With recent market volatility, many investors have been voicing legitimate concerns about the future direction of markets and what they might do about it. What direction are we headed for the remainder of the year? How can we avoid the crash? Below we present a question and answer that we hope investors might find helpful.
From a concerned investor with impressively good timing (question received January 8 of this year) :
Looking at the investment and political scene now – Trump, NAFTA, Dow at record highs, bull market into it’s 8th year, Iran protests, we think the chance of a significant pull-back on the stock market is imminent.
We are beginning to feel, with what’s going on today, that a major pull back could be on the books – like 2008.
What do you think?
Dear concerned investor,
To begin with, you are not the only ones expressing those concerns to us. It does seem the market has been on a strong trajectory for quite some time although we usually recommend investors not worry about the market hitting an “all time high” despite how often it’s cited as a signal of sorts by the financial media/analyst community. The market is always hitting all time highs (Graham wrote this piece on the topic recently that we’d recommend reading- “I’m nearing retirement and the stock market is at an all-time high….what should I do?”– it is relevant for this discussion generally). We have also noticed an uptick in the volume of negative market commentary. Doom and gloom reporting became an industry in itself after the last market downturn! This commentary did seem to become more fervent beginning about a year ago (with the US election maybe?) although with hindsight of course it would have been unfortunate to divest at that point or at several other points during the year when news flow seemed particularly grim.
As you know, stock markets are volatile – sometimes that volatility is coincident with changes to the surrounding political and economic environment, sometimes the market anticipates those changes and sometimes it lags. Without the risk of volatility and downturn and uncertainty generally, markets would not deliver the strong long-term returns we seek as investors. In fact evidence would suggest that investment success is driven more by riding out volatility than by trying to time it. The data on mutual fund returns and money flows shows very clearly that investors actually earn returns significantly lower than the funds they invest in due to poor timing decisions. When markets turn down, investors tend to pull money out. Investors also tend to pile in during times of market euphoria. I think we’re just not hard-wired psychologically to deal with market volatility. The “fight or flight” instinct doesn’t serve us well in this case. The evidence does not support market timing as a successful investment strategy.
It’s also important to examine relevant data. Most commentators refer to 2008 as a period when the stock market was cut in half or worse. Most of these commentaries are US centric. A globally diversified equity portfolio went down very significantly in 2008 but not as badly as 50%. A globally diversified portfolio might have gone down something closer to 30% in 2008. An illustrative portfolio with a 60% stock /40% bond allocation in 2008 would have dropped between 16-17% and rebounded 18% in 2009.
Don’t misinterpret what I’ve said so far as suggesting we do nothing – that’s not what we mean! Just trying to put some context around the discussion.
As we have discussed and also mentioned in the linked article above, expected returns are less about timing skill and stock picking success and more about how much risk you take. It is extremely important to ensure that the mix of stocks and bonds you choose, your “asset allocation”, is appropriate for your willingness, need and ability to assume risk. In other words, your allocation must be something that you can live with through extremely volatile market conditions. The risk, for example, of having too much equity in your allocation is that when a big market sell-off happens (and it will, we just cannot say when, nor can anyone else) you panic and sell everything at the bottom. The fear of experiencing such a downturn may also compel you to sell too early in a market upswing. And remember that selling is only half of the decision. Market timing requires not only that you sell at the right time but that you also buy back in at the right time!
We begin to assess appropriate asset allocation with a risk questionnaire and discussion about an investors’ situation and financial goals. Then, to really properly assess need and ability to take risk and to examine possible market scenarios and their impact on investments and financial well-being, we develop more detailed cash flow projections. Perhaps now is a good time to create those projections and an important next step in making sure the investment portfolio is fit for purpose whether the near term future brings a sudden sell-off, or continued new all-time highs.
We’d also recommend reading a selection of other relevant Chalten pieces: