Investing is synonymous with short term uncertainty. Every investor must accept volatility at one point or another. Market declines can be distressing, but they are also a demonstration that markets are functioning as we should expect. Do any of us really believe we can churn out a consistent 8% year after year?
Market declines occur when investors are forced into reassessing future stock prices. A few recent examples are the United States' trade challenges with China, Apple's revenue hit last month, or the current Coronavirus threat to the global supply chain.
When events like these occur, the market responds to new information as it becomes known. However, the market is also pricing in unknowns as well. As risk increases during a time of heightened uncertainty, so do the returns investors demand for bearing that risk. This pushes prices lower. Any sensible investing approach should be grounded in the principle that prices are set to deliver positive future expected returns in exchange for short term volatility. That is the tradeoff.
During any market decline, I can't tell when stocks will reverse course. My crystal ball is cloudy at best. What I do know is that investors who take risk will be compensated with positive future returns. That’s been a lesson of past health crises, such as the Ebola and swine-flu outbreaks earlier this century, and of market disruptions, such as the global financial crisis of 2008–2009.
History has shown no consistent method to identify a market peak or bottom. This evidence is the reason why investors shouldn't attempt market timing moves based on fear, even as challenging events transpire. For example, if you panic and sell, what if markets start appreciating the week after you cash out? Egg on your face? Yes. Essentially, you have to get two decisions correct, selling at the peak and buying back in at the bottom. How will you know what the bottom is? These decisions can be humbling.
OK, SO WHAT SHOULD I DO?
You might be feeling powerless. Don't. First, if you're not yet retired, a market decline is an opportunity to buy additional shares at lower prices. I know it's kind of twisted logic, but think of a market decline as a sale. We have no trouble ordering countless discounted widgets on Cyber Monday. Is a market decline really that different?
When it comes to the shares you already own, rebalancing during a downturn becomes your best buddy. Here's how it works.
Let's say you own 1 stock and 1 bond, each worth $1. Both positions in the portfolio represent a 50% weight. In a hypothetical stock market decline, the stock declines to $0.50 while the bond holds its ground at $1. Now, we have a portfolio with a stock relative weight of 33% and a bond relative weight of 67%.
What's happened is our portfolio has grown too conservative for our goals. So, we should make an adjustment. We would sell a portion of our bond and reinvest it into our stock. Said another way, sell a winner a buy a loser. Wait... What?
Yup! Think about what's happening. You're selling high and buying low. Isn't that the cardinal rule of investing?
When you apply this portfolio strategy to all your holdings and execute whenever the market moves, voila, you're rebalancing!
SOME MORE MATH
Investors in or approaching retirement might want to reduce volatility in the portfolios they've worked so hard building for decades. It has to do with the severity of a market decline and how difficult it is to recover to a previous high point. It's kind of like exercising as one ages. It's easier to recover after a tough workout when you're 25 compared to when you're 60. If you're not the 25-year old investor or athlete you used to be, you might want to take it easy.
Here's the math.
If you have $1 and lose 50%, you now have $0.50. However, in order to grow from $0.50 back to your original $1, you need to earn a 100% rate of return. How many years is that going to take? To help put that challenge in perspective, U.S. stocks have only achieved a return over 50% in a single year twice, 1933 and 1954.
For investors in their 2nd half, it's important to protect against market declines. To use a sports analogy, you've already put points on the board, so focus on protecting your lead.
ASPEN LEAF WEALTH MANAGEMENT'S APPROACH
We've been executing the same strategy since the early days of the firm. Whenever a position appreciates or declines past pre-determined thresholds, we execute a rebalance.
Our technology allows us to consistently monitor a multi position portfolio whether it's 12 mutual funds or 100+ individual stocks. It doesn't matter if a portfolio is a single account or a portfolio consisting of several accounts. The process is always the same.
The outcome for clients is a variety of benefits. First, our rebalancing process is a forcing mechanism to buy low and sell high. Second, we're maintaining a target level of expected portfolio risk. Last, in taxable accounts, we're keeping capital gains in check so as to not let them grow so large that clients are hit with an enormous tax bill in the future.
WHAT YOU SHOULD DO
The best tactic to take is to ignore the financial media. Call it entertainment, or better yet, noise. The media thrives on fear. But, just like a Nascar crash, it's difficult to look away. Just remember, if you react to every sensational market story, you're asking for trouble. Don't be the portfolio equivalent of a Nascar driver.
Next, you should evaluate the risk you're taking in the bigger context of your Financial Plan. Will your plan still succeed by taking less investment risk? If yes, perhaps it makes sense to take steps to structure your portfolio to still provide the retirement income you need, just with a lower expected volatility.
Consider a gut check. It's been over a decade of relatively smooth returns. Most of us are conditioned to these positive returns. This recency bias can fool us into believing the past is an accurate predictor of what will happen next. It's not. If you have a $750,000 investment portfolio and you lose 30%, your balance is now $490,000. When you open your statement and see that you're down $260,000, how are you going to react? Be honest with your emotions.
Last, hire someone to help you get it right. I'm a bit biased here, but are you really going to watch your investments every week, do the math, execute rebalances across all your accounts, all in the proper amounts? You might, but it's a pain without the right technology. Even if your current fund offers some sort of auto rebalancing feature, it's probably fixed on a set schedule. Research shows this can result in rebalances when you don't need them as well as missing out when you actually do need them! Simply put, it's not as efficient as the opportunistic rebalancing we employ.
For more information about anything discussed in this post, please ask! We're not salespeople. If you use the Contact link in the upper right corner of this page to inquire how we can improve upon your current strategy, you're not signing up a time-share presentation. You're simply initiating a conversation designed to help you achieve a better outcome. Whether you hire us or not, we're happy to help.