Special Market Update
It would be impossible to not notice the coverage of the volatility in the global stock market over the last 3 months. After peaking on September 21st of this year, the US stock market has officially fallen into what is known as a bear market. It is all over the news and it is important to our firm to communicate during these unknown times where fear can take over from an otherwise sound financial plan.
The main points we want our clients to take away from the added volatility are the following:
- What are some of the underlying causes of the market declines
- Importance of Diversification and Discipline during volatile markets
- Several Behavioral mistakes that investors make and how they should be addressed
What is going on with the stock market?
As of Christmas Eve, the S&P 500 joined the Nasdaq, Dow and Russell 2000 in what is known as bear market territory or a 20% peak to trough decline from their recent 52 week high. There are many reasons that have added to the added volatility of the past 3 months and especially this last month. Investor Sentiment has taken over the analysis of fundamentals in the global economy. As a matter of fact, this will mark only the third time in the modern post-war era where the market has entered a “Non Recession Bear Market”. This means that the economy has not entered an actual recession but the price on equities still declined at least 20% from recent highs. Investor sentiment has been the driver of these events historically as much of the economic data coming out is still strong including unemployment rates, GDP growth, and other key indicators.
The sentiment is being driven by a perceived hawkish federal reserve where Fed Chair Jerome Powell raised rates as expected for the fourth time this year but did not come down from his position of more gradual increases in 2019 to get the fed funds rate to the desired neutral rate. Many believe that the economy could be slowing into the later parts of the business cycle and an aggressive stance on raising rates by the fed could push to an overly tight monetary policy and push us into a recession. This has historically been the biggest constant in pushing an economy from late-stage growth to a recession. The federal reserve has to balance being too loose with monetary policy which can create an inflationary environment and being too tight which can push the economy into a recession.
Other global issues also impact prices such as the much-publicized US-China trade/tariff conflict, the ongoing saga of the UK’s “Brexit” from the European Union and the unknown of global geopolitical conflicts.
At this point, it appears that the market has been oversold in our opinions but being oversold does not always correlate to a pending recovery. Investors dictate how low prices go and although the fundamentals now show that stocks are as attractively valued as they have been in almost five years, we are still exercising caution when putting capital to work in this market environment.
Importance of Diversification and Discipline as a long-term investor
The two most important concepts to understand to be a successful long-term investor are diversification and discipline. Most investors are goal based investors such as saving for retirement, college or a new car. Since day one, we have always said that an asset allocation should be based on your risk tolerance, time horizon for the funds and ultimately the rate needed to reach reasonable goals. If you have a goal that requires an unreasonable rate of return in an unreasonable time period, you may need to reevaluate to ensure your expectations are in line with what is realistic or prudent.
We diversify among all of a client’s accounts. Some strategies may see more price volatility than others but the important item to remember with diversification is to look at the whole picture to avoid some of the behavioral traps we will discuss in the next section. Financial planners do not have a crystal ball or the ability to perfectly time market entries and exits. The value that a planner can bring a portfolio is proper asset allocation that may lead to reduced volatility and superior risk-adjusted returns over a long-term investment plan.
Diversification was never more apparent than the 10 year period from 1999-2009 which is known as the “Lost Decade”. During this period, the US Large Cap Indices as measured by the S&P 500 experienced a negative return over a 10 year period for the first time in recorded history since it began in 1926. A diversified portfolio would have outperformed as Developed International, US Small and Mid Cap, Emerging Markets, Real Estate, Private Equity and Global Fixed Income all outperformed the US Large Cap Index and when put together in a diverse asset allocation, it reduced volatility and enhanced returns over that particular period. The purpose of asset allocation is to never have the highest returning portfolio, it is mathematically impossible. This allows to mathematically never have the worst performing portfolio and limit the volatility over a full investing cycle.
Discipline is a concept that is easier said than done for many investors. Everyone has heard “Buy Low, Sell High” as a heuristic for investing. However many self-directed investors that are not disciplined or perhaps are simply investing without a formal financial plan tend to significantly underperform their benchmark especially when volatility lurks it’s ugly head. It is crucial to remember that times like now where volatility has spiked and fear has dropped many prices below their intrinsic values are not when you should take more volatile assets off of the table unless part of the financial plan such as utilizing tax loss harvesting in non-IRA accounts. Also, our clients have layers of protection built in their portfolios with investments that provide some degree of principal protection as well as many non-correlated investments that have not participated during this recent equity sell-off. While it may be difficult to see the big picture when some of the risk assets are experiencing price volatility, it is our job to keep you focused and discipline as investors have historically been rewarded long term for their patience.
Our investment philosophy is designed to smooth out some of the bumps of normal market investing but it is also designed for cash flow needs. A main goal, especially in environments like this, is to not have to liquidate positions at a loss to create liquidity. Liquidity needs are already built into the asset allocation.
The reason investors themselves can be more dangerous than the market itself
Investor behavior can sometimes have unintended consequences, especially during volatility. We witness these almost daily in our meetings with clients. It is important to address that they exist and you may be unaware that these have been your own tendencies in the past(or present).
The first that we see is mental accounting. That is we place pieces of the whole portfolio into smaller, nontransferable portions. Investing is about all of your assets working together but investors tend to say things like “My IRA is outperforming my 401(K) so let’s invest the 401 just like the IRA.” There could be many situations that would create outperformance or underperformance of one account over another such as single stock exposure, lack of diversification, non-correlated assets, cash positions, etc.
The takeaway from this is to consider all of your investments as one portfolio although they are separate. Your outside accounts need to be taken into consideration when putting allocations together. You shouldn’t drop the protected assets when the market is booming and abandon equities completely when volatility resurges. Portfolio performance should take a look at all of your investable net worth to have an aggregate return, not micromanage the pieces.
The number one behavioral characteristic that can hurt investors is Loss Aversion. Kahneman and Taversky won the Nobel Prize in Economics for their study of behavioral finance and one of their key takeaways is that we as humans tend to put twice as pain in a loss as the pleasure received from a gain. This will have some investors be more conservative when there are good buying opportunities or find reasons to stay on the sideline which is a form of market timing.
Market timing is the final reason we will cover. Historically it is time in the market rather than timing the market that has rewarded investors with diverse portfolios. “ I want to wait until the market settles” or “I want to invest my bonus but I want Amazon to get back to $1500 first” are examples of market timing that can harm us long term. These decisions of when to get in and out are the main contributor to why the self-directed investor has historically underperformed their benchmark. If the investor understands that the allocation being recommended is in line with their goals and objectives, there should not be any reason to let market timing impact their actions… but they still will cross your mind.
Corrections of 10% or more historically have happened annually and a 20% bear has historically occurred every 3.5 years. We are here to help you navigate the market and provide a philosophy of investment management that is designed to reduce volatility and provide education to help avoid potentially harmful behavioral actions.
As always, we are here for you so if you would like to discuss any of these topics or others and how they play into your own financial plan, please reach out to us.
Securities and Advisory Services offered through Client One Securities, LLC Member FINRA/SIPC and an investment advisor. Sawyer Wealth Management and Client One Securities, LLC are not affiliated.
The views presented are not intended to be relied on as a forecast, research or investment advice and are the opinions of the sources cited and are subject to change based on subsequent developments. They are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investments.