By Gary Brooks, CFP®
We are more than eight years into the second longest bull market in the history of U.S. stocks. A bull market is defined as market gain of more than 20% until it is interrupted by a decline that exceeds 20% (a bear market).
The S&P 500 Index of large U.S. stocks has gained over 250% since March 9, 2009. This rally has been extraordinarily long, but only if you think in arbitrary terms chosen to represent a bull and a bear market.
The rally has not experienced straight-line growth from the end of the 2008-09 Great Recession to today’s repeated marking of all-time high for U.S. stocks. There have been several periods of negative downturns including a 19% decline for the S&P 500 in August-September of 2011. If that decline had stretched just 1% more, we wouldn’t be writing about the second longest bull market in history. The assumption that it has gone on too long might not be as prominent of a conversation topic as it has become lately.
All-time high market prices combined with high political uncertainty and a historically long stretch without an economic recession in the U.S. seem to stoke fear that the stock market is due for a decline. Adding to this assumption is that U.S. stock valuation measures indicate an expensive market trading at a premium above “fair value” when compared to historical measures of company earnings.
But, there are many factors that could push market higher. Influences such as low interest rates, investor demographics and many other intricacies can cause different outcomes versus seemingly similar prior situations. Stocks also continue to be more (relatively) attractive than bonds in this low-but-rising interest-rate environment.
Why Deal with Uncertain Outcomes
We realize that people who put their money to work in risky assets do so with the expectation of being compensated well. Most of our clients seek expected returns that align with their risk level and life goals they want to fund.
While long-term evidence supports the expectation of being rewarded over time, returns can be fleeting and markets don’t have any knowledge of when they are supposed to conform to an individual’s personal timeline for when they need their money.
We consider a portfolio of 60% stocks, 40% bonds to be a neutral asset mix for a globally balanced investor that is not particularly aggressive or conservative. Investment allocations like this have produced 10-12% returns over the past year through the end-of-May. This terrific result is driven mostly by stock gains. While this has been good news for account balances, the seeds of future trouble can germinate in times like this.
As Steven Romick, manager of FPA Crescent Fund wrote in a recent commentary, “The further you get away from a bear market, the greater the number of people who have convinced themselves they can handle the downside – until the next time, of course.”
Investment volatility (or standard deviation) is a measure of risk. It includes volatility to the upside and downside, even though people are often only concerned about downside volatility. Being mindful of the downside potential in your portfolio, we believe, is very important. Once you’ve experienced it, it’s too late to decide you are uncomfortable with it. This is why we use tools, like Riskalyze, to identify the range of return outcomes that could normally be expected for any investment as well as the decline potential that is possible, although with low likelihood, of repeating a 2008-09 scenario.
Ben Inker, head of asset allocation for institutional money manager GMO, wrote recently: “It is impossible to determine if you are taking an appropriate amount of risk without understanding what the downside is for your portfolio, which means you simply have to do the exercise of understanding what can go wrong.”
In nautical terms, this is called the lifeboat drill. It’s important to practice an emergency exit before it occurs. Journalists would bring in the “red team” to look for weak spots in an important investigation before it goes to print.
To prepare for potential declines, it’s important to evaluate the level of risk in your investments and how such declines would impact your efforts to fund your goals.
Our Approach to Evaluating Portfolios
When we cannot predict outcomes, we must rely on core investment principles that can be applied regardless of how the investment landscape shifts.
Certainly, identifying an appropriate portfolio for each client is a critical element of a financial plan. But, before we can decide how we and the client will feel and respond to market conditions, we have to understand:
- the purpose of the portfolio
- the time horizon for needing the money
- the client’s risk tolerance and risk capacity
Risk tolerance and capacity are different measures. Some people may have the tolerance for fluctuating account balances, but not the financial capacity to withstand large fluctuations at the wrong time. Others may have the financial capacity to take more investment risk and potentially reap higher returns, but may not have the stomach to tolerate large market fluctuations. The purpose of the portfolio and time horizon are something we and clients have a certain level of control.
