I’m writing this post nearly two years to the day that we published the first of many articles on the COVID outbreak and its impacts on the markets and the global economy.
In February of 2020, the world was waking up to the battle against a virus that lay ahead of it. Sadly now, just two years later, the world is confronted with a war on the European continent that many would have thought impossible weeks ago.
We are all hoping for a swift resolution to the fighting and minimal loss of life, particularly for all the innocent people who are caught up in this battle through no fault of their own.
While it’s encouraging to see much of the world rally to support a country’s right to self-determination and massive, quick policy response is unparalleled in some ways, this post will focus on an investment perspective for the diversified investor.
Here We Are Again: Market Volatility
As always during significant world events, it’s worth reviewing some key points on long-term investing—the perspective we shared during COVID, the market drop in 2015, and again after the Brexit vote.
The headlines are always different, but our advice remains largely the same.
While the financial markets don’t like uncertainty, and traders are likely to sell first and ask questions later, it’s important to remember that we are investors, not traders.
As investors, our time frame (and your goals, objectives, and financial plan) is years and decades, not hours, days, or even weeks. The current crisis, or any market movement over a week, shouldn’t derail your investment strategy.
Remember, the impact of a correction, recession, or bear market is built into a well-designed financial plan.
Market Reactions During Time of War
Financial writer Ben Carlson says, “the stock market is heartless.”
“It seems odd to worry about the stock market at a time of war when people are dying, losing their homes and potentially the country they love.
The point here is that the stock market is heartless. It often goes up in the face of godawful events when it almost doesn’t seem right.”
Ben outlines how the markets have reacted to major world events in his article. His article provides more context; a summary is below:
- World War I (1914-1918) +8.7% annual return
- World War II (1939-1945) +7% annual return
- Korean War (1950-1953) +16% annual return
- Cuban Missile Crisis (13 days in 1962) -1.2%
- September 11, 2001 -15% in two weeks, but losses recovered within a couple of months.
- U.S. invasion of Iraq (March of 2003) +30% over the rest of the year.
The point of all this is that war is terrible but that the market’s reaction is often counterintuitive. No one has a crystal ball.
As Dan Egan, Director of Behavioral Finance at Betterment, said at the onset of the COVID outbreak, “The people who actually come out of this the best are the people who think about things in the context of their own plan, not in terms of trying to predict the trends.”
Key Considerations When Facing Market Volatility
So, with the recent market movement in mind, here are 5 key things to remember about the markets and investing in stocks.
1. Things Could Get Worse.
I write this not to alarm anyone (things could also get better) but to set proper expectations. At the time of writing (the market open on the last day of February 2022), the U.S. market (SPY) is down 8.9% YTD. Non-US Developed markets (ACWX) are down 6.1% and Emerging Markets (EEM) 5.3% over this period.
According to an analysis done by Adam Butler at BPG and Associates, since 1962, when the U.S. markets have seen a sell-off of 7% or more, the median final drawdown is 16%.
However, as Jason Zweig has pointed out in a Wall Street Journal article, “Stocks could drop another 10% from here, or another 25% or 50%; they could stay flat; or they could go right back up again.”
The point is that no one knows, which brings us to the second thing to remember.
2. You Don’t Just Hold Stocks.
A well-diversified portfolio most likely holds a healthy allocation of bonds and other diversifiers in addition to an emergency fund in cash outside your portfolio. Events like this are one reason why.
It always depends on a client’s risk tolerance and time horizon. Still, for a client holding 20% of their portfolio in bonds, this means five years of portfolio withdrawals (at the rule-of-thumb 4% withdrawal rate) from these less-volatile investments.
3. You Can’t Time the Markets.
And neither can anyone else. If someone tells you they know what’s going to happen next, they’re likely either lying to you, selling you something or extremely naïve—maybe all three. Since the bull market that started in March 2009, the U.S. market has experienced pullbacks of greater than 5% on 13 different occasions. The largest of these was the nearly 20% pullback that ended in October 2011. And yet, over this period, the market is up 220% — making each of these pullbacks just a blip on the radar over the six-year period (Preceding figures as of 2015).
What matters is “time in the markets, not timing the markets.”
Again, to quote Mr. Zweig, “After a market drop, or at any other time, no one knows what the market will do next. The one thing you can be fairly sure of is that the louder and more forcefully a market pundit voices his certainty about what is going to happen next, the more likely it is that he will turn out to be wrong.”
