Financial planners often work with averages. But the reality is that each bear market will be different from the norm. At the time that I write this, the depth of this particular drawdown does not even rank with the worst in history. Sure, it may still get worse, but thatâs where we are today.Â
We may not want to hear about how things will get better, because the situation with the Covid-19 pandemic and its resulting prescription of social isolation and market downdrafts is scary. But, eventually, things will get better.Â
Keep in mind that things may get worse before they get better. The count of people with the virus will almost certainly increase. If you donât have a source yet, you can keep up with it over here. But eventually, the Coronavirus epidemic will run out of steam. We will get back to our places of work. Kids will go back to school. Financial markets will right themselves out. We will revert to standard toilet paper buying habits. We will start going out to eat again. Life will become normal again.Â
Financially, the question is not just how bad will things get, but how long it will take for our nest eggs to rebuild, so we can put our lives back on tr
Hence, it could take us a while before we make it back to the previous market peak. However, we may want to look at the data differently. This graph shows that, historically, we have needed to achieve a return of 46.9% to recover from a bear market .Â According to Franklin Templeton calculations, these numbers can look daunting. However, they have been achieved and exceeded after every past downturn. While there is no guarantee, these numbers suggest that there will be strong returns once we have reached the bottom of the market. I like to think of this as an opportunity.Â Â
With the time that it takes for investments to grow and get your money back, there is time to take advantage of higher expected returns. For those who have resources available, this means that there is time to deploy your money at lower prices than has been possible in recent months.
Those of us who have diversified portfolios and are not in a position to make new investments, the opportunity is to rebalance to benefit from a faster upswing.Â
We know from history that every US stock market downturn was followed by new peaks at some point following.
Could this time be different?Â
Of course, that too is possible.
I like to think that the future will be better. We will still wake up in the morning looking to improve ourselves, make our lives better, and achieve our goals. We are still going to invent new technologies, fight global warming, and struggle for a more equitable society.Â
We are living through difficult times right now. Losses in our brokerage and retirement accounts are not helping. But we will get through this. Please reach out to me if you have specific questions or concerns.
Thereâs been a lot of sideways action in this yearâs capital markets. We have had a couple of mini-corrections already but equity markets have done a remarkable job of ignoring some clouds on the horizon.
What started back in February as aluminum and steel tariffs has delved into a war of words and escalation of tariffs between the worldâs three largest economies of the US, China and Europe.
There is almost a sense of disbelief that this could be happening after decades of globalization.Â We are so used to the free flow of goods and services across borders that we hardly ever stop and think about where things are made.
Is a Toyota Camry Japanese or a âMade in the USAâ car from a company that so happens to be domiciled in Japan? Is your iPhone an American product or a product made in Asia for a US-based company?
Global companies such as Apple or Toyota operate in highly inter-linked global supply chain and sales channels. A trade war will be highly disruptive to global trade and manufacturing.
Making Your Post-Divorce Portfolio Reflect the New You
Divorce is the final step of a long process. Whether the marriage was long or short, the end of marriage brings about the conclusion of an important phase of your life.
Divorce is an emotional event sometimes anticipated years in advance and at other times coming totally out the blue.
In all cases whether anticipated or not, divorce is a stressful event. According to the Holmes-Rahe Life Stress Inventory Scale divorce ranks as the second most stressful event that a person can experience in a lifetime.
For one, the dollar amounts are less than before and your current investment strategy reflects your goals as a couple rather than your own objectives going forward.
Moreover, most likely your confidence is a bit shot and your desire to take much investment risk is lower than before.
Ok, are you with me? You can control this aspect of your new life. What steps should you take to get the ball rolling?
We suggest an approach rooted in our P.R.O.A.C.T.I.V.E methodology.
The first step involves thoroughly examining your new situation from a non-financial standpoint.Â Where do you want to live? What type of lifestyle are you looking for? If you have children what type of issues do you need to account for?
The second step is to re-evaluate your comfort with taking investment risk.Â Now that you are solely in charge of your financial life how do you feel about taking on risk? Are you comfortable with the inevitable stock market swoons that occur periodically? Are you able to think as a long-term investor given your recent divorce?
The next step is really important. Your post-divorce portfolio needs to work for you. Establishing a hierarchy of financial objectives will drive the type of strategy that is most appropriate for you.
Is your primary objective to save for retirement? Do you have any major objectives besides retirement? Maybe you need to fund college tuition for your two kids.Â Maybe you plan on buying a new home in 2 years once your life has settled down?
Next you need to deal with the nitty gritty of figuring out exactly what you own and cash flow budgeting.Â What you own should not be difficult to figure out as you have just gone through the divorce process.
The second part of cash flow budgeting is often highly sensitive for people not used to budgeting during their marriage.Â If you have never had a budget or stuck to one this step seems like a major imposition. But unless money is so plentiful you have no choice.
At least for a period of time you will have to keep track of your expenses and gain an understanding of where the money is going. The reason this is important is that you may need to tap into portfolio gains to fund your living expenses. If that is the case, your portfolio should be structured to write you a monthly check with a minimal amount of risk and tax consequences.
The next step in the P.R.O.A.C.T.I.V.E process is to evaluate your tax situation. If you are in a high tax bracket you might want to favor tax-advantaged investments such as municipal bonds. If your income is going to be taking a hit post-divorce you probably will end up in a lower tax bracket increasing the attractiveness of a Roth conversion to your traditional individual retirement account.
The last three steps all involve figuring out how best to construct your investment portfolio.Â Going from your pre-divorce portfolio to something that fits your needs and goals will usually require some major re-adjustments in your strategy.
Going through our P.R.O.A.C.T.I.V.E process or a similar approach is probably the last thing you want to do on your own.Â Most likely you will need the help of an advisor to work through this.
Keep in mind that the reason you are doing this is to regain control over your financial life. You sought the help of a lawyer during your divorce. Now is the time to move forward and seek the help of financial professionals with an understanding of your situation and new set of needs.
What is the best way to implement a portfolio strategy for newly divorced people?
The most important aspect of post-divorce portfolio is that it fits you and your new circumstances and desires.Â Using our P.R.O.A.C.T.I.V.E methodology as a framework for evaluating your needs and desires we suggest implementing a portfolio structure that encompasses three âbucketsâ.
A âbucketâ is simply a separate portfolio and strategy that has a very specific risk and return objective. Each bucket in our approach is designed to give you comfort and clarity about its role in your overall portfolio.
What is the role of these âbucketsâ?
Each âbucketâ has a very specific role in the overall portfolio as well as very explicit risk and reward limits.
We label our three âbucketsâ as the Safe, the Purchasing Power and the Growth portfolios.
The role of the Safe Bucket is to provide liquidity and cash flow to you to meet your short-term lifestyle needs. How much you have invested in your Safe portfolio is a function of how much money you need to fund your lifestyle over the next few years.
The second bucket â the Purchasing Power portfolio â is designed to allow you to enhance your lifestyle in terms of real purchasing power.Â What this means is that every year your portfolio should have a return exceeding inflation.
Finally, the third bucket â the Growth portfolio â is designed to grow your portfolio in real terms. This portfolio is designed to maximize your returns from capital markets and will be almost exclusively invested in higher risk/higher reward equity securities.
Going through divorce is one of the most stressful situations anyone can face. Transitioning to a new beginning may take a short term for some but for most people the period of adjustment is fraught with uncertainty and doubt.
People often worry about their finances and whether they can maintain their lifestyle.Â A life event such as divorce also tends to shorten peopleâs horizon as their outlook in life often lacks clarity.
The implications from an investment standpoint are primarily a temporarily diminished desire to take on portfolio risk and a shortening of time horizons.Â In English this translates to searching for greater certainty and not looking too far out.
Our P.R.O.A.C.T.I.V.E approachÂ is designed to make your money work for what you deem important.Â Divorce is difficult and transitioning to a new beginning takes time.Â As you adjust to your post-divorce life your financial assets will also need to be managed consistent with the new you.
At Insight Financial we are experts at guiding you through this difficult adjustment period and transition into a new beginning. To read our full report on our approach for managing your post-divorce investments pleaseÂ click here.
Our wealth management team atÂ Insight Financial Strategists is ready to help you in your transition.Â To set up an initial consultation please book an appointmentÂ here.
Do-It-Yourself (DIY) Investors have been cropping up everywhere since the end of the 2008 Financial Crisis.
DIY investors tend to be well-educated professionals of reasonable means that prefer to build their own portfolios without the help of an investment professional.
They educate themselves about investing by reading a number of investment books (here is a popular one for Bogleheads) and subscription-based services espousing the benefits of the DIY approach.
A lot of DIY investors identify strongly with Jack Bogle, the founder of Vanguard for his dedicated approach to index investing.