Once we’re comfortable with the client’s portfolio purpose and time horizon (some people have different purposes and different horizons for separate pools of money), we wade into the less certain elements of investment management. We use portfolio construction and risk assessment programs to build portfolios that we hope yield the desired outcome. As we make asset allocation decisions (e.g., stocks vs. bonds, U.S. vs. international), we introduce more strategic decisions that are based on probability culled from a wide range of outcomes. When these outcomes are not in our favor, it can be tempting to change strategy at inopportune times. We think David Booth, founder of Dimensional Fund Advisors (DFA) offers wise counsel on this point: “After more than 35 years in the financial services industry, I have found that having an investment philosophy – one that is robust and that you can stick with – cannot be overstated.”
Some active managers will try to time the market by shifting among various segments to capture gains or avoid losses. We don’t believe this is likely to result in higher returns or more safety. However, it will increase transaction costs. Moreover, the more decision points the manager introduces, the greater their chances of being wrong.
So, rather than time markets, we rely on core investment tenets that we expect to be profitable over time, not every time.
When You Can’t Predict, Plan
These core tenets are less-than thrilling. However, we believe good investing should be boring at the portfolio management level and exciting at the spending level when investors use their gains to fund goals.
- Review goals. If investment markets returns don’t conform to the timeline of your goals, how much flexibility do you have to shift the timing or size of your goals? Most people have more control over their spending versus their investment outcome.
- Understand your risk tolerance and capacity and know the difference.
- Make sure short-term funds aren’t invested in stocks. If you expect to need to withdraw funds to cover expenses in the next 1-3 years, you should not have this money in the stock market. Rather, such funds should be in cash or short-term bonds as they are unlikely to see much, if any, reduction of principal. Knowing that your short-term needs are covered may help you ride out the fluctuations in your longer-term money.
- Rebalance to align with the Investment Policy Statement (IPS). Each of our clients has a signed IPS that factors in the portfolio purpose and time horizon to arrive at the target asset allocation. When any asset class drifts meaningfully from the allocation target, we rebalance back to target. This practice may temper return momentum, but, more importantly, it will help reduce risk.
- Communicate / counsel frequently and timely. We are committed to being available and responsive to our clients’ concerns and needs, especially during down markets. As independent sounding boards and experienced investors who are knowledgeable of your personal goals and financial situations, we can help alleviate anxieties arising from declining stocks markets.
- We try to invest wisely. This means utilizing investments that are well-diversified, low cost, transparent and by-products of rigorous academic research.
A Market Drawdown Reminder
Disciplined adherence to these core principles should help set our clients up to capture reasonable returns in rising markets without being overexposed to the full depths of declining markets. But, what does the full depth of a decline look like?
Charles Boccadoro of Mutual Fund Observer has provided a helpful view of investment performance during the past 11 bear markets (Table 1) since the end of the Great Depression in 1936. (The table does not include international investments since those don’t have history back to 1936. Therefore, a modern portfolio including international stocks, bonds and alternative asset classes, could have a moderately different experience than is presented here.) This is an eye-opener by identifying maximum decline in 10% increments of stock/bond weight starting from 100% stocks to 100% bonds. Even very conservative portfolios with 70% or more of the money in bonds had negative returns, but with far less downside than stock-heavy allocations.
Table 1: Charles Boccadoro Analysis of Bear Markets
Boccadoro’s analysis goes on to demonstrate that the best risk-adjusted returns – where you are compensated the most for each increment of risk you add to the portfolio – occur in to middle ranges from 60% stocks down to 30% stocks. His conclusion is that portfolios with 70% stocks or more don’t provide enough return to justify their ulcer potential from downside risk.
The More You Know …
Now is a good time to gut-check your portfolio. If you want to know more about how your investments might perform under different hypothetical conditions and what this may mean to your long-term financial security, we are happy to model the scenarios to illustrate possible outcomes. With this knowledge, we could potentially revise your portfolio to ensure that it balances between competing variables: goals, time horizon, risk tolerance.
Please let us know if you have questions about how you are invested.
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