It’s a long one but hear me out for the first (as promised) in a series of committed articles to be written over the next several weeks. Also as promised, I’ll launch a direct hit on the two delicate questions of when and how to stay the course amidst a severe financial storm.
Section 1 – The first question…” When should you stay the course?”
When is the easy part. To quote Mariana Rivera as he repeats so often in his 2014 autobiography “The Closer”, simpler is always better. As in most things it starts with the why. In this case: Why is your money invested?
- Are you in a savings/accumulation phase and simply needing the power of compounding returns? Then not only is staying invested in a stock heavy portfolio appropriate, but these down periods are just what the doctor ordered. Your deposits go farther in buying up shares than they would have at the start of the year. Stay the course.
- Are you at or near distribution and being financially supported by your investments? This phase is where stakes are the highest. This may also be where the inclination to jump ship to preserve account balances is the strongest and also where the consequences of doing so are the gravest. The key is to take a step back, remove some emotion and try to objectively examine the consequences of bailing on the portfolio. That won’t guarantee you’ll be able to, but you owe it to your future self to do so.
Bailing out to the safety of short-term time deposits and their low or no interest rates will reduce earnings power. This much is intuitive. But the brutal truth is that though your intentions may be temporary, the implications may be permanent. Unless your withdrawal percentage (size of withdrawals relative to the size of your portfolio) is de minimis, your plan likely factored in some appreciation and more importantly, dividend growth in order for your income stream to be sustainable over your life expectancy. Abandoning the plan will elevate principal extinction risk to the extent that downgrades to your standard of living may now be required in order to adequately offset those higher odds of principal extinction down the road. In no way do I suggest this judgmentally, choosing that option and safety of principal may be the right choice for you. If not, stay the course.
- Some investors simply have a savings stockpile with really neither of those goals. You simply are set with your sources of income and have this stockpile as a reserve and no real need for it to grow. In this case, a desire to go to cash to avoid watching the stockpile decline will, needless to say, not be doing you any harm. Yes, inflation will be slowly melting its real value like an ice cube, but with no big goals the consequences aren’t that grave in deciding to not stay the course.
Ultimately, it’s about goals and making sure investment decisions, especially the big ones like these, are in alignment those goals. If your portfolio has been thoughtfully crafted as such, then you’ll know yes, now is the time to stay the course. Now, I’m not talking about strategic or tactical adjustments to the portfolio. Or perhaps you’ve built the portfolio yourself and unsure whether it still fits the bill. I’m talking about throwing in the proverbial white towel and jumping all the way out of their portfolio. Many tend to want to believe they can exit into cash and return “when the coast is clear.” The problem with that are downturns like many recent ones: 2009, 2011, 2018, 2020 – all had recoveries that happened in a very short time frame and had recovered the biggest portions of their declines well before anything looked remotely good in the economy. Sadly, we’ve seen far too many investors come our way that found that out the hard way, never having gotten back on course.
Section 2 -The Second Question “How”
Sadly, but truthfully, there is no holy grail of an answer. I have found several great authors helpful who can do much more than I can to soothe nerves and will post links below to some of their excellent stuff. The common denominator among helpful content for making better investment decisions and successfully reducing the odds of a future regret comes down to how we are thinking. That’s another reason for including the links below – if often boils down to finding the right voice with the right message to sink in. The reason we (the investment advice business) are never able to stop attempting to tackle this investment decision beast is because of the stunning result of the chart below of actual investor returns vs. various assets.
Far too often, following our primitive instincts compels us to jump ship as things look bad and go to cash only to miss a rebound (and then only getting back in to chase what have been good returns). The chart below from JP Morgan is one of my all-time favorites and demonstrates this notion in action. By aggregating the publicly available flows of assets among various fund types, a composite of the “average investor” and his/her real life results can be calculated. I have seen this chart updated several times over the years, and it never seems to materially change; despite all the assets readily available for investors to acquire and ride to solid returns, the “average investor” has only barely been able to outpace cash!
