Bug in your Ear
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It’s easy to forget how high markets had been flying just two quarters ago and how optimistic the mood felt. But thanks to a tiny bug too small to see even with a standard microscope, the world has been turned on its head. Whether you feel the world’s collective response has been out of line with the actual risks or maybe not panicked enough, once fear pervades the market, the reasons don’t matter so much. Our primal instinct to protect ourselves takes over and can rapidly cause major financial and economic harm.
We know instinctively that extremes are bad. But when everyone else is behaving in one way–whether selling stocks or hoarding toilet paper–it’s difficult not to follow suit. After all, maybe others know something we don’t. Maybe group behavior, even if not completely rational, will hurt us if we don’t play along. And the news often makes things worse by reinforcing what everyone is thinking, adding fuel the fire and pushing our collective sentiment—and thus, markets—in a single direction.
This is how self-fulfilling prophecies are born.
Hard as it is to believe right now, sometimes excessive optimism also takes over. Remember the late 90s’ tech bubble with its extreme valuations or the real estate bubble of the early 2000s? More recently, some would argue that prices on all assets had reached unsustainable levels even without the coronavirus.
When times are good, the fear of missing out on gains can cause investors to throw their money at the wrong assets despite elevated price levels. The fear of regret causes real psychological pain that investors try to avoid by making irrational decisions. (You know this regret if you have ever felt stupid in hindsight for not selling at the top of the market or for not buying at the bottom of the market, even though you couldn’t have foreseen what the market would do.)
Our advisors have observed many investors who failed to keep up with the historically long bull market between 2009 to 2020. Reasons for lagging behind included emotional decisions, inadequate long-term allocations to risk assets, poorly performing funds, or an investment strategy that hadn’t been updated for the times (e.g., a heavy foreign emphasis when US stocks were the best investment).
We obviously don’t predict another 11-year long bull market in stocks after this downturn. Nevertheless, we believe you should evaluate your risk level in light of your own goals as well as the current market conditions to prepare for what might lie ahead. Even in times like these, you can discover efficiencies and make use of your losses if you have the right guidance.
Your Ideal Risk
Let’s engage in a little thought experiment to clarify what risk is right for you. Pretend for a moment that there is no real-time source for market information. That means you don’t have an S&P 500 index level to follow or any other outside reference to tell you what “the market” is doing. What performance should you target or expect?
First, you’ll have to base your measurements on something about yourself, rather than the market. Maybe your financial plan indicates that you need to earn a certain percentage each year. Or maybe you know you have to maintain a minimum dollar amount at all times. You might even break up your money into “buckets” based on each goal you have so you can pursue them each individually.
The key point is that you have to develop a financial plan and keep it current to make intelligent portfolio decisions. A retiree with a paid-off house and adequate social security income to cover current expenses as well as good health coverage doesn’t need to make much at all to maintain a comfortable lifestyle. He or she might choose investments that don’t necessarily track the market upside.
On the other hand, a middle-aged working professional probably needs to target higher returns to enable retirement in the first place. Such an investor must understand that the risk of short-term loss is very real and must prepare for the inevitable bumps in the road. More aggressive types might even actively sell into rallies or use cash to buy when everyone else is selling.
How Does Risk Relate to Returns?
Traditionally, those who study financial markets hold that to earn higher returns, you must take higher risk. And in common understanding, risk means “stocks.” Such a view is not clearly wrong, but we feel it is simplistic. If you better define what risk means to you, you can build a more nuanced portfolio that is responsive to current events and that includes the right kinds of risks for the times.
The most obvious risk is the risk of losing your money, or principal. Investments that very quickly gain or lose value include stocks, precious metals, currencies, works of art, and even sometimes real estate. When your goals include hitting it big, you must typically put some portion of your money into investments that could lose big in the short run. To protect against principal loss, you typically concentrate your investments in cash and bonds, or even in insurance products.
But outliving your money represents a real risk, too. Inflation has remained tame for most of the past several decades. Consequently, investors have grown complacent to the risk that an upsurge in prices could severely diminish their purchasing power. Yes, cash and short-term US Treasury bills would have protected you in the month of March, but with short-term rates now set to zero, you can’t expect to make anything on safe investments. If you hold them too long, you will likely lose purchasing power as well as miss out on the opportunity to outpace inflation in the coming years.
The Hidden Risk and its Opportunity
A risk that not all managers discuss has to do with being incorrectly positioned for the current market environment. When you buy and hold over 50 to 100 years, you can probably safely ignore market-moving events. You’ll get the long-term average, and the average will probably be sufficient if you set realistic portfolio goals. But what is your plan for a major dislocation such as we are experiencing in 2020?
