As the old saying goes, "perception is reality". The perception of extreme volatility seems to be the general sentiment these days. While it is certainly true that volatility has returned to the marketplace, it has returned in a rather typical way. The recent market correction is the second significant downturn this year, with the first beginning in February. Much of this may seem amplified due to the fact that 2017 was a year of historically low volatility.
As we pointed out in our February Special Edition Update around similar volatility, the average intra year market decline for the
S&P 500
is about
-14%
from the peak to trough before turning into positive territory 75% of the time. With that being said, if the markets are positive 75% of the time, by default they are negative 25% of the time. So it is entirely plausible that this is the one time out of the four years (the historical average), in which the markets may close in negative territory.
When looking at the major commonly cited benchmarks such as the
S&P 500
or the
Dow Jones Industrial Average
, even after the recent downturn, they were barely negative for the year. Unfortunately, it is somewhat innate for investors to view financial market declines only through the lens of where they were at the peak, and not where they started. When looking at this year from the perspective of the start of the year, the good news is that at this stage it would be hard to define this as a bad year, or a bear market. At the moment, the
S&P 500
remains modestly in positive territory. When considering that markets can commonly demonstrate a negative return in which the
S&P 500
has been down
-10%
to
-20%
, it is a positive that we are nowhere near that type of a decline as of this writing. This is not to suggest that this is impossible. In fact we would suggest that such a year is inevitable and expected at some point in time.
The bad news, at least for this year is that a number of asset classes other than the
S&P 500
are not only in negative territory, but some are significantly negative. As an example, International stocks have posted double digit negative returns.
Real Estate Investment Trusts (REIT's)
have turned modestly negative, as have
US Mid Cap
stocks. In addition under the pressure of rising rates, the
Barclays Aggregate Bond Index
is negative more than
-2%
year to date.
What makes this relevant is that a well-diversified investment portfolio that matches the risk level of an investor needs exposure to many asset classes. In doing so, some years this diversification will be a lag on returns, while in others it will greatly reduce the volatility. What we know through empirical evidence is that all asset classes rise if given enough time, as there is an inevitable reversion back to the mean return. In other words, what leads the pack this year, likely won't lead the following year. A good example of this would be international stocks, which were the top performers in 2017, and are now the biggest drag in 2018 year to date. Our objective is to always build a portfolio with a combination of the right risk, yet reducing the correlation so all assets do not necessarily move in tandem.
Often times we have discussions with clients which many of you may have had with us in which we discourage you from taking additional risk if it is not for the right reason. At the same time, we often discuss not overreacting to market volatility during these rapid market declines and avoiding that inevitable feeling of wanting to become more conservative. These conversations are common and expected as emotions often affect the behaviors of investors. One constant theme you will hear from us is that it is important to stick to the allocation of risk that we arrive at together based on the financial planning we work on collectively. This process of learning about your overall objectives drives the risk tolerance. It is based on the assumption that there will be not only such volatility, but that we will experience that 1 out of 4 years in which the markets decline. Whether this is one of those years should be irrelevant in the investment process if the planning was done properly, and we gained a true realistic understanding of your goals.
Key to maintaining that investment discipline is the process of rebalancing a portfolio on a consistent basis. This rebalancing is the process of selling whatever asset class has risen or declined less recently, and buying additional shares of the asset classes that have fallen. Simply selling high and buying low. We generally try to address this quarterly. However, in the face of an uptick in volatility and a rapid selloff in financial markets, we'll likely act sooner. As a result, some of you may have seen more recent trading activity.
In 2009 at the height of the market panic, Knight Kiplinger put out an interesting piece in Kiplinger magazine titled the "Investor's Manifesto". It's an interesting set of guidelines for the average an investor to live by, and these are some of the principles by which we manage the wealth of our clients.
"Investor's Manifesto"
I am an investor.
I do not trade my assets frequently. That's speculation, not investing.
I am also a saver,
fueling my investments with continuous savings from current income.
I know that every kind of asset entails risk
-- even cash, which can be eroded by inflation.
I know that higher returns entail higher risk,
in every kind of asset.
I accept those risks
, but I mitigate them by owning a diversity of assets.
I regard my home as a place to live,
not as an investment. It is not a substitute for retirement savings.
I have an investment plan
and a plan for asset allocation, in consultation with a financial adviser.
I invest regular amounts every month,
in both rising and falling markets. I know I cannot gauge market tops and bottoms. If I received a windfall -- a bonus, bequest or gift -- I gradually feed it into my regular investment mix.
I don't pour more money into hot markets
nor completely cash out of plunging markets.
I spread my investments
among several asset classes, in a mix fitting my age and risk tolerance.
*My share of bonds
roughly equals my age. I will allocate to stocks a declining portion of my financial assets as I get older.
*This is one we disagree with as a "rule". Often this is not the case, as it depends on each client's specific circumstance. As an example, a number of clients may find themselves more financially secure (such as with large pensions, and decreasing expenses), and are then looking to pass their portfolio down to future generations.
I rebalance my portfolio every quarter.
If the stock market plunges, pushing my stock allocation way below its target percentage, I sell bonds and use my cash to buy stocks.
I force myself to sell high and buy low
by periodic rebalancing - just what is temperamentally difficult for most investors to do.
I know that stocks are risky in the short run,
so I hold in equities no money for which I have a likely need in the next three years.
But stocks are not too risky in the long run.
They have outperformed all other commonly traded assets over periods of 15 years or longer.
Foreign stocks account for a least 15%
of my stock allocation. I believe that developing economies will enjoy much higher growth than the U.S. in the decades ahead.
I never borrow against my stocks.
Margin calls could force me to sell good assets at a bad time.
I stick with my game plan.
I do not check the value of my investments every day or even every week.
I try to keep my cool
when other folks are losing theirs.
I remind myself often: I am an investor.
