STRATEGIES FOR TOLERATING VOLATILE MARKETS
The recent market decline is making many clients nervous. As your advisor, we employ different strategies depending upon our view of the expected length and depth of the decline. Heroic changes were employed in the 2000-2002 and 2008 market drops but patience plus minor risk reductions for modest but normal market corrections seem more appropriate now. We believe that our primary focus for long-term investors should be on their long-term goals, and not constant trading based on emotions and market noise. Market timing is both difficult and expensive. It is important to understand that market downturns happen frequently but are usually followed by recoveries.
For clients who cannot handle market volatility, the best solution is a more conservative asset allocation model that seeks more stability and income and less fluctuation. This portfolio may not achieve the same appreciation as more aggressive models but it will align the investment risk with your goals and help to cope with the market volatility.
All investors should match their asset allocation model based on their risk profile. The decision should not be based on just the desire to make as much money as possible (greed) or the reluctance to avoid all risk (fear). To achieve your long-term goals, you should work backward from your future spending needs, your starting investment assets and ability to invest regularly, and then calculate your required average rate of return for success.
Market declines should be expected but don’t overlook upside surprises that historically occur with even more frequency. Warren Buffett has been aggressive in making huge investments recently, consistent with his philosophy of buying when others are fearful.
The best five-year return in the U.S. stock market began in May 1932, after the 1929 market crash but still during the Great Depression. The next best five-year period began in July 1982, when we were in the middle of a huge recession with double-digit levels of unemployment and interest rates. The U.S. stock market rebounded from 15 corrections since 1975. So, is the glass half empty or half full? Is the recent market action merely giving us a heads up for another long-term buying opportunity?
The prudent investor globally diversifies based on his or her time horizon, goals and risk tolerance. If the focus is on achieving long-term goals, and being comfortable with the emotional drain of tolerating short-term ups and downs, and your expectations are realistic, you will be more likely to stick with your long-term strategy and remain invested during the tough times that will surely follow.
Diversification by definition includes some investments that are performing well and some that are doing poorly. It seems counter intuitive to intentionally include both. However, market rotations frequently occur between the best and worst asset classes because money seeks out of favor categories in an effort to buy low. The amateur often does the opposite and buys the best performing stocks with the expectation that they will always go higher. The dot com crash wiped out the dreamers. Still, there will be future bubbles when prices achieve much higher multiples than normally. During such times, many investors continue buying at unsustainable levels. To paraphrase Warren Buffett again, he sells when others are greedy.
Since we really never know the future for certain, it is comforting to diversify for more stability with some investments always going up. If all investments are perfectly correlated, then everything will go up and down in tandem. The mixture depends on the degree of risk desired. Cash and bonds provide stability and income, and stocks provide growth. However, the characteristics and performance between large, mid and small stocks differ. Foreign developed and emerging market stocks often move on a different timetable. Real estate and commodities often goes up and down at different times than other assets classes.
We don’t have to review the patterns more than the past few years to recall when large and small domestic stocks provided all the positive results in 2013, but small stocks did poorly in 2014 and foreign stocks did poorly in both years only to reverse course starting early 2015 when they became a favored category. Of course, we all recall the meteoric rise in the price of gold to over $1800 per ounce, followed by a decline to today’s price of close to $1100. During this period bonds did well because of declining interest rates. Because of this rotation, each of these asset classes could be included in a diversified portfolio. Over the next several years, their performance will likely be different than the past.
Market timing is often the fool’s game. It requires two perfect decisions – getting out at the top and back in at the bottom. It is enticing because if done perfectly it will outperform all alternatives. Some have a knack for getting out near the top and others can often identify market bottoms. Few get both trades right, and almost none do either consistently. It is expensive, tax inefficient, and time consuming.
Our conclusion is not to actively time the market or to “set it and forget it”. The diversification or mixture of different asset classes should be somewhat dynamic and actively managed based on economic circumstances but the overall level of risk should be more steady and passive based on your current and expected financial needs and emotional risk tolerance. The markets will fluctuate and, without a crystal ball, cannot be controlled. The amount of risk you assume, however, can be.
Invest regularly and the negatives of investing at market tops will be balanced by purchases at the market bottoms. The amount of time in the market is a more valuable strategy than attempting to time the market.
A well thought out and sound investment strategy will not guarantee results but should put the odds on your side, provide both positive financial results and emotional solace, survive the peaks and valleys of the market and help to achieve your financial goals.
With best wishes for your financial success,
Marv Kaye, J.D., CFP®
Kaye Capital Management
11835 West Olympic Blvd., Suite 385E
Los Angeles, CA 90064
310-207-KAYE (5293) Telephone
310-231-1213 Fax
Marv@kayecapital.com
www.kayecapital.com
Investment decisions should be based on an individual's own goals, time horizon, and tolerance for risk.
Past performance is no guarantee of future results.
Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
In general, the bond market is volatile, and fixed-income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed-income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
The commodities industry can be significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions.
Changes in real estate values or economic conditions can have a significant positive or negative effect on issuers in the real estate industry, which may affect your investment.
The S&P 500 Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
The Dow Jones Wilshire 5000 is a market capitalization-weighted index of approximately 7,000 stocks.
The Barclays Capital Global Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar denominated.
MSCI EAFE (Europe, Australasia, Far East) Index is a market capitalization-weighted index that is designed to measure the investable equity market performance for global investors in developed markets, excluding the U.S. & Canada.
1. Historical returns for the various asset classes are based on performance numbers provided by Ibbotson Associates in the Stocks, Bonds, and Inflation (SBBI) 2001 Yearbook (annual update work by Roger G. Ibbotson and Rex A. Sinquefield). Domestic stocks are represented by the S&P 500® Index, bonds are represented by U.S. intermediate-term government bonds, and short-term assets are based on the 30-day U.S. Treasury bill. Foreign equities are represented by the Morgan Stanley Capital International Europe, Australasia, Far East Index for the period from 1970 to the last calendar year. Foreign equities prior to 1970 are represented by the S&P 500® Index.
It is not possible to invest directly in an index. All indices are unmanaged.