One thing that distinguishes todayâs crop of DIY investors from the original crop back in the 90âs is that todayâs investors are much more focused on exchange-traded funds (ETF) as compared to individual stocks.Â A large number of inexpensive and liquid ETFâs have made this possible.
The primary appeal of DIY investing revolves around gaining control over your portfolio.
You are in charge and make all decisions. From selecting a specific ETF to all buy and sell decisions.Â A secondary appeal of DIY investing is cost â if you are the manager of your own portfolio you save yourself the fee that would have gone to your investment advisor. Typically this fee amounts to about 1% of the value of your portfolio.
DIY investors tend to do well when capital markets exhibit low volatility and the trend in price is well established.Â Everybody loves up-trending markets that donât fluctuate much.Â But as Humphrey Neill, a famous contrarian investor used to say âDonât confuse brains with a bull marketâ.
The analogy I like to use is that of a pilot. When everything is calm even a novice will look good. But when the friendly skies become turbulent, a novice pilot will likely tense up and the odds of making a mistake will increase significantly.
DIY investors face the same situation. During periods of calm, portfolio decisions will come easily. The cost of a poor decision is not likely to have major consequences in such a benign environment.
But when the capital markets get dicey, the implications of oneâs actions increase dramatically.Â A poor decision could decimate the value of your portfolio and seriously harm your overall financial health.
Stock market corrections are not fun for anybody, but experienced investment managers have the real benefit of having seen a movie of the same genre before.
I have lived through the 1987, 2000-2002 and 2008 stock market meltdowns.Â None of these were fun but I learned valuable lessons in each of these crises. Â Mainly I learned not to panic but also ways to course correct once it became clear that action was required. A key insight is that changing fundamentals require changing portfolio compositions.
A crisis such as 2008 is extremely disorienting even for professional investors, but the advantage that experience and knowledge of capital market behavior afford you is a game plan honed by the school of hard knocks.
Without the benefit of having lived through previous periods of real capital market stress and the knowledge of how markets typically behave, DIY investors are at a significant disadvantage.
The potential for errors during a crisis goes up exponentially.Â Three common reactions or mistakes that we have seen from DIY investors involve:
1. Selling Everything in a Panic
No questions asked, just get rid of everything that is taking a hit before it gets even worse.Â Taking action by selling everything may give the DIY investor a sense of relief.Â But making decisions in a highly charged emotional state is asking for trouble.
If the decision to sell is based on solid research and is well thought out, fine.Â But if it is based on impulse and an immediate need to get rid of the stress then it is most likely that the portfolio was not appropriate for the individual in the first place.Â Investing comes with volatility, there is no way around this!
DIY investors tend to focus on the initial portfolio composition or asset allocation but often fail to plan ahead should market conditions change.Â And if there is one thing that holds true is that change is inevitable and an ongoing part of financial markets. Planning ahead for changing market conditions is an integral component of a well-designed investment plan.
Fortunately, most DIY investors know that impulsively selling everything in a panic is not a good wealth creation strategy. But donât kid yourself â in a market meltdown you will want to sell everything and more!
You will have to control your emotions and have the stomach to weather the inevitable periods of market turbulence.
Photo byÂ Goh Rhy YanÂ onÂ Unsplash
2. Becoming extremely risk-averse and freezing up even if action is clearly needed
Most market corrections are short-lived and while painful in the short-term they barely register on the long-term map. For example, in 2018 we have already had a couple of equity market corrections but in each case, the market recovered its losses fairly quickly.
No harm, no foul! Doing nothing or standing pat works just fine when markets recover.
The bigger problem for investors is when corrections take on a bigger life and become outright market crashes.Â For example, the S&P 500 was down three straight years from 2000 to 2002.Â What do you do when the roof seems to be caving in?
Many DIY investors close their eyes and pretend that this is not happening to them. They get frozen and choose to ignore reality.Â This is not an abnormal reaction at all for us humans, but we also know that small problems many times lead to big problems if we do not address the underlying issue.
Wishing the problem away does not work.Â From the field of behavioral finance, we know that investors tend to hang on to their losing investments way too long.Â The flipside is that research has also shown investors to sell their winners way too soon. This effect is known as the disposition effect.
The price of financial assets such as stocks is a function of fundamentals (growth and profitability), the fair price of those fundamentals (investment multiples) and the sentiment of buyers and sellers.
You observe falling prices and you get more and more uncomfortable.Â But is there any real economic information in investor sentiment?
Experienced investors while not immune to the same feelings of fear will look at the underlying fundamentals and the value of those fundamentals. Experienced investors know that investor sentiment is fickle and lacks much predictive ability.
Has something changed recently to warrant this drop in market values? Are growth rates and profitability permanently impaired, or is the market overreacting? Are investors reacting to the perception of market over-valuation? These are all questions that require some real expertise and most importantly an understanding of context.
There is no cookie cutter way to analyze market action making the experience in similar conditions coupled with knowledge of historical market behavior all that much more valuable.
3. Failing to assess the changing risk levels of their portfolios
A frequent mistake made by DIY investors is to focus almost exclusively on returns and ignore the risk and correlation structure of their portfolios.
Much of the thought behind DIY investing hinges on ideas derived from Modern Portfolio Theory (MPT) but somehow you hardly ever hear DIY investors justify changing allocations based on the volatility structure and composition of their portfolios.
A related mistake is to often assume diversification benefits that often are not there when you need them most.Â A good read on âfake diversificationâ can be found here.
Ignoring changing asset volatility and correlation is a serious mistake made by many non-professional investors.Â In fact, one could say that by ignoring the volatility structure of portfolios DIY investors are ignoring some of the lowest hanging fruit available.
As Nobel Prize Winner Harry Markowitz once said: âdiversification is the only free lunch provided by capital marketsâ.
In a study done a couple of years ago on portfolio rebalancing, I showed just how much stock and bond volatility and correlations can change over time.
Source: Global Focus Capital LLC
Stock volatility, in particular, can move quite a bit around. Bond volatility while still variable shows much lower variability.Â And, correlations between stocks and bonds can move between positive and negative values implying large changes in diversification potential for a portfolio.
Say, a DIY investor has a portfolio composed of 60% US stocks and 40% US Bonds. The DIY investor diligently rebalances this portfolio every month so that the weights stay in sync. What would this 60/40 portfolio look like in terms of volatility?
Using the above study over the 2000 to 2016 period, the average volatility of this 60/40 portfolio would average 8%.Â Assuming that the average volatility would not change much would be a mistake. The range of volatility goes from 4% to 15% as shown in Figure 2.
Even the old standby 60/40 portfolio exhibits wildly fluctuating levels of portfolio risk.Â A 4% volatility level implies a much lower level of potential downside risk compared to a portfolio with a volatility of 15%.Â Experienced investment professionals inherently understand this and often seek to target a narrower pre-defined range of portfolio volatility.
Source: Global Focus Capital LLC
DIY investors do not often construct portfolios targeting an explicit range of risk. Instead, the often hidden assumption is that over the long-term asset returns, volatilities and correlations will gravitate toward their ânormalâ levels. These assumptions are not supported by the empirical evidence.
Also, correlations among investments within the same asset class (broadly speaking equities, bonds and alternatives) tend to also jump up during periods of crisis leading many to question the benefits of asset diversification.Â What investors should be questioning instead is why they did not re-adjust their portfolios to reflect the changing conditions.
DIY investing is here to stay. Many non-investment professionals have educated themselves as to the virtues of retaining control over their portfolios. After all, DIY investors are saving themselves the fee that they would normally pay their advisor for managing their portfolio.
When markets trend up and volatility is low, DIY investors will typically fully participate in the gains.
But there is another âcostâ that DIY may be incurring on their own that often rears its ugly head especially during periods of capital market turbulence.
We are all human and we suffer from the same biases and fears. The difference is that experienced professional investors have the advantage of having seen similar periods of capital market stress before and possess a more nuanced perspective of normal capital market behavior.
Professional investors while prone to the same fears as the DIY crowd are better positioned to focus their attention on the fundamentals of investment performance -growth, profitability & valuation â that ultimately drive portfolio values.
Experience and knowledge gained over many market cycles are at a premium when your portfolio most needs it.Â At Insight Financial Strategists we are experts in integrating your financial planning needs with your investments.
You do not have to go at it alone and compete against the pros.Â Our investment approach is rooted in the latest academic research and implemented using low-cost investment vehicles.
Interested in talking? Please schedule a complimentary consultation here.
Investors throw out lots of platitudes about their portfolios being diversified.Â Financial literature often contains allusions to diversification but do Main Street people really understand this important concept?
Think of portfolio diversification benefits in the same way you think about insurance on your house. When nothing bad happens you go on and maybe for a second you think about whether you really need this form of protection.