You might have heard that sticking to the program is the best advice. That depends on your program, though. Most investment allocations were not built to anticipate market crashes. They were based on average performance over long periods of time and might not include an adequate rebalancing discipline or the ability to shift among assets based on special situations.
Take, for example, the last crash in 2008-2009. At the start of the year in 2009, when investors were panicked, long-term US Treasuries (UST) had returned double digits. Way to go, conservative investors! But the same assets took huge hits when the stock market turned around. If you look at UST performance in 2020, you may already see echoes of 2009. The point is that safe investments can quickly become risky assets merely due to market movements.
Had you shifted from long-term US Treasury bonds at the start of the 2009, however, and invested at least some of the proceeds in high-yield bonds (uncomfortable, we know!), you would have seen double-digit current yields as well as significant capital gains in next couple of quarters. The same went for shifting into equities, which posted even higher gains in subsequent years.
This isn’t just hindsight bias, either. If your investment policy had a rebalancing rule that moved you into equities when you fell, say, 10% below your target, or if you shifted once per year to the highest-yielding assets (stocks or bonds), you would likely have rebalanced to your substantial benefit. [Rebalancing into a falling market does not guarantee higher returns.] We could give more examples, but we feel the above are sufficient to highlight the need to have a plan or an astute advisor for when major market moves throw one-off opportunities your way.
What About Your Situation, Right Now?
First of all, don’t just follow your emotions.
Emotional investors often choose their investment goals when times are good but then reverse course when times are bad. Nearly everyone loses money in a significant downturn, but emotion-based investors who have no clear long-term probably plan hurt themselves the most. If you have lost money in this market, it’s time to take stock rather than react.
Emotional investors not only bail out of markets after losses have become too difficult to bear, they hesitate to buy back in when markets are on the mend and thus crystalize their losses. There is even academic research showing that the average mutual fund investor significantly underperforms the average mutual fund because of poorly timed trading decisions.
We urge you to construct a thoughtful financial plan and to keep it current. Doing your work up front helps you stick with the right program but allows for reasonable adjustments as markets fluctuate. Working with an advisor to follow through on your investment program for you can also help, as your advisor can bring some much-needed objectivity to the process. If you have no financial plan or rebalancing discipline, we invite you to contact us for a discussion.
Some Good News
As of this writing, the government has undertaken historically unprecedented stimulus measures, some areas have reported a decrease in the spread of the coronavirus, and companies still sell products and services and earn a profit. Perhaps we’ll have a vaccine in the near future, as well.
Beyond stock prices that are much lower than they were a quarter ago, we have observed attractive opportunities in the bond market now that prices have taken a hit. Could there be a temporary opportunity here to make higher returns with reduced risk? After all, bonds have a guaranteed maturity value (if their issuers remain solvent).
Stocks generally make no such promises, but the long-term average price-to-earnings ratio on S&P 500 stocks has been in the 15-20x range. To the extent that we fall below that, stocks might overshoot and provide upside potential that wasn’t there a year ago. After the quarantine ends, we may also see some pent-up demand boosting corporations’ income in the near term.
Build Your Portfolio Recovery Strategy Now
Whether or not true recovery is imminent, we urge you to review your strategy now and make sure it fits you for the future. In 2019 you might have stayed on the wrong side of the market trend, lagging behind the major indicators for years. In the current downturn, you could have seen larger losses than expected and not had a context for deciding whether to sell, or when or how to get back in after selling.
We would like to help you position your portfolio now, while markets are down.
If you update your strategy during a bear market, not only do you get to “rewind the clock” to stock values from many quarters ago, buying what you wish you had held up to now, you may be able to reduce your tax burden. You might even get to “bank your losses” to make future rebalancing less costly. This article’s supplement explains the tax loss concept more thoroughly.
Through our Discovery Process, we will help you determine what is important to you, clarify your investment goals and expectations, and define your personal and financial goals. Out of this process comes a recommended portfolio built to match your return needs and risk tolerance. As active managers, not only do we keep our you on track with your long-term program, we also watch for opportunities to shift assets when we see special situations.
Get a Second Opinion
Even if you choose not to become a client yet, we can provide you a free “Second Opinion” portfolio review to get you started. This can be especially helpful if you are wanting to understand our approach. You will gain valuable insights by having a professional advisor review your holdings and give timely feedback.
While we won’t pretend to answer where the market will go tomorrow, next week, or even this quarter, we can help you use this difficult time to your best advantage.
Schedule a consultation now by clicking here.