Each time I hear someone suggest investors should 'stay the course' as markets tank, I fear such well-intentioned advice fails to adequately capture the predicament investors are in. Worse, the 'stay the course' mantra may set many investors up for failure.
So what's wrong with sticking to one's holdings when they tank? I would be the first to agree to encourage investors to stick to a plan when the markets are in turmoil, but only if its investors have been on a plan all along. Let's assume for a moment that an investor has done his or her homework, possibly even sat down with a financial planner or given his or her money to someone to manage. We are all good then, right? I'm afraid that may not yet cut it.
Investors developing a financial plan tend to look at parameters that consider the person's life situation expressed in factors such as financial goals, income, expenses, and risk tolerance. They tend to choose a mix of assets to pursue their goal.
If you are a stay-the-course investor (retail or professional) and say that, of course, anyone taking investments seriously considers volatility and correlation, let me ask you this: what processes do you have in place to manage volatility and correlation in your portfolio?
If you think you have a good process in place, what have you been doing with your portfolio in recent years to manage risk and ensure you are properly diversified? I am asking because in my conversations with hundreds of investors - professional and retail alike - the common thread was that investors enjoyed the ride. Now, if your investment philosophy is to "enjoy the ride," then good for you. But if you think to have a process of managing risk and diversification, you may have noticed at least two phenomena:
- Volatility in both equities and bonds was, for quite some time, below its historic norm;
- Asset prices were increasingly directionally correlated, i.e. investors may not get the sort of diversification that they expect.
It's during good times that it's time to get ready for the rougher times. No, this doesn't mean a buy-and-hold investor needs to become a tactical asset allocator. But it means that periodically, investors should revisit their goals to stress-test their portfolios.
Sure, if you have your money managed professionally, you'll have your periodic visit with your financial planner or investment adviser. But are you holding them accountable, quizzing them whether the strategy they pursue for you will work when the tide shifts? Or will you be one of those swimming naked when the tide goes out?
I think the most straightforward way to stay the course in a bull market is to take chips off the table, i.e., reduce assets that have outperformed (to rebalance a portfolio or to raise cash). I'm not insisting anyone has that strategy - in fact, if someone says they'll go all in, no matter what, I don't have a problem with that. Relevant is that you need to have a plan you are comfortable with, then have healthy cross-checks as you go along, consciously amending the plan if you deem prudent as the parameters that went into your plan change.
Before you wonder why such common sense would get me riled up, it's because reality looks very different from theory. During the bull market that I believe has lasted until last summer, many investors did not take chips off the table, but 'bought the dips' instead. Retail and professional investors alike looked to be increasingly afraid of missing out on rallies; more so, what could possibly go wrong when asset prices move higher and higher on the backdrop of low volatility? In such a "low risk" environment, isn't it prudent to load up on stocks, especially when fixed income doesn't yield anything? So maybe you were more active and purchased income producing investments, be that dividend paying stocks or high yield bonds. In my assessment, the Federal Reserve (Fed) and central banks encouraged risk taking. I'm not telling you anything you don't know. However, only you (and hopefully your financial adviser, if you have one) know your financial plan. Did you stay the course, or did you follow the call of the Sirens? And since I believe we've had a high proportion of investors following the call of the Sirens, i.e. not take the good times with a grain of salt when it came to their portfolios, it is hypocritical at best to only remember to stay the course once asset prices plunge.
In my opinion, staying the course is especially important when asset prices rise. Take 2008: the prudent investor would have taken chips off the table in the run-up to the financial crisis. Then, when asset prices plunged they would have had ammunition to buy when prices were low. In practice, however, investors had not taken chips off the table, with some losing 50% or more of their nest egg. Then, as we were at the bottom, pundits called for investors to double down. Sure, such portfolios might have bounced back, but it may be difficult to ask someone who has lost half their net worth to increase their risk profile; I allege such a person cannot afford to risk that much. If your financial plan is to play the lottery when times get rough, I won't criticize you. But if you had a plan and didn't stick to it when asset prices were rising, I'm not sympathetic to any outsized losses endured in a downturn.
So let's look at 2016. U.S. equity markets are down more than 10% from their peak. That's not much given how far we've come, but the volatility of late has gotten investors' attention. Any investment model asks you about your "risk tolerance," an abstract concept until one has experienced downside risk. Consider the following:
- If you have a "60/40" portfolio (60% equities, 40% bonds), have you periodically rebalanced your portfolio? If not, odds are that the risky (equity) portion of your portfolio has grown to over 60%; odds are then, too, that the elevated volatility exceeds the risk profile you are comfortable with. In my opinion anyone suggesting you stay the course with an overweight in equities is irresponsible.
- If you have periodically rebalanced your portfolio, but you are surprised that "risk" means exactly the type of thing that has happened to your portfolio of late, you need to have a serious chat about what risk you are comfortable with. Because: while the current volatility may be a tad above the historic norm, the abnormal times were the years of extraordinarily volatility until last summer. While I can't give specific investment advice, if you can't sleep at night because of the volatility in your investment portfolio, you may be over-invested in risky assets. In my opinion anyone suggesting you stay the course is irresponsible.
- If you have rebalanced your portfolio and believe you can stomach the volatility we have had of late, check what portions of your portfolio went up the first week in January to see if you are as diversified as you would like to be. Did your overall portfolio perform in a way that was consistent with what you think a diversified portfolio should have? If not, then in my opinion anyone suggesting you stay the course is irresponsible.
For full disclosure: I made an argument for a looming bear market last August, ahead of the market turmoil. As such, I personally believe most investors would be better off preparing for what's ahead by doing far more than simply rebalancing. However, there are lots of potentially successful investment strategies, and I wouldn't want to impose my own on everyone. What in my view all successful investment strategies have in common is that they are based on a plan, but a plan that overarches the entire investment horizon, not merely one to be pulled out of a hat when times are rough.
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