But when something bad happens like a stock market crash or a tree falls on your garage, you do not even think for a nano second as to what you paid for the protection.Â Whatever the price was, it was well worth it!
The portfolio diversification concept is, however, different from typical insurance in some important ways.Â When you buy insurance on your house you have a contract regarding the conditions under which the insurer will pay, how much, and importantly a maximum out of pocket deductible.
The devil is always in the details, right?Â You may think that your portfolio is diversified because nothing bad has happened yet. Or, you may think that your portfolio is diversified because your advisor said so. Who knows?
When typical investors hear the word diversification they think protection against portfolio losses. If you are diversified, your losses will be less than if you are not diversified, right? During a stock market meltdown such as 2008 your diversified portfolio should do ok, right?
Probably not. Remember the old saying – assume makes an a** out of you and me!Â Better be safe than sorry when it comes to your financial health.
Letâs start with some basics. Very simply put, diversification means that you are not exposed to any one investment type determining the bulk of your portfolio returns.Â One investment will neither kill nor make your whole portfolio.
A diversified portfolio contains investments that behave differently. While some investments zig, others zag.Â When one investment is up big, you might have another one that is down.Â Your portfolio ends up in the middle somewhere.Â Never as high as your best performing investment and never as low as your worst nightmare investment.
Asset classes such as bonds and stocks have very different behavior patterns. Sometimes these differences get lost in jargon such as risk and return or the efficient frontier concept.
Why do you own stocks in your portfolio? Why do you own bonds and, say, real estate? Why do you have some money stashed away in an emergency fund at the local bank?
I know these questions may Â seem a bit sophomoric but knowing the âwhyâ for each of your investments is important to understanding how well prepared you are to withstand periods of financial market stress.
The whole point of owning stocks, bonds and potentially other major asset classes as a mix is to protect your portfolio from bad things happening.
Sure we would all love to get the upside of stocks without any downside but in reality nobody has the foresight to tell us in advance (please avoid subscribing to that doom and gloom publication that just popped up in Facebook) when stocks will collapse and when they will thrive.Â Anybody up to buying some snake oil?
Diversification is not necessary if you have a direct line to the capital market gods. If you are a mere mortal proper diversification is absolutely necessary to ensuring you remain financially healthy.
Spreading your bets around, mixing a variety of asset classes, hedging your bets, not putting all your eggs in one basket â whatever your favorite phrase is you also need to live it. Diversification is one of those good habits that you should practice consistently!
With that warning in mind, what are 5 telltale signs that your portfolio may let you down when you need it the most?
Accumulating investments over time is a very common practice.Â People sometimes get enamored with a certain investment type such as tech in the late 90âs and when things donât pan out they are reluctant to sell the investment.
Not dissimilar to hanging on to that old dusty treadmill in the basement or that collection of Bennie Babies in the attic.Â Many individual investors are hoarders without admitting it.
Sometimes it is as simple as when people change jobs leaving behind a 401(K).
Solution: Research each one of your funds. For example if you own the Alger Large Cap Growth fund (ACAAX) use a free tool such as Morningstar to do some basic research.
But let me warn you â looking only at past returns will tell you much about the past but virtually nothing about the future.Â Ruthlessly eliminate funds that you donât understand, have high fees or simply do not fit the style that youâre looking for. Donât eliminate funds based solely on past performance.
Some people think that if you own a lot of different funds or investments you are automatically diversified. A bit of this and a bit of that. Some growth, some value, a sprinkling of emerging markets and a Lifestyle fund thrown in the mix.Â There is no rhyme or reason for any of this, but many people use this approach, right?
This is a very common mistake of investors.Â A lot of funds of the similar ilk does not make a diversified portfolio. It makes for keeping track of many more things, but not necessarily things that matter to your financial health.
Solution: Less is often better when it comes to your investments. Too many funds means extra confusion.Â Simplify to a small number of funds that will serve as your core portfolio holdings.Â Think of these funds as the pillars holding up your financial house.
Choose low cost funds that you will be comfortable holding for decades.Â Hint â focus on a small number of broad based index funds covering stocks and bonds.
Photo by Natalie Rhea Riggs on Unsplash
Symptom 3: Your portfolio contains lots of investments with the same âthemeâ
Sounds like you have a fun portfolio when things go well but a nightmare when they donât.Â People fall in love with investment themes all the time.Â They ride the theme hard not properly understanding that market sentiment is often fickle and can change on a dime.
In the late 90âs it was all about the internet.Â Many people loaded up on the sector and lost their shirt soon after.
Starting in mid-2017 the buzz was all about cryptocurrencies.Â Many investors especially those too young to have experienced a stock market meltdown went head first into the craze and now probably are licking their wounds.
Solution: Theme investing is risky. Identifying the next emerging technology or the next Amazon or Google has a very low probability of success. Even the most seasoned venture capital firms thread lightly when it comes to the ânew, newâ thing.Â You should too!
If you really understand a theme think about how long it will take for the mainstream to adopt it in mass.Â Â Invest only a small percentage of your portfolio. For the rest of us, best to keep our greed in check and just say, no!
Symptom 4: All your investments are in the same asset class
This is a variation of the previous issue.Â Sometimes you hear people say, âI am just a bond guyâ. Or, maybe they say âI am a stock jockeyâ. People come to identify with their investments as a badge of honor without realizing the consequences to their financial health.Â As my mother would say, âdo things in moderationâ. I still think that this is great advice whether it is about eating or investing.
The problem with just owning investments in one asset class is that you do not get the main course of the free lunch. You get the appetizer, but then you are shooed out of the room.
Letâs take the case of stocks. In any given day, most stocks tend to move up or down together.Â When the overall equity market (say the S&P 500) is up big for the day, you only find a very small percentage of stocks down for the day.Â Similarly, when the broad equity market experiences a meltdown you will unfortunately only find a handful of stocks that went up for the day.
Same applies to bonds but the herding effect is even stronger.Â Take the case of US bonds of a similar maturity, say 10 years.Â This cohort of bonds moves in a pack all taking their lead from the 10 Year US Treasury.Â If the 10 Year Treasury moves up, the vast majority of bonds move up in lockstep.Â Same on the downside. Just like sheep.
Sure, some stocks or bonds will do better than others. Overall, securities within an asset class tend to move up or down together.Â Call it a sister or brotherhood, while major asset classes relate to each other more as distant cousins.
Solution: For most people it makes sense to hold investments in all the key asset classes.Â The three main asset classes that you should own are stocks, bonds and real estate.
Donât get too cute. If you own a home you probably already have enough real estate exposure.
Why should you own stocks? For growing your nest egg over the long-term.Â Sure stocks can be incredibly volatile, but if you plan to hold your stock investments for say longer than 10 years, history tells us that you can potentially maximize the growth of your portfolio. For a good review of the long-term power of stock investing read our recent blog.
Why own bonds? Historically, people held bonds for the yield and stability. Â In the current low interest rate environment, focus on stability but keep an eye out for a more normal interest rate environment.Â In the US we are already moving in that direction as the Federal Reserve hikes rates and Europe is not that far behind.
But, why is the stability of bonds useful? Mainly as an anchor to your stock investments. Bonds tend to do well during period of stock market stress so they tend to offset some of your losses.
Because bonds tend to be less than 1/3 as volatile as stocks holding a combination of bonds and stocks in your portfolio will dampen valuation changes in your accounts.Â The value of your holdings will still be heavily influenced by movements in your stock holdings.Â Your account values will, however, not fluctuate as much.Â Is this worth it to you?
For many people holding bonds allows them to sleep better at night especially when equity markets go through the inevitable corrections. Â A good nightâs sleep is a prerequisite for a happy life.
Symptom 5: Your portfolio has never gone through a tough market environment
Given the low level of capital market volatility that we have had in the last few years, I would not be at all surprised to see people who dismiss the need for diversification.Â After all if you just pick your investments wisely why should you worry?
Somebody that has been riding the FANG (Facebook, Amazon, Netflix and Google) stocks for a number of years probably does not see any need for bonds in their portfolio. Maybe they got a hint that they should diversify a bit during the February 2018 mini-correction but all seems to be forgotten three months later.
Go back to the late 90âs. Investors were riding AOL, Cisco, Dell, and Microsoft.Â Very few individual investors saw the implosion that was about to hit and obliterate equity portfolios.
For example, investors in the Technology SPDR ETF (XLK) were riding high on the hog until March 1, 2000 when the XLK hit $60.56.Â By July 1, 2002 the price had dropped to $14.32 â a horrific 76% decline from the peak.Â It took until late 2017 for the XLK to hit its March 1, 2000 peak. That is a long time to wait to breakeven!
You donât need diversification when things are going well. You only need it when the bottom is falling out from one of your investments.Â Every single investor in the world has gone through a rough performance patch and nobody is immune to the pain and agony of market crashes such as 1987, 2000-2002 and 2008-2009.
