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Investing: What’s your VUCA market tolerance?

If you have investments in the global stock and bond markets, you’ve likely dealt with VUCA over the past few weeks. VUCA stands for volatility, uncertainty, complexity and ambiguity. It is a term that has become popular in business management programs. To successfully manage the implementation of their strategic plans, business leaders have to get comfortable with the VUCA associated with their decisions.

It’s the same for investors. Volatility, uncertainty, complexity and ambiguity are daunting terms, synonymous with risk. In the context of retirement savings and investment accounts, people often deal with VUCA in one of three ways. They ignore it, they oversimplify it or they are confused by it.

Your best hope as an investor is to demystify it. Volatility, uncertainty, complexity and ambiguity will always exist when making decisions about managing your money for future growth. Address these realities of your investments and it will help ease your ability to make decisions amid conditions that are not ideal.

NO RISK-FREE CHOICE

The desired reward of an investment return requires taking risks. The art of managing VUCA in investing is trying to understand the relationship between the amount of risk you are taking, how you expect to be compensated for that risk and the timeline required to realize expected returns. Sometimes investors end up taking excessive risks because they choose to concentrate a portfolio or shorten their investment time horizon. This happens when the pressure for achieving an outsized return is greater than the understanding of the potential risks.

Generally, if you are educated about risks and prepared for the volatility, uncertainty, complexity and ambiguity that is inherent in money and markets, corrections or bear markets shouldn't surprise you. They don’t appear on any regular schedule or with any signal of their inception. But we know that U.S. stock markets post negative returns about one out of every four years on average.

Performance of the S&P 500 Index of U.S. stocks in "modern" investing times shows a four-to-one ratio of calendar year positive returns to negative. From 1970 through 2014, there were 36 positive years and nine negative. From 1990 through 2014 there were 20 positive and five negative.

When stock markets are building gains, they often progress in small consistent increments. When they reverse, it tends to come in sharper moves that can instigate detrimental emotional responses. But VUCA isn’t an exclusive description of stock markets. There is plenty of volatility, uncertainty, complexity and ambiguity in bonds and other assets also. For example, did you know that before the August downturn, the U.S. stock market had not had a decline of more than 10 percent since September 2011? In that time, U.S. long-term government bonds (represented by the iShares 20+ Treasury exchange-traded fund) had three 10 percent declines and three more separate instances of declines that exceeded 7 percent.

Sometimes, it's those places where you don't expect to find risk that may be more problematic.

VUCA PREPAREDNESS KIT

In the investment context, the best way to deal with VUCA may be through diversification — owning a global mix of different types of assets. This is the get-rich-slowly route for people who understand that their biggest risk is permanent loss of capital, not dealing with fluctuating market values. When you are broadly diversified you always will own more of what you wish you didn’t (such as emerging markets stocks in August) and less of what you wish you had. That’s not a failure of diversification. Over time, it’s a benefit. This feature of a diversified portfolio will help you stay disciplined when human nature is tugging at you to chase what’s currently leading the market.

As part of building proper diversification into your investment mix, it can be helpful to simulate market conditions and think about how you might respond to events that stretch your comfort zone. You don’t have to wait for a post-mortem evaluation of what happened. Do a pre-mortem stress test of what could happen and how you would feel about it. Understand the potential range of outcomes for each of your investments and what that means for the total portfolio.

When you purposefully evaluate risk and then identify what it means in the context of your goals, you may fare better than the average investor.

Disciplined investors, accepting the permanence of volatility, uncertainty, complexity and ambiguity, should be better positioned to:

▪ Understand investment risk/reward tradeoffs

▪ Make more informed, less emotional decisions, and

▪ Absorb short-term market unpleasantries (the outward expression of VUCA) in order to improve the probability of experiencing more favorable long-term outcomes.

Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Tacoma. Reach him at gary@bhjadvisors.com.

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