The Hardest Thing to Do Right Now
When it comes to investing, particularly in down markets, it’s usually easy to see why diversification matters…usually.
Here we are, though, in a market environment where rapidly rising interest rates have become a de facto reset button on all assets. Higher rates mean higher capital costs, which then translates into reduced valuations and lower prices. When rates are rising at a more measured pace, markets are better able to adjust for those higher capital costs. Yet even though the economy has shown some resilience via positive Q3 GDP growth, inflation has stayed too high for too long, forcing the Fed to rapidly reverse their monetary policy that was far too dovish for far too long. As low interest rates have fueled a decade-long surge in asset prices, the reversal of such a policy was bound to reverberate across all corners of the investment universe.
Make no mistake, this is an extremely rare market environment, both in terms of the pace of rising interest rates and the magnitude of its adverse impact on asset prices. Look at the scatterplot below, which maps the annual returns of the S&P 500 against the annual returns of long-term U.S. government bonds since 1926 (97 years). That encircled dot in the bottom left is the year-to-date performance for 2022 (as of 9/30/22).
Source: Data retrieved from Dimensional Fund Advisors LP. The information contained above is for illustrative purposes only. Past performance is no guarantee of future results. The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon.
As the chart shows, stocks and bonds often both provide positive returns in the same year, with more upside in stocks. Further, long-term government bonds have often been able to provide positive returns when stocks were down, as seen by the scatter of blue dots in the upper left quadrant.
When both stocks and bonds are underperforming, it’s easy to want to uproot a strategy, no matter how many historical precedents argue against that inclination. This “we need to do something” crowd can be grouped into two broad categories. The first group wants to take risk off the table (e.g., selling and moving to cash) while the other sees the downturn as an opportunity or a need to take more risk.
Taking RISK Off / Hedging
A growing number of investors looking to make a change are in the risk-off category. With short-term yields now at the highest levels in more than a decade, safe-haven assets like money market funds are an increasingly attractive asset class. Still, this risk-off group aims to return to riskier investments when they see signs of a recovery; what those signs are vary widely, but all are often poor predictors of future performance.
Everyone has likely heard the phrase “time in the market is better than timing the market.” Unfortunately, the desire to sell in a down market is hard for many to ignore, even though most of us know it’s impossible to predict when the market will bottom. Yet, when selling or hedging risk exposure, many of these risk-off investors believe they won’t miss out on much, eventually returning to stocks as they start to feel the worst is behind them.
Yet, as shown below, missing on just a few days can lead to far worse results, especially right after the inflection point when markets rally off the bottom.
Source: J.P. Morgan analysis using data from Factset. Returns are based on the S&P 500 Total Return Index. The hypothetical performance calculations are shown for illustrative purposes only and are not meant to be representative of actual results while investing over the time periods shown. The hypothetical performance calculations are shown gross of fees. If fees were included, returns would be lower. Hypothetical performance returns reflect the reinvestment of all dividends. The hypothetical performance results have certain inherent limitations. Unlike an actual performance record, they do not reflect actual trading, liquidity constraints, fees and other costs. Past performance is not indicative of future returns. An individual cannot invest directly in an index. Data is as of January 31, 2022.
This result is not just restricted to timing the stock market. The average investor in a balanced portfolio is often their own worst enemy when it comes to making tactical shifts—taking risk off, in both stocks and bonds, at the most inopportune times.
Taking More Risk
The opportunistic, buy risky assets group is harder to dissect because this decision should be specific to the individual investor. It’s irresponsible to make a blanket statement that now is the best time for everyone to buy and take more risk (never, NEVER, take market advice from someone who doesn’t know your personal financial situation). We often tell our clients that a portfolio should be defined by their willingness and ability to take risk; in markets such as this, missteps in managing investments often occur when decisions are driven by the former more than the latter. This is true for both risk seekers and risk avoiders.
However, one’s willingness to take more risk should never override their ability to do so. Ability is the more objective assessment, defined by multiple factors such as investment horizon, liquidity needs, and outside cash flows (i.e., current income). But even assuming an investor has the ability to take more risk, it’s important to evaluate why they weren’t willing to do so previously.
Today’s market environment has some feeling like diversification is broken; a balanced portfolio didn’t protect on the downside and will now struggle to “catch up” when stocks begin to rally. As a result, the desire to take more risk is driven by fear of perpetual underperformance. Thus, the 60/40 portfolio may shift to 80/20, or even 100% all-in on stocks. This is a common inference, but it’s important to take such conversations a step further as the fear of underperformance is likely to manifest into a risk-off desire somewhere down the road. A portfolio heavily concentrated in stocks is likely to experience several drawdowns within just a ten-year period. Stocks have 10-20% corrections roughly every 2 years; since 1950, the S&P 500 has, on average, fallen more than 20% every 6.5 years, with an average drawdown of -34.5%.[i] So, if you’re feeling like the “risk on” crowd, first be sure you have the ability to do so, but then make sure you have the gumption to avoid turning into a risk-off market timer when stocks inevitably face multiple downturns.
The Third OPTION: Keep Calm and Carry On
Our team at SineCera Capital is firmly in a third group of investors. We’ll call it the “keep calm and carry on” group. Any well-constructed portfolio, no matter how many hypothetical stress tests it’s been put through, will underperform at a given point in time. No portfolio has a batting average of 1,000 (100% success rate). Further, tweaking a portfolio to provide a short-term hedge, or adding an investment that happens to be outperforming in the short-term will, in my view, lead to lower long-term results.
I recently heard a comment at a family wealth conference that clients are tired of hearing the keep calm and carry on advice. That may be true, and those client conversations may be challenging, but the best advice shouldn’t be dictated by how popular or unpopular it may be. Staying the course is easier said than done. As fiduciaries, it’s our job to set that course—with clarity, confidence, and purpose—and make sure our clients stick to it.
Don’t just take our advice. Here are some of the greatest investors’ thoughts about the value of patience:
“The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.”
Benjamin Graham
“Waiting helps you as an investor and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.”
Charlie Munger
“The stock market is a device to transfer money from the impatient to the patient.”
Warren Buffett
Keep calm and carry on. Right now, that’s the hardest but [likely] smartest advice to give.
Best Regards,
Adam J. Packer, CFA®, CAIA®
Chief Investment Officer | SineCera Capital