4. Weeks Like This Are A Big Reason Stocks Return More Than Bonds.
From 1928- 2014, stocks compounded at 9.6% annually versus 5.0% annually for bonds. This 4.6% difference is called the “equity risk premium.” And there are fundamental reasons for this premium: It’s compensation for stocks being lower in the capital structure than bonds and as a reward for being subject to both the downside and the upside of a company as an equity shareholder.
But, the feeling you have right now—that uncomfortable feeling in your gut making you wonder, “is my portfolio all right?”—that’s also a big reason that stocks have returned more than bonds over time. In a very visceral way, owning stocks compared to bonds is simply more painful at times. These pullbacks happen, and it’s not a whole lot of fun when you’re in the middle of one.
I think what’s important is to step back and see the forest for the trees. These pullbacks (the trees) can seem pretty big and important when we are in the midst of them. But zooming out to the forest-level view, we get a sense of just how minor each individual pullback is to long-term market performance.
The chart below from my friend, Michael Batnick at Ritholtz Wealth Management, paints this picture nicely. Notice how much of the time the stock market has spent in either a 5%, 10%, or 20% drawdown. And yet, from 1957-2014, for those disciplined investors willing to ride out these drawdowns, the market has returned 10.2% annually—turning a $1,000 investment into more than $250,000! Again, what matters for the disciplined investor is “time in the markets, not timing the markets.”
Source: S&P 500 Index via Michael Batnick
5. Your Behavior Matters: Don’t pay the Panic Tax.
We just saw that stock market investors spend a good chunk of their time in a drawdown. Therefore, to realize the equity premium risk, we have to avoid buying and selling, based on fear or greed, at the wrong time. We call it the “Panic Tax,” and paying this tax can have a significant impact on your returns.
According to Morningstar, for the ten years ending in 2014, investors in U.S. equity funds lost 1% annually from their returns because of these poorly timed buy and sell decisions (International fund investors fared worse, costing themselves 1.2%). For example, in 2012, the U.S. equity fund category saw the largest net outflows (-$94 billion), and taxable bonds had the highest inflow ($270 billion). Their returns in the next year: 35% for U.S. equity versus 0.15% for bonds.
What Should You Do When Facing Market Volatility? What Are We Doing?
Most of the time, doing nothing, as boring as it sounds, really is the best action. But it can be difficult to “not just do something; sit there,” as the saying goes. So, now that we’ve gained a little perspective, taken a deep breath, you might wonder if there are any actions worth taking.
Glad you asked.
1. Frame Current Market Movements In Light Of Your Long-Term Goals.
Chances are nothing that happens this week will deter your long-term financial goals or plan. View your investments as a means to achieve your long-term financial goals, and don’t worry about the tick-by-tick movement of your portfolio.
2. Assess Your Portfolio Risk Now.
If the recent market movements have you nervous, use this as a reminder to assess the riskiness of your portfolio. Instead of trying to predict when market corrections will happen, it’s better to figure out: Are you comfortable with the way your portfolio is positioned? Are you comfortable with the risk you’re taking? And are you able to stick with your strategy in a down market?
If you’re currently a client, you’ve gone through this portfolio risk assessment already. You know what to expect from your portfolio performance both in terms of returns captured on the upside and the downside. However, if you would like to review it again, as always, please give us a call.
But chances are, if you’re not working with an advisor, assessing your portfolio risk isn’t something you’ve reviewed recently. Some people, still scared from 2008, are taking too little risk; they’re limiting their returns and, therefore, the potential to achieve their goals. Others, spoiled and complacent after the great run of the last six years, have too much risk in their portfolio. The risk here is panicking during a market correction, selling out, and missing any market recovery. Either way, taking too much risk or not enough is damaging to your portfolio returns—but, even more importantly, to achieving your financial goals.
So, does your portfolio have a level of risk you are comfortable with? A strategy you can stick with and that gives you confidence in achieving your goals? Now is the time to assess.
3. Look For Opportunities.
Whether it’s rebalancing, Tax-loss harvesting, or making Roth conversions when the markets are down, volatile markets can create opportunities to take action.
In periods of market stress, remember to keep the big picture in mind. No one knows exactly what will happen next, but it’s a fair bet that, like they always have, stocks will go both go up and down. Because of this, it’s important your portfolio is positioned in support of your long-term goals and objectives and is designed with a level of risk you are comfortable taking.