Solution: Stress test your portfolio or at a minimum ask yourself what would happen if certain events of the past repeated themselves.
Could you withstand a sudden 20% daily loss in the stock market? How about a couple of years of major losses such as over the 2000-2002 period? Would you have the stomach to weather these storms?
Many times the tension is between your rational side and your emotions.Â Behavioral research shows that most times the emotional side wins out.Â Most investors panic during corrections because they are not properly diversified.
Investing is fun when capital markets are going up and everybody is making money.Â Equity market corrections and, heaven forbid, crashes are extremely stressful for the vast majority of investors.
Having a little bit of a cushion can mean the difference between emotionally and financially staying with your investing plan and chucking it all at what may turn out the most painful time.
Recovering from painful events is especially difficult when your state of mind is poor and your pocket book is much lighter than before.
Making decisions under stress is never optimal.Â Self-improvement experts always talk about making decisions while in peak states, not when you are emotionally down.
Nobel Prize winner Harry Markowitz called portfolio diversification in finance its only free lunch.Â Most people agree with his statement and attempt to build diversification into their investment strategies.
But the devil is in the details.Â Many people remain confused by the term and its impact on their financial health.
But understanding portfolio diversification is not an academic nicety â it materially affects your financial health
For most investors the relevant context for diversification involves the key broad asset classes of stocks, bonds and real estate.
If you like smoother rather than bumpier rides, portfolio diversification is for you. You will sleep better at night especially when equity markets go haywire.
Investors can easily fall in the trap of thinking that their portfolios are diversified or that they do not need any diversification.
Making too many assumptions is not a good investment practice. Better to know in advance whether you have the mental fortitude and financial resources to weather the inevitable storms.
For technically oriented investors Portfolio Visualizer is a great free tool that allows you to estimate correlations among your list of funds.
For a more in-depth analysis of your portfolioâs true diversification consult a professional consultant experienced in portfolio construction issues.Â You will get a lot more than simple correlations among your funds. You will get a full picture of the risk profile of your investments but keep in mind that ultimately the portfolio you own must work for you.
Your ideal portfolio must be designed in relation to your goals and needs while allowing you to sleep at night.Â Only a comprehensive wealth management assessment can give you the level of detail required.
We are expert portfolio construction professionals and would glad help you assess the quality of your portfolio.Â Donât assume that you are diversified.Â Contact the team at Insight Financial StrategistsÂ for a free initial consultation.
At Insight Financial Strategists we are your fiduciaries. Our advice is focused solely on our view of your best interests. As fee only practitioners, our interests are aligned with yours.
The last couple of months have tested investors.Â In a sense, we all got lulled by the wonderful returns of last year and any hiccup was bound to create some stress.
The talk at the end of 2017 was all about tax cuts and the short-term boost that lower tax rates would provide to consumer spending and the bottom-line of US corporations.
For the first month of the year, things couldnât have been going better for equity investors. Bond investors while not exactly sitting in the catbird’s seat were slowly adapting to the inevitable rise in yields.
Emerging market equities, in particular, jumped ahead and the mood among global investors was one of optimism.Â Market commentators were even talking about a stock market melt-up!
Two months later the mood has changed drastically. Investors are nervous and we have already witnessed two small corrections in the equity markets.
Source: FRED (Federal Reserve Economic Data), Insight Financial Strategists, April 2018
The first mini-correction attributed to rising inflationary expectations took the S&P 500 from a peak of 2873 on January 26 to a low of 2581 on February 8. The 11% drop while not unprecedented was keenly felt by investors accustomed to the record low levels of volatility seen in the last year. It felt like going from a newly paved highway to a dirt road without any warning signs! Â
Were rising inflationary expectations to blame for the early February stock market fall?Â Our research did not support this story.Â We had been seeing a slow rise in inflationary expectations for about a year but US Inflation Protected Note prices containing the marketâs consensus forecast of inflation over the next 5 and 10 years did not exhibit any significant upward pressure.
Inflation in the US seems to be fairly range bound with the latest year over year reading of 2.3% (February). Inflationary expectations as of April 6 for the next 5 years stand at 2.0% and for 10 years out at 2.1%.
The market implied forecast may turn out to be too benign, but for now, our own view of economic conditions in the US is closely aligned with these market-based expectations.
A number of events could have caused the early February correction, but in the context of long-term capital market history, we think that this episode will appear as a mere blip on price charts. Rising inflationary expectations do not seem a likely culprit for this episode of equity market stress.
Source: Quandl, FRED, Insight Financial Strategists, April 2018
What about the most recent late March equity market drawdown? US equity market markets staged a strong recovery from the February lows with the S&P 500 having recovered all but 3% of the losses from the January 26 peak. Since early March the global markets have, however, been on a roller coaster ride.Â Up one day, down big the next. As of April 6, the S&P 500 has lost over 6% since March 9.
The second mini-correction of the year has re-tested the resolve of equity investors. Volatility levels have jumped up and have risen significantly from the lows of 2017. The intraday movement of markets (the difference between the high and low of the day) has been about 2X that of normal periods and 4X that experienced last year.
Source: Quandl, FRED, Insight Financial Strategists, April 2018
Market volatility has been historically low over the last few years but the large intraday swings we have been seeing this year are distressing to even seasoned investors.Â John Bogle in a recent interview for Marketwatch commented that he had not seen such a volatile market in his lifetime. He was referring specifically to the huge intra-day moves seen over the last two weeks.
Â What has caused this recent bout of stock market volatility? As always there are many possible reasons, but this time around we see a more direct link to the uncertainty surrounding a possible global trade war.
Markets do not react well to uncertainty especially to events that are both hard to quantify in terms of the probability of occurrence and the magnitude of consequences.
Trade wars are not everyday events.Â The last time wholesale tariffs were imposed in the US happened in 1930 when the Smoot-Hawley Tariff Act was passed.Â While economists will debate whether the Act exacerbated the Great Depression, in general, it is acknowledged that tariffs limit economic growth.
Free-trade has been a goal of most nations for the last 50 years. Gains from free trade provide a win-win outcome enabling producers to focus on goods and services where they enjoy a comparative advantage and consumers to reap the benefits through lower costs is one of the strongest held beliefs of modern economics.
Global trade of goods and services currently accounts for 27% of worldwide output (according to the OECD). Disrupting global trade by imposing tariffs on a large number of items seems reckless.Â It is especially reckless when considering that we picked a fight with the worldâs largest economy â China.Â China also owns 19% of the outstanding supply of US Treasuries.
No doubt Chinese trade practices are unfair to US companies. Forcing US companies to transfer technical know-how to Chinese firms seems especially egregious given the state of Chinaâs economic development.Â China is the largest global economy and many of its technology companies are already global powerhouses.
Another bone of contention for some is the under-valuation of the yuan.Â An undervalued currency is a huge weapon for increasing the attractiveness of a countryâs exports.Â However, it is not clear that the yuan is under-valued. According to an IMF report in July of 2017, the fair value of the yuan was roughly in line with market prices and fundamentals.
At first, the tariffs proposed by the Trump administration seemed fairly innocuous â washing machines and solar panels. Then on March 1, the US proposed tariffs on steel and aluminum.Â Not good especially since many traditional allies of the US (mainly Canada and South Korea) would be the primary targets. Gary Cohn, the administrationâs top economic advisor, resigned in protest sending shockwaves through the financial community. The S&P 500 reacted with a 1.34% loss for the day
However what really got the capital markets in a tissy was the announcement on March 22 of tariffs on $50 billion worth of Chinese imports.Â The fight was on and it did not take very long for Chinese authorities to retaliate with in-kind tariffs on US goods.
The S&P 500 dropped 2.55% on March 22 and 2.12% on the next day.Â Likewise, Chinese equity markets reacted quite negatively to the possibility of an all-out trade war with the US with the iShares China Large-Cap ETF (FXI) dropping 3.8% and 2.4% respectively on those days.
Where is this all going to end up? In an all-out trade war like after the passage of the Smoot-Hawley Act? Or, in serious bilateral negotiations between the US and China?
Our guess is that there are enough rational agents in both the US and Chinese administrations to avert an all-out trade war, but getting the negotiations going will not be easy and will take time.Â China has already requested negotiations through the WTO Dispute Settlement Mechanism. Luckily there is at least a 60 day comment period separating talk and action.
The US is not likely to be a winner in a global trade war.Â Nobody is really.Â The most likely outcome is lower overall global growth and increased uncertainty â not a good recipe for capital markets especially in light of current above-average valuation levels.
The main problem for the US is that as a nation we are not saving enough.Â The current net savings rate as a function of GDP currently stands at 1.3%. This number has been steadily trending down â the average since 1947 when numbers were first compiled is 6.6%.
