Portfolio Management May 23, 2016

    At risk of stating the obvious, losing money never feels good. In fact, research has found that investors tend to fear losses twice as much as they enjoy gains. This behavioral bias is known as "loss aversion."1

    Despite that bias, investors all too often ignore the potential downsides of investments and focus instead only on annualized long-term returns—assuming that their investment performance in the year ahead will grow at an "average" rate. Of course, their investments might do much better or worse than their long-term average at any given time.

    When you ignore the potential volatility of your investments, you're likelier to be caught by surprise when the market takes a big swing downward. This surprise can lead to panic, which is when many investors abandon their plans. So it's important to have a solid understanding of the potential losses you can withstand while staying focused on your longer-term goals.

    Smart investing considers both risk and return. Investments with higher expected returns tend to be riskier, and even conservative portfolios can experience short-term losses.

    The return required to fully recover from a downturn grows larger as losses mount. As Figure 1 illustrates, a 10% loss requires an 11% return to break even, while a 50% loss requires a gain of 100%.

    Figure 1: Larger losses require larger subsequent gains to break even
    Beginning portfolio value Portfolio loss Portfolio value after loss Subsequent return required to break even
    $100,000 –10% $90,000 +11%
    $100,000 –50% $50,000 +100%

    Source: Charles Schwab & Co., Inc. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product.

    Matching your asset allocation to your risk tolerance is key

    One way to help manage risk and dampen your portfolio's potential downside is to diversify across a range of asset classes. That way when one investment is struggling, a different one might be doing better.

    Diversified portfolios can include a mix of asset classes such as stocks, bonds, commodities and cash. But a more conservative investor might emphasize bonds and cash, which tend to be less volatile, while a more aggressive investor might hold more stocks.

    As illustrated in Figure 2, during the rocky first quarter of 2016, the S&P 500® Index—an index of domestic large-cap stocks—fell more than 10%. During that same period, a hypothetical diversified moderate portfolio fell about half as much.

    Similarly, during the severe market declines of 2007–2009, the diversified moderate portfolio fell less than the S&P 500. This underscores the importance of getting your risk tolerance right. You could select a more conservative or more aggressive portfolio than the moderate portfolio, with potentially smaller or larger losses.

    DIversification can help moderate portfolio declines

    Smaller drawdowns mean less ground to make up

    The smaller losses for the diversified moderate portfolio in Figure 2 mean that an investor would have had less ground to make up after each decline. Importantly, the investor also would have recovered more quickly in each case, as shown in Figure 3. In early 2016, it only took a month and a half for the diversified moderate portfolio to drop and then return to its prior peak. And during the financial crisis of 2007–2009, the diversified moderate portfolio was back to breakeven in just over half the time it took the S&P 500 to recover.

    Figure 3: Smaller declines can result in faster recoveries
    Time for roundtrip from peak to trough and back to breakeven
    Diversified Moderate Portfolio S&P 500 Index
    Q1 2016 45 days 54 days
    Time for roundtrip from peak to trough and back to breakeven
    Diversified Moderate Portfolio S&P 500 Index
    Financial crisis 29 months 54 months

    Source: Morningstar Direct, 1/1/2016–3/31/2016 and 1/1/2007 –12/31/2012. Time periods measure the number of trading days from each portfolio's peak through the trough and subsequent recovery back to breakeven. The Diversified Moderate Portfolio is the same portfolio as in Figure 1. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product. Past performance does not guarantee future results. Indexes are unmanaged; do not incur management fees, costs or expenses; and cannot be invested in directly.

    As history shows, big drops can and do occur—look no further than the financial crisis of 2007–2009—so if you need your money sooner rather than later, think hard about whether your allocation is sufficiently conservative. A more conservative portfolio might have had a smaller decline and shorter recovery period than the diversified moderate portfolio.

    And if you have a higher tolerance for short-term volatility in the pursuit of potentially higher long-term returns, you might select a more aggressive portfolio. But how do you know what your risk tolerance is? This is one area where Schwab Intelligent Portfolios® can help.

    Schwab Intelligent Portfolios is designed to recommend a portfolio based on your risk profile

    With Schwab Intelligent Portfolios, your answers to the online Investor Profile Questionnaire about your goal, time horizon and risk tolerance help determine which type of portfolio across the risk spectrum from conservative to aggressive is most appropriate for you.

    We know that being able to ride the inevitable ups and downs of financial markets is key to helping you stick with your financial plan. Because of that we built Schwab Intelligent Portfolios to consider both risk and return, including considerations of the behavioral bias of loss aversion, to help you stay focused on your longer-term investment objectives.

    David Koenig CFA®, FRM®, Vice President and Chief Investment Strategist for Schwab Intelligent Portfolios®

    1. Daniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision under Risk," Econometrica, 1979.

    Investing involves risks including loss of principal.

    Diversification does not ensure a profit and does not protect against losses in declining markets.

    The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

    Indexes used in the Diversified Moderate Portfolio are: U.S. large-cap stocks, S&P 500® Index 18%; U.S. small-cap stocks, Russell 2000® Index 8%; International large-cap stocks, MSCI EAFE Index 10%; international small-cap stocks, MSCI EAFE Small Cap Index 5%; emerging market stocks, MSCI Emerging Markets Index 8%; real estate investment trusts, S&P U.S. REIT Index 5%; Treasuries, Barclays U.S. Treasury 3–7 Yr Index 12%; investment-grade corporate bonds, Barclays U.S. Corporate Index 5%; high-yield bonds; Barclays U.S. VLI High Yield Index 5%; international bonds, Barclays Global Aggregate Ex-USD Index 7%; emerging market debt, Barclays Emerging Markets Aggregate USD Index 4%; gold and other precious metals, S&P GSCI Precious Metals Index 5%; cash, Barclays U.S. Treasury Bill 1-3 Mo. Index 8%.


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