By Richard A. Anderson
In the past few weeks, there has been an increase in volatility in stock markets around the globe. The first bout of volatility spanning the last week of January and first week of February was caused by concern the Federal Reserve would raise interest rates at a faster pace than the markets were anticipating. As a result, the S&P 500 declined by 10% before regaining some, but not all, of the losses.
The second bout of volatility spanning the last two weeks was due to two different geopolitical events and an economic event. The first geopolitical event was President Trump’s proposed 25% tariff on steel imports and 10% tariff on aluminum imported to the United States from other countries. The new tariff proposal, which some fear may lead to an international trade war, prompted a three-day decline in the S&P 500 of 3.67%. The second geopolitical event was the announced resignation of Gary Cohn from his position as White House chief economic advisor. Cohn’s resignation as President Trump’s top economic advisor caused markets to decline intra-day Wednesday, but it ultimately had little effect. The economic event was a better than expected February jobs report. The U.S. economy added 313,000 new jobs in February, which was the strongest monthly gain since July 2016, and the unemployment rate remained at 4.1% for the fifth straight month. The better than expected jobs report was viewed positively by the markets, with global stock markets rising on Friday.
With the recent market volatility and concerns that stocks may be overvalued, some investors may think now is a good time to get out of the market. To quote Jack Bogle, the founder of Vanguard, “One thing that I strongly urge: Don’t ever, ever, ever, if you’re an investor, think of being out of the market or in the market.”
Taking a binary approach (all in or all out) is a gambler’s approach to investing. This is because the baseline probability with gambling is a negative total return. A smart gambler knows the odds are not in their favor, so they only gamble when the odds are unequally in their favor. With investing, it is the exact opposite. The baseline probability is a positive total return, so investors want to have their assets invested in the markets because it provides for the highest probability of success over the long-term. Cash, which is the equivalent of being all out of the market, is a guaranteed negative real return.
Thinking in terms of all in or all out investing can have short-term implications. You may feel it would be less stressful being out of the market altogether, but what if you are wrong? You are going to feel stress every day the market is up, thinking about how much your assets would have been worth had you remained invested. In this sense, there is stress whether you are in the markets or out of the markets.
Thinking in terms of all in or all out investing can have long-term implications for your portfolio. The chart below shows the returns of the S&P 500 over the past 28 years.
The bars represent the hypothetical growth $1,000 over the period and shows what happened if you missed the best single day during the period and what happened if you missed a handful of the best single days. Being fully invested for the entire period would have generated a 9.81% annualized return. Missing the single best day in the market would have generated a 9.38% annualized return, which amounts to a 0.43% reduction in annualized returns. The data shows being on the sidelines for only a few of the best single days in the market would have resulted in substantially lower returns than the total period had to offer.
While we don’t advocate making all in or all out decisions when it comes to investing, there are some steps we take to ease your nerves:
1. Perhaps the most important step occurs before investing in the market. We help you develop an understanding of how markets work so you can trust the markets. This is done initially through our risk coaching presentation and reinforced through our weekly email newsletters, quarterly newsletter and periodic in-person meetings and phone calls.
2. The second step occurs also occurs before investing in the market. We construct a portfolio that aligns your risk tolerance with your investment goals. This provides a balance between risk and return that will reduce the potential for you to experience a decline in value that would cause you to want to exit the market.
3. A third step is the monitoring of your portfolio and rebalancing when necessary. Rebalancing involves selling the best performing assets and buying the assets that have not performed as well. This may sound counter-intuitive, but it is a risk management practice that helps maintain a consistent risk and return profile.
Knowing your risk profile and behavioral tendencies are important, but it is still hard to resist temptation. If it were easy, there wouldn’t be a whole field known as behavioral finance dedicated to understanding why investors behave the way they do. That is why we place an emphasis on downside protection when constructing portfolios and why we place a tremendous value on helping you understand why we do what we do.
If you have any questions about the recent market volatility or our portfolio management process, please contact a member of the HIGHLAND team.