The US balance of payments and trade deficits are a function of the imbalance between domestic savings and our thirst to grow and consume.Â In 2017, the US had merchandise trade deficits with 102 countries. China is not our only problem!
Letâs hope that cooler heads prevail and that the disruption to global trade proves minimal.Â Some of the damage has already been done as uncertainty has engulfed global capital markets.
The real economic damage of a global trade war is likely to be substantial.Â Both equity and bond markets would come under significant stress.Â Equities would likely take the most immediate hit as earnings growth, especially for multi-nationals, would drop significantly.
Bonds are also likely to take a hit as a likely reaction by the Chinese authorities would be to decrease their investments in the US Treasury market. Interest rates in the US would likely jump up causing pain to fixed income investors as well as worsening the federal budget deficit.
What do we expect in the intermediate-term from capital markets? While all this talk about trade wars and inflation scares may fill our daily news capture, it is worthwhile to remember that fundamentals drive long-term asset class performance.
In the short-term, capital markets can be heavily influenced by changing investor sentiment, but over the horizons that truly matter to most investors most periods of capital market stress tend to wash out.
Our current capital market perspectives assume that a trade war will not materialize.Â Our views are informed by a number of proprietary asset class models updated as of the end of March.
Our current intermediate-term views reflect:
A preference for stocks over bonds despite their higher levels of risk
A desire for international over US equity based on valuation differentials and a depreciating US dollar â we especially like emerging market stocks
Within the fixed income market, wefavor corporate bondsÂ as we believe that economic conditions will remain robust and default risk will be contained
Small allocations to commodities as this asset class gradually recovers from the bear market itâs been in since the 2008 Financial Crisis
A reduction in our exposure to real estate as the asset class is being heavily penalized in the markets for its interest rate sensitivity
Minimal allocations to cash â the opportunity cost of holding large sums of low yielding cash is high especially for investors with a multi-year horizon
A return of risk on/off equity market volatilityâ this will surely stress investors without a solid plan for navigating market turbulence
Â What should individual investors do while politicians flex their muscles? For starters evaluate your goals, risk attitude, spending patterns and investment strategy.Â Make sure that the shoe still fits.Â Capital markets are not static and neither are personal situations.
A long-term orientation and tactical flexibility will be a necessity for investors as they navigate what we think will be difficult market conditions over the next decade.
Such an approach will be especially important for individuals near or already in retirement. The sequence-of-returns-risk is especially important to manage in the years surrounding retirement when the individual will start drawing down savings.
Our approach at Insight Financial Strategists explicitly deals with this type of sequence-of-returns-risk by building the individualâs portfolio around the concept of goal-oriented buckets. Each bucket has a distinct goal and risk profile.
The short-term bucket, for example, while customized for each individual, has the overriding goal of providing a steady stream of cash flow to the individual.Â This is the safe money designed to exhibit minimal volatility.
The goal of the intermediate-term bucket is different â this part of the portfolio is designed to grow the purchasing power of the individual in a risk-controlled manner. A sometimes bumpier ride is the price of growth for this bucket but the rewards should be more than commensurate with the additional risk taken.
Finally, the long-term bucket is designed to maximize the long-term appreciation of this portion of the portfolio.Â This bucket will be the most volatile over the short term and is suitable for individuals with time horizons exceeding ten years and able and willing to withstand the inevitable periods of capital market stress.
Investment risk is an inevitable part of capital markets.
Markets do not just go up as much as we wish for that to be always the case.
Sometimes capital markets experience stress and the draw-downs can be extremely uncomfortable to investors.
How investors react to periods of capital market stress is incredibly important.
Become too aggressive and you could end up with major short-term losses and your financial survival may be at stake.
On the other hand, become too cautious and you may end up excluded from any future capital market appreciation.
So, if risk is inevitable, what can you do about it? Being either extremely aggressive or extremely risk-averse are probably the least desirable options especially if you wait to act until there is a market meltdown.
In the first case, you may not be able to stay invested as short-term losses cripple your psyche and your pocketbook.Â Even though you believe in your investments, your emotions will be tugging at you and second-guessing you.Â This is the curse of being too early.
In the case where people become too risk-averse, being too cautious prevents you from making up the losses experienced during periods of capital market stress by participating in the good times. Most likely you second guess yourself and by the time you take the plunge back in you have probably already missed out on some large gains.Â This is the curse of being too late.
Â Investing is not easy especially when things go against you in the short-term. It is best to understand what you are getting yourself in and have a plan for when things go awry. As Mike Tyson once said, “everybody has a plan until they get punched in the nose”.
Getting punched in the nose is not an uncommon experience for stock market investors.Â For bond market investors the experience is not as common but it still happens.
Understanding that investing can at times be brutally taxing on your pocketbook and psyche is an essential element of reaping the benefits of any investment plan. A great game plan is useless unless you have the ability to withstand the dark periods.
Investors are frequently confused by capital market behavior.Â Over the short-term asset classes can go almost anywhere as investment sentiment is usually a strong driver of returns.Â Market pundits attempt to provide some rationale for why things are moving in a certain direction, but in reality, most of what goes on from day to day in capital markets is usually nothing more than noise.
Markets are prone to bouts of over-confidence where all the bad news gets ignored and investors appear overly upbeat.Â Other times, markets will be laser-focused on negative short-term events of little economic significance and investors will become overly pessimistic. Â Even seasoned investment professionals feel sometimes that there is no rhyme or reason for what is happening to financial asset prices.
Over longer-term horizons, asset class fundamentals start being reflected in prices as investment sentiment becomes secondary.Â Profits, valuations, profitability, growth potential become the drivers of prices.Â Periods of stress are frequently forgotten and appear as mere blips on historical price charts.
One of the key tenets of long-term investing is that risk and return are inextricably tied together. Â Â Without any risk, you should not expect any incremental returns. Investing is inherently risky as outcomes â short or long-term â cannot be predicted with total certainty.
Most investors understand that, on average, stocks do better than bonds but that the price of these higher returns is a lot more risk.Â Investors also understand that longer-maturity bonds will do better most of the time than simply purchasing a CD at the local bank or investing in a money market mutual fund.
But beyond this high-level understanding of capital market behavior, there is lots of confusion. Gaining a better understanding of key asset class risk and return relationships will help you become a better-informed consumer of investment strategies.
Understanding what you are getting yourself in when evaluating different investment strategies could significantly alter your wealth profile for the better and allow you to take advantage of market panics rather than simply react to crowd psychology like most people.
To become an informed consumer of investment strategies the first step is understanding key asset class risk and return tradeoffs. Â We use a dataset kindly provided online by Professor Aswath Damadoran at NYU to look at calendar year returns on US stock, bond and bill returns. Â Bond returns proxy for a 10-year constant maturity US Treasury Note and bills correspond to a 3 month US t-bill.Â US stocks are large capitalization stocks equivalent to the S&P 500. Figure 1 depicts the annual asset class returns since 1937.
The first thing that jumps out from the chart is the much higher level of return variability of stocks.
The second thing that jumps out is the incredible year over year smoothness of T-bill returns.Â Bonds are clearly somewhere in between with volatility characteristics much more similar to bills.
The third thing that jumps out are the rare but eye-popping large equity market meltdowns such as during 1937, 1974, 2002 and 2008.Â Lastly, of notice are the very large positive spikes in equity returns during years such as 1954, 1958, 1975, 1995 and 2013.
Â Figure 1
What is not entirely clear from looking at the yearly return chart is the huge cumulative out-performance of stocks relative to both bonds and bills. Table 1 provides summary statistics on calendar year returns for each asset class.
Over the 1928-2017 period, stocks have returned on average 12% per year with an annual standard deviation of 20% year. Bonds are next in line with an average return of 5% and a volatility of 8%. Bills have had the lowest rate of return at 3% with a volatility of 3%. These numbers correspond to the usual risk/reward relationships that investors know all about.
In 27% of the years between 1928 and 2017, stocks have had a negative return. The average return when the market has gone down is -14%. Nobody likes losses but even bond investors saw negative returns in 18% of the years and when they happened the average loss was -4%. The only way never to lose money in any given year is to invest in bills.
If one had invested $100 in December 1927 and held that investment the ending portfolio value would be $399,886 â a huge rate of growth despite the infrequent yet terrifying equity market meltdowns. Bonds donât come even close with an ending portfolio balance of $7,310. Playing it safe with bills would have yielded a portfolio value of $2,016.
From a cumulative wealth perspective, stocks are clearly the superior asset class but only if the investor is able to stomach the rare but large equity drawdowns and seeing losses in over a quarter of the years.
If the investor is seeking stability with no chance of principal loss, T-bills are the preferred asset class. The rewards compared to stocks will be meager, but the ride will be smooth and predictable.