Sure, you’ll find investors here and there who stayed the course and generated the 7.5% from the S&P 500 or the 6.4% from a balanced 60/40 portfolio. However, the “average investor” composite is just that – the average net result which simply contains a large number of investors who jumped to cash at the wrong time and overwhelms the number of those that stayed the course. One famous example of a specific fund puts a bright spotlight shine to this phenomenon. Peter Lynch rang up a spectacular 29% compound annual return for the Fidelity Magellan Fund during his long stretch of running it. Yet, the average investor who bought into his fund LOST money! See, you had to be there in the beginning, middle and end to earn that 29% average return. But again, too many simply shoveled their portfolios into the fund following its good years only to bail when it was down. These are the exact forces we must combat in order to succeed
Section 3 – Five Steps to help stay the course
Step 1: Accept mediocrity
I know, that sounds more like a sensible goal for my Indiana Hoosiers football team. But how we stay the course effectively starts on the up or later parts of a cycle, not at the usual point of desperation when we start asking ourselves if it’s time to flee. The easiest path to earning those compound generating returns that place you in the middle/middle left on the asset class return chart as opposed to being near the average investor on the right is the acceptance of mediocrity. When things look rosy, the temptation is to get comfortable with the juicy returns being created and bail on the underperforming parts of the portfolio to load up on the leading horses. And, to an extent you do want to ride those winners. But if you are concentrated in the portfolio enough to be at the top of the charts, you are concentrated enough to reverse too quickly and take too much heat on the way down. It’s the degree of that pain that becomes the emotional source of trouble.
It may be too late to be thinking about step 1 at this point, but don’t let that stop you from starting where you are and moving on to (the potentially offensive!) step 2.
Step two: Stay skeptical of news sources (even if they make you feel better)
Stay off the cable news and be careful with information sourced from web. For the record though, this is not a liberal or a conservative point – the advice is the same for both sides of the aisle. As a practitioner, I have observed (especially lately) that questions from clients that were clearly provoked from cable news channels have gotten noticeably more dangerous over time. Yes, its natural and healthy to want to be informed. Our desire to be at least periodically surrounded by those that think like us is soothing. But that soothing comes with a cost of getting hooked into some fairly difficult to change positions. That hook, again, is easiest landed through the fear.
The internet can even be more dangerous. None of us are immune. I recently saw a financial industry name I hadn’t heard of in years, so I did a quick search to find out what he’s been up to and where he is currently writing. Mistake! Ever since, I have been bombarded with outlandish ads from this author proclaiming some pretty far-fetched theories. These are great for generating clicks, but horrible for any help at probability estimation (for my fellow math nerds, these are “tail risks” being presented as “highly probable”).
I’ll throw out what I have found most helpful over time in cultivating news sources. Sadly, I haven’t yet tracked down a good television source (so please tell me if you have a good one that I have missed). But I do find it easier to ground myself by reading news sources in a published collection (ahhh… an old school newspaper format) helps to avoid getting links thrown at me that was established by what was last read. WSJ has a great reader. Bloomberg preset 5 things you should know is also a good one. One of those leans right, one leans left – which helps to balance out the political bias and noise.
Step 3: Look out, not down.
I liken this to the same advice we might be given if high up in the air or are carsick where both cases call for looking out to the horizon.
Serious drawdowns are a part of the game of investing in risk assets. Intellectually, you know that. You may even remember that your financial plan was built with these sorts of drawdowns in mind. A good advisor, or by your own stress testing, ran scenarios that included these types of environments. Emotionally, it’s a different story to see the losses in real time. I find another of my favorite go-to charts from JP Morgan to be a huge help. They present the range of annual returns going back to 1950 for 3 different portfolio types: 100% invested in stocks (green), 100% invested in bonds (blue) and a 50/50 split (grey).
What we see is that short periods of time are going to expose us to severe declines. Partly why this year has been so stressful is that stocks and bonds have simultaneously had down years, giving that 15% low water mark a run for its money. That’s where we need to zoom out. And you don’ have to go out 20 years to make yourself feel better. If you simply go out and look at the range of outcomes of all 5 year rolling periods, you’ll find that a 50/50 portfolio has not had a losing 5-year period in the modern era! That doesn’t mean it won’t happen going forward. But there have been some pretty nasty periods during that time (The high inflation of the 1970s, the deep recessions of the early 80’s to end that era, the dot com bust, the Great Recession, the Covid crash, and more).
Step 4: Allow yourself to entertain the thought of the worst-case scenario.
The fiercest challenge to historical stats of say the past 70 years (like the one above) is that they don’t include the Great Depression. For some reason, I have been asked many times lately something along the lines of “Yeah, but what if this is another Great Depression?” To that, I say fair question and exactly what step 4 calls for. More commonly, the recommendation might be to consider how different this era is and how unlikely a repeat of a Great Depression is. Yet, I say, let’s consider it. But…. let’s do so by taking a good long hard look at the data. We can have great appreciation for the harsh living standards many endured for the better part of a decade, but we want to objectively pivot from anecdotes and economic data to the realities confronted by investors.
