The markets are volatile, the news is bad, and the value of your portfolio is going down.
You’re afraid things may get worse and you want to do something about it.
This is a perfectly normal reaction. When faced with something painful, we look for ways to ease the pain.
While such a response serves us well in many areas of life, investing is not one of them.
Because pain is an inevitable part of investing, without which there would be no gain.
The S&P 500 has returned an impressive 10% per year since 1928, but not in a straight line upward – far from it. In order to receive that 10% return, an investor would have had to incur a median intra-year drawdown of 13%.
As chance would have it, that’s exactly what investors have experienced thus far in 2022.
And as one might expect, the headlines have been filled with bad news: war, tightening monetary policy, rising interest rates, plunging consumer sentiment, and the highest inflation rate in 40 years.
We naturally assume that things will only get worse, and look for ways to cauterize the wound and prevent further pain.
What immediately comes to mind?
Taking action: moving to cash and waiting for things to get better. Surely, we assume, that when the headlines are filled with positive news, it will be a safer time to invest.
The problem, of course, is there’s no such thing as a safe time to invest. Risk is always present, even if you can’t always see it.
And by moving to cash, you not only have to get the sale part right, but also the timing in buying back in. Few have shown the ability to do so on a consistent basis.
The proof: the list of billionaires, which is filled with long-term founders/investors and their stories of hardship, and devoid of market timers who sidestepped all pain.
If selling everything and moving to cash is not advisable, what should an investor be thinking about during market corrections?
Here’s a checklist to consider…
1) First, Do No Harm
As John Bogle once said: “don’t do something, just stand there!” Given the risk of a timing error, the hurdle for action should be exceedingly high.
That means having a strong, evidenced-based rationale for any change you make.
If you can’t clearly explain your process or edge in making a buy or sell decision, then there’s likely no justification for doing it.
That’s especially true when you’re under duress, with fear clouding your thinking. Instead of immediately acting on that fear, clear your head by going for a walk, reading a good book, or watching your favorite movie. The market will be there when you get back and you’ll be in a much better frame of mind to make any decision.
2) Find Your True Risk Tolerance
Everyone thinks they have a good idea of their risk tolerance until they are punched in the face with a large drawdown.
During smooth up markets with only minor pullbacks (ex: 2021), many assume their risk tolerance is higher than it actually is. You can tolerate any level of risk when risk is seemingly absent.
It’s only when the correction hits and you can’t sleep at night because your portfolio is down that you begin to understand your true risk tolerance. And when it comes, you’ll probably be thinking in dollars and not percentages.
A 50% decline for someone with $10,000 invested early in their career is not going to be viewed nearly the same as a retiree that has $1 million invested. A $5,000 drawdown is more tolerable than $500,000 to almost everyone, even though the percentages are exactly the same.
If you can’t stomach a large dollar decline in your portfolio, you can’t hold large percentage of your portfolio in equities. Since 2000, we’ve seen two bear markets in the U.S. with over 50% declines. If it happened before, it can happen again.
Try to imagine the value of the equity portion of your portfolio being cut in half. If such a loss would cause you distress and increase the urge to sell everything, you need to re-evaluate your risk tolerance.
3) Make Sure You’re Really Diversified
Corrections always induce fear, but if you’re concentrated in the wrong asset class they can be downright frightening.
What’s the wrong asset class?
Nobody knows, which is why maintaining an diversified portfolio is so important.
From year to year and from decade to decade, the leaders change.
The S&P 500 was up over 18% per year during the 1990s, a cumulative return of 433%.
The next decade it was down 9%.
And the decade after that? Up 257% (13.6% annualized).
If these returns seem impossible to predict, that’s because they are.
Luckily, if you’re diversified you don’t need to predict, as you’ll benefit from whatever asset class does well in the future. And more importantly, when there’s a sharp decline in any one position, there will be other holdings that mitigate the damage to your overall portfolio. True diversification helps you stay invested long enough to reap the incredible benefits of compounding.
4) Rebalance to Manage Risk and Buy Low/Sell High
Large movements in markets can lead to big changes in your portfolio and introduce risks that you may not be aware of.
The Nasdaq 100 ($QQQ ETF) has been the best performing major asset class over the last 10 years, gaining 686%. US Bonds ($AGG ETF) were up roughly 32% over the same time period.
Due to this wide differential in performance, a 50/50 portfolio split between the Nasdaq 100 and US Bonds ($AGG ETF) back in 2012 would now have 86% in the Nasdaq 100 and only 14% in bonds. That shift means a dramatic increase in your portfolio’s volatility and risk of a large drawdown. With 86% in equities, a 50% decline would nearly cut your portfolio in half (assuming bonds were flat over that time period), and a 2000-2002 Nasdaq 100 decline (-83% from peak to trough) would lead to a more than two-thirds reduction in your portfolio (again, assuming bonds are flat).
If that’s a risk you’re not comfortable with, the time to do something about it is before the large declines commence. Rebalancing (back to target weights, in this case 50/50) is a systematic way to combat that risk, reducing volatility and the potential for drawdowns in your portfolio.
The opposite situation arises during bear markets, where the equity portion of your portfolio falls. A 50/50 portfolio initiated in January 2000 that was split between the Nasdaq 100 ($QQQ) and US Bonds (Bloomberg Barclays US Aggregate) would have moved to 14% in the Nasdaq 100 and 86% in Bonds at the lows in March 2009.
The risk at that point in time would be of a different kind, that your current portfolio might not have enough equity exposure to outpace inflation and meet your future objectives. In this case, a rebalance back to 50/50 would have increased the volatility of your portfolio, but decreased the risk of a subpar long-term return.
These two real-world examples illustrate how rebalancing after large moves up or down can be a systematic way to buy low (add to asset classes that have done poorly) and sell high (reduce asset classes that have done well).
5) View Declines as Opportunities to Add to Exposure
If you are a long-term investor, every large decline should be viewed as an opportunity.
Because time is on your side. And history has shown us that the longer your holding period, the more time you have to compound, and the higher your prospective cumulative returns.
This has been true irrespective of where the market is in relation to its all-time high, but if we look ahead 15 to 20 years, we actually see higher future returns following periods with higher drawdowns.
Valuation is also a factor to consider, with lower starting valuations tending to lead to higher prospective returns. And when stocks fall sharply, they invariably get cheaper.
The S&P 500 today is in the highest decile in terms of valuation (CAPE ratio of 37), which means investors should be anticipating lower future returns. If the current correction were to deepen significantly, that would change the calculus, with the expectation of higher long-term returns.
If you have a long enough time horizon, any stock market crash should be viewed as a gift for it gives you the opportunity to add new capital and/or reinvest dividends at lower prices.
You must be cognizant of your risk tolerance, but assuming you can stomach an increase in the potential for volatility/drawdowns, the best time to add exposure is often during large declines.
The next time you’re faced with a market correction, refer to this checklist. And remember Abraham Lincoln’s favorite saying: “this, too, shall pass.”
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Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.