What happens when you extend the holding period out to, say 10 years? Does the spikiness of stock market returns disappear? What about the frequency of down years?
Using the same data set as before and forming rolling 10-year holding returns starting in 1927 we observe in Figure 2 that some of the volatility of stocks and bonds has dissipated. Instead of spikes we now have mountains and slopes.
The chart on rolling 10-year returns exposes the massive cumulative out-performance of stocks during most ten-year holding periods.Â There are instances of negative 10-year stock returns (6% as shown in Table 2) but they are swamped by the mountain of positive returns especially when viewed in relation to bond and bill returns.
We see only three periods when equity investors would have loved to play it safe and be either in bonds or bills â the early years post the Great Depression (1937-39), the Financial Crisis (2008-9), and economic stagnation and inflationary years starting in the mid-70s through the beginning of the equity bull market of 1982.Â In the first two instances, equity holders lost money.Â In the latter instance, equity investors enjoyed positive returns but below those of either bonds or bills.
Some observations are in order:
As one extends the holding period from 1 to 10 years some of the spikiness of one-year returns is smoothed out â not every year is fantastic and not every year is terrible, periods of stress are usually followed by periods of recovery and so on
Over a ten year holding period stocks do not look as scary â only in 6% of our observations do we see a negative return. When those losses occur the average loss is 10% on a cumulative basis.
Rolling 10-year maturity bonds every year over a decade yields no periods in our sample where the strategy exhibits a loss. The same holds true for bills.
Investors able to extend holding periods from short to longer maturities such as ten years significantly lower their odds of seeing negative returns as confirmed in the empirical data
What happens when we mix and match asset classes? Does that help lower our probability of loss? We look at some typical multi-asset class mixes over one-year holding periods:
The 60/0/40 portfolio composed of 60% stocks and 40% bonds â a traditional industry benchmark
The 40/0/60 portfolio composed of 40% stocks and 60% bonds â a moderately conservative mix
The 25/50/25 portfolio composed of 25% stocks, 50% bills and 25% bonds â a conservative mix for a very risk-averse investor
Mixing asset classes is usually referred to as multi-asset class investing.Â The premise for such an approach is based on the diversification benefits afforded by allocating in varying proportions to asset classes with their own unique risk and return characteristics.
It turns out that over the 1928-2017 period stocks were essentially uncorrelated to both bonds and bills.Â The correlation between bonds and bills was 0.3.Â Building portfolios with lowly correlated asset classes is hugely beneficial in terms of lowering the volatility of the multi-asset class mix.
What are the main conclusions that we can reach when mixing asset classes with widely different risk and return characteristics?
When combining stocks, bonds, and bills in varying proportions we arrive at portfolio results that fall between those of equities and bonds
The traditional 60/0/40 portfolio had a lower frequency of negative returns compared to an all-equity portfolio, significantly lower volatility and a cumulative ending portfolio value only about a 1/3 as large. What you gain in terms of lower risk, you lose in terms of compound returns.
The 40/0/60 portfolio which represents a lower risk alternative to the investor lowers volatility (to 9%) but at the expense of also lowering average returns (to 8%) and especially cumulative wealth (ending value of $58,090)
The lowest risk multi-asset class strategy that we looked at â the 25/50/25 portfolio â had the lowest average returns (6%), lowest volatility (6%) and lowest long-term growth.
A key implication of multi-asset investing is by combining asset classes with disparate risk and return characteristics you can build more attractive portfolios compared to single asset class portfolios
Comparing two traditionally low-risk portfolios â 100% bonds and the 25/50/25 portfolio â demonstrates the benefits of multi-asset class investing. The multi-asset class portfolio not only has higher average returns but lower risk. The frequency of calendar year loss is smaller (11% compared to 18%) and the long-term portfolio growth is over 2X that of the all-bond portfolio.
Three very significant lessons emerge from our study of asset class behavior that can vastly improve your financial health.Â The first relates to the holding period.Â Specifically, by having a longer holding period many of the daily and weekly blips that so scare equity investors tend to wash away.
Equity investments do not look as volatile or risky when judged over longer holding periods of say 10 years.
The second lesson relates to the power of compounding. Small differences in average returns can yield huge differences in long-term cumulative wealth.Â In terms of the multi-asset class portfolios â the 60/0/40 versus the 40/0/60 â yields only a 1% average return difference but a 2X difference over the 1928-2017 period.
Seemingly small differences in average calendar year returns can result in massive wealth differences over long holding periods.
The third lesson relates to diversification. By mixing together asset classes with varying risk and return characteristics we can significantly improve the overall attractiveness of a portfolio. Lower portfolio risk is achievable with proper diversification without a proportional sacrifice in terms of returns.Â Â Properly constructing multi-asset class portfolios can yield vastly superior outcomes for investors.
Every investor needs to come to terms with the risk to reward relationships of major asset classes such as stocks, bonds, and bills.Â Understanding the risk and return tradeoffs you are making is probably the most important investment decision affecting the long-term outcome of your portfolio.
Some investors can stomach the sometimes wild ride offered by stocks and choose to overwhelmingly use equity strategies in their portfolios. They donât worry much about the daily vicissitudes of the stock market.Â They accept risk in return for higher expected returns.
Not everybody, however, can stomach the wild ride that sometimes comes from owning stocks despite understanding that over the long-term stocks tend to better than bonds and bills.
Some investors are willing to leave a bit of money (but not too much, please) on the table in return for a smoother ride. They may elect to hedge some of the risks.Â Or they may mix in varying proportions of risky and less risky asset classes and strategies.
Yet other investors are so petrified of losses and market volatility that they will forego any incremental return for the comfort and steadiness of a safe money market account. They choose to avoid risk at all costs.
Which is the better approach for you? Avoid all risks, save a lot and watch your investment account grow slowly but smoothly?
Or, take some risk, sweat like a nervous high schooler when capital markets go bust and grow your portfolio more rapidly but with some hiccups?
The answer depends on you â your needs, goals and especially your attitude toward risk and your capacity to absorb losses to your wealth.Â If you already have a financial plan in place great. If you need help getting started or refining your plan, the team at Insight Financial is ready to share our expertise and bring peace of mind to your financial life. Book an appointment here.
Understanding that investing can at times be brutally taxing on your pocketbook and psyche is an essential element of reaping the benefits of any investment plan.Â In subsequent articles, we will be exploring different ways of managing risk and structuring portfolios.
Stock Market Corrections are tough on equity investors.Â Over the last couple of weeks, there has been nowhere to hide â normally defensive strategies provided little relief.
After a long period of minimal equity market hiccups investors were reminded that the opposite side of the return coin involves risk.
Equities do better than bonds, on average, precisely because investors require compensation for the additional risk of their investments.
If risk and return are tied together why do investors get so nervous when suddenly equity markets go haywire?Â Memories of 2008 come flooding back and investors get hyper fixated on relatively small market movements.
As of Friday, February 9, the S&P 500 had dropped 8.8% from its high of January 26.Â Granted the drop has been swift and intraday market action (the difference between the high and low of the day ) has been off the charts, but you would have thought that we were on the verge of another Financial Crisis.
Figure 1 depicts the rolling 12 month returns on the S&P 500 as of the end of 2017. There are more periods of positive rather than negative returns as expected. We can also see that the downdrafts in recent years have been painful for investors â the implosion of the Technology Bubble (2000-2002) and the 2008 Financial Crisis still very much linger in investor minds today.
The key insight that investors need to come away with from looking at the history of stock market returns is that to get the good (those returns averaging 10% a year) you must be prepared financially and most importantly emotionally to endure the bad (those nasty corrections).
Investors need to remember that risk and return are the opposite side of the same coin.Â They also need to understand the context in which market corrections take place.Â While history always rhymes every equity market correction possesses unique elements that shape its ultimate effect on investors.
Understanding the market and economic context is incredibly important for everyday investing.Â It is, however, absolutely critical for understanding the implications of equity market corrections and most appropriate course of action.
The point is that not all equity market corrections are made of the same cloth.Â Some are deep and lasting. Some are deep and over before the eye blinks. Others last for a year or two and progress at a slower rate. And, finally other corrections turn into cataclysmic events that leave investors bruised for a long time.
Given the events of the last couple of weeks we understand the skittishness of equity investors. Last year was fantastic for investors.Â We hardly had a hiccup in the last year. Investors started adapting to the environment â high returns and low volatility.
All the fireworks have come from Washington rather than Wall Street.Â Yet, the lingering suspicion is that this party like all others before it must end at some time. Maybe it is just time, right?
We are professional wealth managers, not magicians or fortune readers. Nobody knows when the next big stock market crash will happen and least of all nobody knows the severity of the downturn.