THE stat that makes this the mother of all stock market comparisons is the Dow, after suffering an 89.2% drop, did not recover its 1929 peak until 1954! That’s what scares us….to consider the possibility that a 65-year-old with a $1,000,000 investment in a bucket of large cap stocks following that parallel beginning at the end of 2021 could conceivably see that investment temporarily drop below $100,000 before recovering that prior $1,000,000 level in 2046!!
That is terrifying, there is no way around it, and it is worthy to consider. But let’s dig deeper.
The first thing to consider is that until recent era, stocks were an income investment. The recent era has been dominated with price appreciation. Prior to that period, returns were significantly more reliant on dividend income. Take that hypothetical $1M portfolio above. During that ’29 – ’54 period, it would have produced an average annual income of $37,500. Only so much can be done to ease the sting from an 89% price drop, but an income of that magnitude is nothing to scoff at. You can see the impact that would in comparison to a pure price return if dividends are to be reinvested.
The second thing to consider is even more important. Thus far, we’ve only been talking about stocks. Especially for someone at or near a point of distribution, you’re going to be looking at a more balanced portfolio with a healthy dose of bonds to balance the risk. The result isn’t that a painful decline is avoided as an approximate 50% wipeout was still in the cards. The ~ 6-year recovery period though is distinctly less painful than the 25-year period it appears at first glance. In fact, as it turns out – even in the great depression that 5-year balanced portfolio return range holds! Refer back to that JP Morgan chart from step 4 and recall that the range of returns for a 50/50 balanced portfolio experienced positive returns through all periods of the modern era. Even though there is no assurance this holds going forward it somehow retrofits the great depression era.
Last consideration is that we always preach that it is the real return that matters. The real return is what your nest egg is worth after figuring the effects of inflation. Whilst inflation is a main source of angst today, deflation was the great consternation of the 30s. (Thus, why bonds were a strong diversifier). As painful as the era was, a silver lining was the falling price levels to boost purchasing power of portfolios.
To be clear, I am not arguing the great depression resembled anything rosy. For a 60/40 portfolio saw over 1/3 of its purchasing power wiped out. Additionally, I wish to reiterate that the economic and human toil is not to be diminished. However, in this view with a balanced portfolio, it was just a few years later in 1933 that completed a full recovery when factoring in deflation. I simply wish to objectively review that period from an investment standpoint and see a similar result. Fear of a Great Depression repeat is unequivocally not a reason to jump ship.
Step 5: Avoid expensive and unnecessary products
Each time we see a decline of any significant magnitude, sales for high-cost variable annuities or equity indexed annuities skyrocket. That’s because we, as humans, are shown that the fear of and pain stemming from declines is so severe that we will do just about anything to avoid it. That leads us to products with insurance. This phenomenon causes us to continually and appreciably overpay for the insurance embedded in products. These products can be made to sound appealing, especially during a downturn. But you have to consider the fact that all of us investors are picking from the same orchard. You, me, the insurance companies. They are investing your money in the same pool of assets, so it’s not as if they are able to produce a more bountiful or more efficient harvest. It’s simply they can make the apples look shiny enough to make it look too good to ignore. I wrote extensively about annuities a while back, to read more click here.
Conclusion
As stated above, surviving rough patches is all about having the right mindset which often is all about connecting with a person that has the right words for you at the right time. This post was a heavy commitment. I personally benefited, especially doing the research on the Great Depression. But if this string of approximately 3,000 words landed with just one person and added just a little bit to their frame of mind for this cycle, then mission accomplished.
This piece started with the great closer and his success based on simplicity. This was a lot of words, but really full of simple stuff. Extremely difficult, but simple in nature. Just as the great Mariana Rivera preaches. Enter Sandman:
“And never mind that noise you heard
It’s just the beast under your bed
In your closet, in your head”
You can look for the next piece in this series soon which will turn from when and how towards what we should be considering heavier doses of for the portfolio.
Links to better writers on the topic (as promised from above)
Barry Ritholtz: The Uncertainty Monster – The Big Picture (ritholtz.com)
Morgan Housel: Staying Put · Collaborative Fund
Blair Duquesnay: Don’t Panic Sell – The Belle Curve (blairbellecurve.com)
