draw that will cover their expected expenses.

Investors often overreact to the news of the day. Headlines like “Ukraine could be the worst war in Europe since 1945” do not reassure. Investors are selling risky assets like stocks and buying “safe” investments like U.S. Treasury bonds and gold.

However, as we remind our clients, the stock market ultimately only cares about three things: company revenues; company earnings; and interest rates.

Even with the Russia-Ukraine war, the employees of Amazon, Apple, JP Morgan, Pfizer, and the thousands of other companies that make up the U.S. stock market will keep doing their jobs, generating revenue and earnings. In 2021, S&P 500 earnings grew 47% (during a pandemic!) and are expected to grow another 10% this year.

The Federal Reserve is expected to raise interest rates four to five times in 2022 and two to three more times in 2023. Even so, interest rates will only rise from the current 0.25% to perhaps 1.75% by the end of 2023. Fed funds were 2.5% prior to the COVID-19 pandemic and 5.25% before the 2008-2009 financial crisis.

In December we said earnings would push stocks higher in 2022. But rising interest rates would push stocks lower for net gains of 6% to 9% by year-end. Our year-end forecast has not changed because of the Ukraine situation, which is a humanitarian crisis, not an economic crisis. To make our minimum year-end target of 6% gains in the S&P 500, stocks would have to gain 20% from current levels.

Volatility risk generates headlines, but we focus instead on these risks:

Longevity Risk - The chance that a person outlives their money

People often conclude that retirement assets must be invested conservatively. That conclusion is valid – in your retirement years. If your retirement is still at least 10 years away, your 401(k) and IRA accounts should be invested 100% in equities. As a client reaches his or her 50s and 60s, we increase the allocation to bonds by 5% to 10% each decade and make sure the retirement accounts get the maximum tax-deferred growth.

With some clients, we encounter a situation where a family spends far less than they could afford in retirement. As we often say, “Dying with millions is not a win.” Managing longevity risk means spending enough, not too much or too little.

Liquidity Risk - The chance that a person will have too little cash on hand for necessary purchases

People often invest too much cash in illiquid assets like real estate, thinking of homes as stable stores of value that will appreciate over time.

The ’08 financial crisis demonstrated the less- than-absolute security of real estate. Plus, it takes time and money to turn a house back into cash, which could be costly during emergencies.

We help our clients develop a clear sense of their cash needs for the next year, next one to five years and five years and beyond. We then segregate assets into different accounts with different liquidity characteristics. For the needs of the next year, only cash is an acceptable investment. For needs of the next one to five years – bonds. Beyond five years – stocks.

Foreign Market Risk - The risk of loss that accompanies investments in foreign economies

Generally speaking, investing outside U.S. markets should improve investors’ returns. Generally speaking, non-U.S. economies, particularly emerging economies, grow faster than the U.S. economy, and therefore investments in local stock markets should also grow faster.

However, foreign stock markets can be more volatile than U.S. stock markets, and the cost of trading in and out of foreign markets is higher. Getting good information on foreign stocks can be expensive.

We manage these risks by limiting our stock exposure to 10% invested in developed markets like Europe, Australia and Japan, and 5% in emerging markets like China, India, South America and Africa. We only invest using broad-based index funds. If emerging markets do well, raising our allocation to 7%, we automatically rebalance back to 5%.

Concentration Risk - Over-allocating investment funds to a single company or industry

In 1999 during the internet bubble, the hottest-performing mutual funds returned 150%, 200%, 250% as pure-play internet investments. Those same funds gave up 70% to 90% in 2000. Concentration risk cuts both ways. Commonly we see 401(k) plans that invest 90% in company stock. Employees of Facebook saw gains of 220% in their stocks over the five years through September 2021 and losses of 45% over the last five months. Holders of single-stock positions in Sears, Enron and General Electric all lost their life savings.

People hate selling their employee stock over regret of missing the subsequent upside and the pain of paying capital gains taxes. We advise clients to bite the bullet, set up a systematic plan to reduce positions over time (sell 5% per quarter). Yes, our clients will never get the “top tick” on selling out the position, but they will never face the agony of losing everything.

David Edwards is president and wealth advisor with Heron Wealth, a $500 million registered investment advisor based in New York City working with 225 client families across the U.S. and around the world. Dustin Lowman contributed additional research for this column. Edwards and/or his clients hold positions in Amazon, Apple, JP Morgan and Pfizer.