At best, we can analyze the current equity market downturn and attempt to better understand the context in which current equity market prices started heading south.
While all equity market downturns are unique, for simplicity sake we categorize periods of extreme equity market distress into three distinct types of corrections â technical, economic and structural.Â Each type of correction has its own distinct patterns and associated implications for investors. Not every moving animal in the woods is a Russian Bear!
This type of correction typically comes out of nowhere and takes market participants by surprise. One bad day for the stock market turns into 2 or 3 in a row and soon enough there is an avalanche of pundits predicting the next global crisis.
Maybe a bit surprising to some, pundits use perfectly logical arguments to justify their bearishness â inflation is about to spike up, the economy is tanking, earnings are coming down, there are no buyers left, and so forth.
All perfectly valid reasons for an equity market correction but the key characteristic of such prognostications is that they are mostly based on speculation and not rooted in contemporaneous economic trends. The arguments are more based on what we fear as opposed to what the current reality is.
Technical Corrections tend to occur on a regular basis especially for higher risk asset classes such as equities.Â Long-term equity investors have seen these before and do not seem fazed by the market action.
Newer generations of investors, however, experience great fear and regret.Â The immediate response is to sell down usually their most liquid holdings and wait for the market to calm down.Â Maybe they will get in again after the panic is over.
Technical Corrections tend to last only about a week or two.Â In the context of long-term capital market history they barely register to the naked eye. Boom they are gone, and people quickly forget what they just went through.Â Technical corrections are learning opportunities but are most often quickly forgotten until the next blip.
These types of capital market corrections are caused by the economic business cycle, i.e., periods of economic expansion followed by recession and eventual recovery.Â Typically, the clues as to whether the economy is heading into a recession are present ahead of time.
Usually a large number of economic indicators will point in the same direction.Â For example, the yield curve may become inverted (long rates lower than short-term rates), business confidence surveys start showing some downward trends, companies start hoarding cash instead of investing in plant and equipment and layoffs start accelerating in cyclically sensitive sectors.
In the last half century, business cycle recessions have been mostly shallow and short-lived. Economic recessions are, no doubt, painful but the implications to investors are fairly straightforward.
In the early stages of a recession, equity investments suffer the most while bond market strategies tend to provide the upside.Â As the economy starts recovering, equity investments outperform marginally but with significant volatility.
Being early is never comfortable but it beats being late.Â Some of the best equity returns happen during the late early stages of a recovery when the average investor is still too snake bitten to put any money at risk.
And finally, as the economy moves into full expansion mode equity investors typically enjoy a nice margin of outperformance relative to safer assets such as bonds.Â As the uncertainty regarding the economic recovery fades in the rear view, capital markets tend to become less volatile as well.
These are the most severe type and involve periods of real economic and financial stress.Â Something has gone off the rails and public capital markets are the first to feel the brunt of the economic imbalances.
Structural Corrections are not merely stronger business cycle events. The integrity of the entire economic and financial system is at stake.Â Without decisive fiscal and monetary policies there is a risk of total economic collapse.Â Under these circumstances, equity investors are often completely wiped out and bond holders donât fare much better.
Structural Corrections happen during periods of total economic unravelling.Â The most usual signs of eminent economic collapse are massive unemployment, huge drops in productive output, and the unavailability of credit at any cost.Â The financial system is usually at the root cause of the crisis and liquidity in the system suddenly disappears.Â Faith in the system dries up overnight â the first stop are banks, next are capital markets.
The Great Depression of 1929-39 and the Financial Crisis of 2007-09 are prime examples of Structural Corrections that were felt across the globe.Â History is, however, littered with other instances of more localized cases such as the 1997 Asian Crisis, the 1998 Russian Default and the Argentinian collapse of 1999-2002.
What should investors do during a correction?
The answer depends on the context surrounding the capital markets at that moment.Â For example, the implications of a Technical Correction are very different from those of a Structural Correction.
Misdiagnosing what type of correction you are in can have severe consequences for your financial health.Â Becoming too risk averse and selling everything can be as harmful as not being risk-aware enough and always expecting the markets to recover irrespective of business and capital market conditions.
Finding the right balance is key. In reality, after many years of watching markets one is never really 100% sure of anything.Â In fact, if anybody says that they have perfect certainty all it means is that they either have not done all their homework or that they fail to understand the statistical concept of probability.
Our preferred approach is based on a solid understanding of capital market behavior coupled with hands-on experience under a variety of capital market situations.Â Understanding capital market history is the prerequisite but experience is the key extra ingredient to gain confidence in properly evaluating the context in which markets are experiencing distress.
Table 1 provides a checklist as to the type of issues that we consider when evaluating the type of correction we might be in.
Where are we today?
As of February 12 we have already seen signs of recovery, but the S&P 500 is still down 7.5% from its January 26 peak. Investors remain nervous. The CBOE Volatility Index stands at close to 27% which is significantly higher than where it was before the equity market started convulsing.
A 7.5% drawdown on the S&P 500 is not that uncommon. Investors should be wary but also keep their eye on their long game of growing risk-adjusted portfolio returns.
We believe that the current equity market downdraft falls under the category of a Technical Correction. Why? The numbers back up our assertion. Â Our view is that equity markets remain healthy and will out-perform lower risk alternatives such as bonds.
Letâs start with a rundown of the negatives about equity markets.Â The biggest knock on equity markets is that they are over-valued relative to historical norms such as price-to-earnings ratios. Agreed, the current Shiller P/E stands at 33.6 relative to a historical average of 17.Â For access to the latest Shiller data click here.
On an absolute basis the S&P 500 is over-valued.Â When considered relative to interest rates the picture changes.Â Estimates by Professor Domadoran at NYU, for example, yield fair valuations on the S&P 500.
What else? Interest rates are too low. Agreed again, but low yields are the problem of the bond investor. A low cost of money is actually good for equity investors.
What about rising interest rates? The 10 Year US Treasury Note hit a low of 2.05% in early September and has been rising since. It currently stands at 2.84%.Â Higher, for sure.Â A real danger to equity markets? Not quite, especially in light of low rates of inflation.
Inflation-adjusted yields (sometimes called real yields) are still significantly below historical norms.
Higher real rates imply lower equity values.Â We agree, but we see the current upward progression of interest rates in the US as fairly well telegraphed by the Federal Reserve.
We also still believe that US monetary policy is accommodative.Â For example, Federal Reserve Bank of Atlanta estimates generated by the well-known Taylor rule show current Fed Funds rates about 2% too low (read here for a review).
What about the positives regarding equity markets? For one, we have a strong global economy.Â Every major economy in the world is in growth mode.Â The IMF recently raised their estimate of global GDP growth to 3.9% for both 2018 and 2019.
Inflation seems under control as well. The IMF estimates that global inflation will run 3.2% in 2018, unchanged from last year. Inflation in the US ran at 2.1% in 2017.
Monetary policy remains accommodative.Â In the US the Fed reserve is slowly weening investors off artificially low interest rates, while in most other parts of the world (Europe and Japan in particular) central banks have yet to embark on the process of normalization.
The recently enacted lowering of the US corporate tax rate is also a positive for US domiciled companies. Â Lower corporate tax rates translate immediately into higher cash flows.Â Higher cash flows translate into higher corporate valuations. The main beneficiaries of lower corporate taxes are ultimately shareholders.Â
What should investors do today?
Our analysis of the data leads us to the conclusion that the current equity market correction is driven by technical considerations and not fundamental issues.
We do not know how long the equity downdraft may last, but we expect this blip to barely register in the long-run.
Our advice may be rather boring but plain-vanilla seems the best response to the current state of investor panic.
If you were comfortable with your financial plan at year-end, do nothing. Donât obsess over every single market gyration. There is not enough evidence to merit an increase in fear or a significant re-positioning of your portfolio towards safer asset classes such as bonds
If you did not have a plan in place, donât go out and sell your equity holding before figuring out the status of your financial health in relation to your goals. Consult a certified financial planner if you need help.
If you have some cash on the sidelines, deploy some of it in the equity markets. Given that all major equity markets have taken a beating spread your money around a bit. We still rate International Developed Markets and Emerging Markets as attractive.Â Consider whether it makes sense for you to put some money in the US and some abroad.
Whatever you do donât panic. Focus on your asset allocation in relation to your needs, goals and appetite for risk. Don’t let that Russian Bear get to you!
Taking risk and suffering the inevitable equity market drawdowns is part of investing. Be cautious but be smart. Talk to your Advisor if you need help. Make your money work for you!
The mental picture I use is that of flying.Â The six hour trip from Boston to LA is great when it is all smooth sailing.Â The plane seems to be flying itself and you pay more attention to the movie you are watching than thinking about the age of the aircraft or training of the pilot and crew.
