On January 4, 2016, we wrote a blog about the volatility and performance of the financial markets in 2015. To say the financial markets have been “interesting” since then exemplifies an understatement. As we write this on Feb 11, 2016, the S&P 500 has declined approximately 10% since the end of 2015 and has fallen approximately 13% from its high in May of 2015. No way can one look at an investment portfolio in these market conditions and “be happy!” However, we should try to look at these conditions in light of 1) how to protect (to some extent) against such market moves, and 2) what to do now.
What’s the Perspective?
Fresh in most investor’s memory is the October, 2007- March, 2009 decline. The S&P 500 declined from about 1565 in October, 2007 to 676 in March, 2009 (a decline of about 57%!!). The S&P regained its October, 2007 high in March, 2013 (or 4 years later) on its way to 2131 in May of 2015. Obviously only one incident may not be representative of future market movements; however, the stock market historically moves up, even with the intermediate ups and downs.
How Should You Prepare?
So what does an investor do? With perfect hindsight, one would have moved into cash to avoid the downturn. Such market timing always brings the question of “when” to reinvest. Numerous empirical studies show investors suffer anemic returns because they wait too long to re-enter the market. For example, Putnam Investments published research showing that an investor who missed the best 10 days in the market during the time period 12/31/2000 -12/31/2015 would have an annualized return of 1.18% vs. the 5.80% earned by the investor who held the portfolio throughout the time period. That return differential represents $11,365 more on an initial investment of $10,000 ($23,295 vs. $11,930).
Numerous factors go into portfolio management; we will discuss only one here—asset allocation. Asset allocation involves having a portfolio positioned in such a manner that “not all eggs are in the same basket.” Some ramifications of that are as follows:
- Money needed in the near term is invested in cash or conservative bonds such that those needed moneys are not subject to the volatility of the stock market.
- Different investments in the portfolio can move in different directions relative to each other and the market in general (their correlation). We mentioned the S&P is down about 10% year to date; the aggregate bond index is up approximately 2% in the same time period.
- A subset of the correlation argument is use of alternative assets where the investment itself or the investment manager’s style is designed to give some portfolio protection in a declining stock market. Mutual funds utilizing a “long/short” or “market neutral” strategy are available to provide some loss protection and still maintain liquidity. Obviously the quality of that investment is highly dependent on the fund manager and fund strategy; care should be taken when integrating such assets into a portfolio.
What Do You Do Now?
Preparation is great, but it’s an historical thing. If it’s not done before now, you may be too late. So what does an investor do now? Consider the following:
- Review the cash needs from the portfolio for the next several years. Do you have sufficient cash or investments with gains to cover those needs? If so, you can “wait it out.” You have no need to go into panic portfolio liquidation.
- Almost every diversified portfolio will have some assets with a gain—especially if they have been in the portfolio for a while. Do some “tax harvesting” where assets are sold and the gains of the “winners” are offset by losses of the “losers.” This action results in avoiding taxation on the gain and allows resetting cost basis on investments in the future.
- What did you do the day after Thanksgiving? Millions of Americans went shopping because things were “on sale.” Apply the same mindset to the stock market. Stocks are currently going “on sale.” Investors may have hard time thinking about adding to positions in such markets, but for the right stocks and in the right portfolios, these times may be buying opportunities.