Have you thought about your exit strategy?

It is widely accepted amongst investors that a well thought out investment plan, and by extension investment portfolio, is a key factor in achieving one’s financial goals. The “investment plan” is often articulated through a policy document such as an Investment Policy Statement. The policy document is charged with recording one’s financial goals and mapping them to an investment portfolio comprised of various asset classes and securities (e.g. bonds, equities, real assets etc.). In aggregate, the investment portfolio should be consistent with one’s specific objectives, such as return and income targets, as well as one’s specific constraints, such as volatility tolerance and liquidity requirements. As you can imagine, or perhaps even know firsthand, much time and effort are spent on the policy document’s investment plan. But what is often missing, regardless of the document form, is a similarly well thought out “exit strategy”.

In those instances when an “exit strategy” is in place, it generally relies on simple protocols, such as reducing exposure to assets that have higher historical volatility. While this specific and often employed approach makes sense intuitively, especially as one gets closer to funding a financial goal, is it sufficient?

Let us look at an example of this type of well-intentioned exit strategy through what is known in the investment industry as “life-cycle” funds. This class of investment funds utilize “automatic” rules-based protocols that focus on narrowly defined criteria, specifically the historic volatility behaviour of two broad asset classes – stocks and bonds. Their protocols dictate that they must reduce exposure to so-called “higher” risk assets, often defined as stocks, as they approach a particular target date (akin to funding a financial goal). Simultaneously the fund will increase exposure to “lower” risk assets, often defined as sovereign or investment grade bonds, in order limit potential losses from market fluctuations. Investors choose a life-cycle fund with a pre-defined “maturity” date that best coincides with a specific goal, such as retirement funding, charitable gift etc.

While there is definitely merit imbedded in the aforementioned “life-cycle” approach, in and of itself it is not a sufficiently well-thought out exit strategy. Its one-dimensional rule-based protocol – historic volatility – fails to consider the investment’s current reality. Consideration should also be given to valuation, income characteristics, outlook, and key components of the broader macro backdrop, such as interest rates and inflation. Failing to review these additional factors is akin to a trader relying solely on pre-determined price targets for purchasing and selling a security. Doing so may reduce the role emotion plays in the trader’s decision-making, in this case for both entry and exit, but it fails to account for any changes that should be factored into the price targets.

In sum, investors need to employ the same level of thought and analysis in developing their exit strategy as they factor into building their investment portfolio. By clearly identifying the criteria that define when an investment no longer contributes to one’s financial goals, the greater the likelihood of meeting those goals. Perhaps it is time for you to review your exit strategy.

Author: Zubair Ladak

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