But the first time there is a little air bump and maybe lighting strikes your plane you immediately tense up and fix your gaze on the crew.Â Are they calm? Do they seem competent? Is this their first rodeo?
You form a mental image of what you want your pilot to look like.Â Calm and collected for starters. But mainly experienced. We all want to see Captain Sully at the helm.
Clearly, we all would love smooth capital markets forever. But the close friend of return is always uncertainty.Â The two are inseparable even though they may not always be in direct contact.Â In times of turbulence you want experience at the helm and a solid understanding of how the two are intertwined.
How do we think of uncertainty in the capital markets? There are as many ways of defining uncertainty as there are opinions as to who the greatest quarterback in history is (we all know it is Tom Brady, right)Â but without hopefully appearing too cavalier we think that it is useful to think of uncertainty as a normal distribution of potential outcomes.
We fear the left tail where things go terribly wrong, we accept the middle of the distribution as textbook risk/return, and we think that our own brilliance (just joking) has led us to the right tail of the distribution.
In 2017 equities, in particular, had a monster year with the S&P 500 up over 25% and many international markets up even more.Â The year turned out much better than expected.Â What do we expect for this coming year?
Our baseline assessment is fairly benign as we discussed last month in our Capital Market Overview. A quick review is in order.
We expect equities to again do better than bonds.Â We also expect international assets to outperform domestic strategies.Â We expect robust global growth.Â Our most likely scenario for this year is for continued growth, subdued inflation and no major equity or bond market meltdown.Â In our judgement there is about an 80% probability that such a scenario plays out in 2018.
On the downside we expect the low volatility that has accompanied capital markets recently to once again revert back to risk on/off.
Our baseline assessment is fairly benign
We expect to see more large jumps in market prices caused by low probability events lurking in the left hand side of the distribution.Â The press calls these events Black Swans. Our best assessment is that there is about a 15% probability of seeing a Black Swan event in 2018.
On the other end of the uncertainty distribution you have what we call Green Swans â events, low in probability that when they happen are wildly positive for investors. We attach a 5% chance of experiencing such extreme positive events over the current calendar year
1. An inflation spike caused by a sustained rally in commodity prices
Inflation in the US is currently running a bit above 2% and market participants do not expect to see any major revisions over the next two decades (see the Philadelphia Federal Reserve estimate of inflationary expectations).
In our view, forecast complacency has set in and the risks are to the upside. Traders would describe the low inflation trade as over-crowded.Â Maybe it is time to re-think what happens if the consensus turns out to be wrong.
The immediate effect of an upward spike in inflation would be a rise in bond yields.Â Equities would probably take a short-term hit but the primary casualties would be found in the fixed income market.
What could cause a sustained surge in commodity prices? One, could be a supply disruption say in the oil market. Another could be related to the resurgence of global growth and continued demand for commodities such as iron ore and copper.Â Third, a depreciating US dollar leading to commodity price inflation.
2. A spike in capital market turmoil caused by a geo-political blowup
The blowup could be anywhere in the world but most political commentators point to North Korea and Iran as the most likely centers of conflict.
Another possibility is a cyberattack endangering public infrastructure facilities especially if it is sovereign sponsored. Third, Jihadi terrorism on a large scale and on high profile targets. And last, the outcome of the Special Counsel investigation into Russian meddling.
All of these events have blowup potential.Â While the probability of any of these events happening in 2018 is low, the magnitude of the capital market response is likely to be large and negative especially for equity markets.Â Global economic growth would also, no doubt, loose some of its momentum.
3. An avalanche of bond defaults in the apparel and retail industries in the US and/or a debt bomb crisis in China
It is no secret that the US apparel and retail sectors are going through massive consolidation driven in part by the shift to online shopping.Â It is widely acknowledged that the US retail market is over-built.
According to the Institute of International Finance global debt hit a record last year at $233 trillion.Â Debt levels as a percentage of global GDP are higher today compared to 2007.Â Figuring prominently in the debt discussion is China.
Global Debt Reaches a Record in Q3 2017 Source: IIF, IMF, BIS
The IMF recently issued a warning to the Chinese authorities about the rapid expansion of debt since the 2008 Financial Crisis.Â The rapid expansion in debt has funded lesser quality assets and poses stability risk for global growth according to the IMF.
Estimates by Professor Victor Shi at UC San Diego put Chinese total non-financial debt at 328 percent of GDP. Other estimates are even higher leading to an overall picture of rising liabilities and numerous de facto insolvencies.Â The robust GDP growth in China and the tacit understanding of the monetary authorities of the extent of the problem will hopefully keep the wolves at bay.
The implications of a debt scare for investors would be quite dire. Investors have had plenty of experience with debt crisis in recent years â Greece and Cyprus come to mind as Black Swan events that temporarily destabilized global capital markets.Â A Chinese debt scare would no doubt be of greater impact to global investors. Emerging market debt spreads would certainly blow up.
What about the right hand tail of the uncertainty distribution â the Green Swans?
These are wildly positive events for investors that carry a low probability of happening.Â What type of Green Swan events could we hope for that would lead capital markets to yet another year of phenomenal returns?
1. Positive global growth surprise possibly brought on by the recently enacted US tax reform
The US is the largest economy in the world and still remains a significant engine of global growth.Â Could we be surprised by a spurt in US economic growth this year?
According to the Conference Board US real GDP is expected to growth 2.8% in 2018. Could we see 4% growth? The President certainly hopes so.Â Not that likely. The last time that US GDP growth was above 4% was in 2000.
What could give us the upside scenario for growth? Â Maybe a jump in consumer spending (representing 2/3 of GDP) driven by real wage growth and lower taxes.
Another possibility is a surge in investment by US corporations driven by cash repatriations and recently enacted corporate incentives.
We view both scenarios as likely but providing only a marginal boost to growth. As they say we remain cautiously optimistic, but would not bet the farm on this.
2. A spurt in exuberant expectations driven by the cryptocurrency craze
Fear of missing out (FOMO) takes over repricing all investments remotely tied to the cryptocurrency craze along the way.Â We saw a similar scenario play out in 1999 in the final stages of the Technology, Media and Telecom (TMT) bubble.
In those days TMT stocks were no longer priced according to traditional fundamentals but instead on the idea that laggard investors would buy into the craze and drive prices even higher. Lots of investors succumbed to FOMO in the final stages of the bubble.
Photo by Ilya Pavlov on Unsplash
The recent price action of Bitcoin and most other cryptocurrencies has a similar feeling to the ending stages of the TMT bubble.Â It is almost as if Bitcoin and its cousins are being discussed along with the latest Powerball jackpot.
No doubt fortunes have been and will continue to be made in cryptocurrencies.Â Blockchain technology which underlies the crypto offerings is here to stay, but we worry about the lack of investor education and the speed of the price action in late 2017.Â Whatever happened to Peter Lynchâs âbuy what you knowâ approach?
What would be our best estimate for capital markets should the cryptocurrency craze gain further momentum in 2018? First, technology stocks would continue out-performing. Chip suppliers such as Nvidia and AMD would continue to see massive growth.
Companies adopting blockchain technologies would see their valuations increase disproportionally.Â In general, animal spirits would be unleashed onto the capital markets making rampant speculation the order of the day.Â The primary beneficiary would be equity investors.
History tells us that it is almost certain that after 8 years of an economic expansion and stock market recovery we should see an outlier type of event in 2018.Â What shape and form it will take (or Swan color) we donât know.
Preparing for tail risk events is very expensive and under most scenarios not worth bothering with.
Black Swans create great distress for investors, but the opportunity cost of playing it too safe is especially high today given prevailing interest rates that fail to keep up with inflation.
The fear of missing out (FOMO) during Green Swan events is also a powerful investor emotion.Â Again playing it too safe can result in many lost opportunities for capturing significant market up moves.
Investing in capital markets is all about weighting these probabilities and focusing on a small number of key research-driven fundamental drivers of risk and return.
How you structure your portfolio and navigate the uncertainties of capital markets is important to your long-term financial health. Putting a financial plan in place and having an experienced Captain Sully-type as your captain during times of turbulence should reassure investors in meeting their long-term goals.
Note:The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice.Â Views expressed are the opinions of Insight Financial Strategists LLC as of the date indicated, based on the information available at that time, and may change based on market and other conditions.Â We make no representation as to the accuracy or completeness of the information presented.Â This communication should not be construed as a solicitation or recommendation to buy or sell any securities or investments. To determine investments that may be appropriate for you, consult with your financial planner before investing. Market conditions, tax laws and regulations are complex and subject to change, which can materially impact investment results.
Individual investor performance may vary depending on asset allocation, timing of investment, fees, rebalancing, and other circumstances.Â All investments are subject to risk, including the loss of principal.
Insight Financial Strategists LLC is a Registered Investment Adviser.