As I write this, the stock market continues to hit all time highs. So what’s next? Are we going to repeat the double digit gains experienced last year or will we see another Great Recession like December 2007 to June 2009? The answer is that no one really knows, and those that think they do know are likely to be wrong. But the facts indicate that the probability of the next market correction or recession is growing with each trading day.
“Mark Twain shrewdly noted that history does not repeat itself, but it does rhyme. The next episode of excessive fear or greed won’t look quite like the last, but it will have in common an unrealistic expectation that tomorrow will look exactly like today and that ‘this time is different.’” [1]
What does forecasting future market conditions mean for a long-term investor? First, we need to remember that the full length of time that the average person invests is between 40 and 60 years. Breaking news…. once you reach retirement, you don’t sell all of your investments. Yes, you probably reduce your risk and limit the amount of stocks in your portfolio but you stay invested throughout retirement. Therefore, the first important point is:
1. You don’t have REAL gains or REAL losses in your portfolio until you sell something. The changes in value are just temporary adjustments reported on a piece of paper.
If markets adjust downward and you buy, then isn’t that a good thing? As my wife likes to say, you just bought something on sale. But you might ask, “what if I am selling and there are temporary declines? That would be bad, right?" Well it would, but only if you sold everything. If you or your advisor is managing the portfolio distributions and you stick with the mindset that markets do work over time, then the value of depressed markets will come back and so will your portfolio value. This time is never different.
“Most investors understand intuitively that managing risk is important, but few understand that the management of the downside is even more important than the pursuit of upside.” [1]
There are three (3) primary risks assumed for every investment:
SYSTEMATIC RISK - Systematic risk is a risk to the entire market or market segment. This type of risk is both unpredictable and impossible to completely avoid. An example of this was during the Great Recession (December 2007 to June 2009). It didn’t matter if you owned a stock, a bond, real estate, global or domestic, the value of most assets reduced in value.
BUSINESS RISK - This is when you buy too much of a single company. I have talked with individuals that retired from General Electric and many of them gleefully informed me that they had the majority of their retirement assets allocated in their beloved former company’s stock (GE). They loved their old employer and they had worked for them most of their life. They would say, “It has worked so far, so Why NOT continue with what has worked in the past?” Because General Electric (GE) stock fell almost 80% from July 2016 to the December 2018! Prior to the dip, it was considered one of the most preferred well established “US Branded” stocks traded in the market place. Same theme as Enron, prior to their own scandal in 2001. These are reminders that bad things can happen, even to some of the best reviewed and trusted company stocks. Therefore, your investment success or failure should not be concentrated with a single or even a handful of companies.
BEHAVIORAL RISK - This one doesn’t get discussed enough, and it's why I am writing this blog. Behavioral risk is the potential for your actions to increase the probability of permanent loss of capital. What does this look like? In the last quarter of 2018, most US indexes fell around 20% in a few short weeks. I know, you probably were not affected, but for many, after listening to the financial talking heads, the fear finally got through and they began to make fear-based decisions. In other words, their panic led them to sell at a pretty significant loss.
So what does all of that mean for you? It brings me to the next major point...
2. The fear of loss can become extremely powerful, even to those who know better.
I believe that we have something biologically programmed in us telling us to avoid loss of all kinds, including money. If we observe behavior when markets are down, most of our peers take steps to limit their losses… in other words, selling. So, then, we use their behavior to confirm that we should do the same. I mean, if your investing friends are getting out, they must know something, right? We think, ‘This time is indeed different. Trump is going to get impeached. We are going to war with Iran. This virus from China is going to spread worldwide. My advisor doesn’t know what they’re doing.’ Whatever your reasoning may be, you feel convinced that this time you have to do something. If you don’t, it is a certainty in your mind that you are going to lose even more …maybe even everything.
Research has proven that ALL investors feel fear at some point when markets decline. Each of us are worried about losing capital. But the more likely cause of fear is the underlying feeling that the current market conditions will likely prevent us from living the financial life that we desire. When you find yourself here, who will help talk you down off the ledge? Will your advisor answer the phone during the dip or will your concerns go unanswered? If you have a friend or an advisor that can help you maintain your strategy during the tough times, then you are in a small percentage of investors so count it as a blessing. If you don’t have this counsel, you need to have a plan in place so you don't sabotage yourself.
“Just as anyone can look up a sensible workout regimen, it is not difficult to find instructions on investing in a broadly diversified mix of asset classes. But if knowledge were sufficient to induce behavior, America would not now be the most obese developed country in the world and staring down the barrel of a looming retirement crisis.” [1]
If we know that during our investment lifetime (remember, that's 40-60 years for most) we will experience bear markets, corrections, and recessions, then what should we do coming out of a bull market? Part of your investment strategy should be to evaluate the downside risk of your investment portfolio. What would your current investments do if they experienced another Great Recession? You should know the downside percentage and the real dollar amount associated. Knowledge is power.
Fear makes neither a good poker player or investor.
If you can’t stomach the idea of losing a certain percentage of money while markets are good, you simply will not be able to maintain your strategy when markets eventually go down. Notice that I said when, not if.
Planning for the next temporary decline is a powerful tool to help you maintain your investment strategy through whatever may come next. And there’s a freedom in that… you don't need to guess at or worry about what’s going to happen because you’re fully prepared either way. Take the least amount of risk necessary to achieve your goals. After all, losing money feels twice as bad as making money feels good.
As former Goldman Sachs model-maker Emanual Derman says, “The similarity of physics and finance lies more in their syntax than their semantics. In physics you’re playing against God, and He doesn’t change His laws very often. In finance you’re playing against God’s creatures, agents who value assets based on their ephemeral opinions.”
🤔 Curious about what the market changes could do to your accounts or want to pin down how much risk you’re personally comfortable with?
Check out this neat tool you can use to do just that. You can make adjustments up and down, figure out the returns you need to meet your goals, and see how you’ll weather different market conditions. My clients get the full version of it, of course, but this simplified version is a great starting point for those who want to do some investigation on their own.
If you want my guidance in evaluating your current portfolio’s potential downside or if you just want to talk through some scenarios that are specific to you, go ahead and schedule a conversation with me. I look forward to helping you get prepared to deal with whatever the market decides to do next.
1. The Laws of Wealth - Dr. Daniel Crosby