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Managing Risk In A Rollercoaster Market

Northwestern Mutual

By Jeff DeAngelis, former chief investment officer of Northwestern Mutual Wealth Management Company.

A friend said recently, “You never truly understand your risk tolerance until you actually have money on the line.” I get it; the stock market can be a scary place, especially when volatility is on the rise, as it has been this October. Early in the month, the Dow Jones Industrial Average (the Dow) marked its biggest single-day gain (nearly 275 points) and its biggest single-day drop (335 points) since 1997—on back-to-back days. It’s been a rollercoaster ride ever since.

Time to Batten Down the Hatches?

Stocks have been bouncing up and down on concerns about the health of the global economic landscape, unrest in the Middle East and elsewhere, and fears of an Ebola pandemic and the impact it could have on the U.S. economy. Add to this the fact that we’re in the midst of earnings season (which tends to bring its own volatility) and nearing the end of the Federal Reserve’s bond-buying program, and it’s easy to see why many investors are on edge. In fact, Wall Street’s so-called “fear gauge,” the Chicago Board Options Exchange Volatility Index (the VIX), is at its highest level since February and back above its 20-year average of around 20.8. This suggests that more near-term market ups and downs are to be expected.

What You Don’t Know Can Hurt You

If past volatility has taught investors anything, it should be that risk is a normal part of investing and that sell-offs often provide attractive buying opportunities. But that doesn’t change the fact that market prices can move quickly and unexpectedly, which makes it incredibly difficult to accurately predict what will happen next. For this reason, managing risk continues to be the cornerstone of a sound, long-term financial plan.

While you can never fully eliminate risk from investing, there are ways you can mitigate it. The first step is to understand the two main categories of risk and how they may impact your portfolio:

1. Market Risk: What Goes Up Can—And Does—Come Down. Market, or “systematic,” risk is the risk that all or a particular segment of the market will decline at the same time because of “outside” forces (macroeconomic factors), such as changing interest rate or inflation levels, shifts in monetary policy, currency fluctuations, and political or social events. These factors affect the entire financial world, not just one particular company or industry.

Market risk can also be triggered through the domino effect of institutional investors, who tend to buy and sell stocks in massive volume, thus negatively impacting the share price of a particular company that is otherwise healthy and sound.

Balancing market risk is difficult because no company or industry can avoid the losses that come from major news events in the financial or political world. What you can do is invest in a broad mix of asset classes with the understanding that one may be better positioned to weather difficult economic conditions than the others.

2. Business Risk: Things Can—And Do—Go Wrong. In contrast, business risk, or “non-systematic risk,” is the risk that something can go wrong at the company or industry (micro-economic) level, causing a company’s stock or bond to fall in value. Non-systematic risk factors include poor earnings reports, company mismanagement, labor issues, product rollout delays, key employee turnover, or other bad news impacting the financial health and profitability of a company.

Think of the impact a flight attendants’ strike could have on the financial health, and thus the stock value, of a particular airline. Another example is a stock price dropping on news that its company’s founder (think former Apple CEO Steve Jobs) is battling a serious health issue.

Because business risk is based on the performance of an individual company or group of companies, it can be managed by holding a well-diversified portfolio of investments. For example, mutual funds and exchange traded funds (ETFs) typically spread business risk by investing in a broad mix of individual investments. That way, when a portfolio experiences an unexpected loss in one company, it might be offset by an earnings surprise in another.

Because the market is inherently unpredictable, market and business risks are ever present. How can you achieve your financial goals despite inevitable market ups and downs?

First, make sure you have a sound asset allocation strategy based on your goals, time frame and risk tolerance. The specific risks inherent in one asset class may offset the risks in another, helping your overall portfolio weather inevitable dips in the market. Over time, asset allocation has proven to be a sound investment strategy. Despite sometimes significant ups and downs along the way, the stock market historically has trended up, providing investors with attractive long-term returns over time.

Second, remember that volatility can be your friend. If you stick to your plan and the targets you set, market ups and downs may provide you the opportunity to sell high and buy low through rebalancing, thus helping you to preserve any gains and reduce potential losses. It can also help you remain invested in the market so that you can “ride up” market movements when they happen.

Finally, consider getting professional help. When you work with a qualified financial professional, he or she can help ensure you have a strategy to help you reach your financial goals, proactively manage the risk in your portfolio, and provide the reassurance you may need to stay on track, regardless of what happens next.

Northwestern Mutual Wealth Management Company is a subsidiary of The Northwestern Mutual Life Insurance Company.

The opinions expressed are those of Jefferson DeAngelis as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Information and opinions are derived from proprietary and non-proprietary sources.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against a loss. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Bond investors should carefully consider risks such as interest rate risk, credit risk, securities lending, repurchase, and reverse repurchase transaction risk. Greater risk is inherent in investing primarily in high-yield bonds. They are subject to additional risks, such as limited liquidity and increased volatility. There is an inverse relationship between interest rates and bond prices. For example, when interest rates rise, the market value of the bond declines, which could negatively affect overall performance.

The Dow Jones Industrial Average Index® is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since Oct. 1, 1928.