From time to time, we publish our thoughts on current market events to provide clients with insights into these events and how they relate to our investment outlook and their portfolio, but we thought this would be a good time to provide our thoughts on volatility in the equity market in general. Over the years we have received questions on a wide range of topics, but at the end of the day the question most people are asking is – I think something bad is about to happen, should I sell my stocks? The answer, if you are positioned properly heading into any market volatility, is no.
Generally, you will think something bad is about to happen much more often than bad things actually happen. This is completely understandable. No one wants to experience losses, and most external sources of information (the news) tend to focus on the extreme and sensationalize, so we are predisposed to want to make a cautious decision if we think something is going to negatively impact our investments. This bias also works in reverse. When things are going well and all the news stories coming at us are positive, we tend to want to get more aggressive. However, both courses of action are incorrect. The best course of action is to maintain a portfolio of stocks and safer investments in a balance that will allow your portfolio to participate in the upside when things are going well, but preserve capital in a down market. This is called an asset allocation, which, at the most basic level, is a mixture of stocks and relatively safe bonds.
One thing to keep in mind is that all investments have a risk premium. Think of this as hazard pay for an investment. The greater the amount of risk an investment has, the greater the potential reward is for that investment. Put another way, stocks increase in value more than most other asset classes over the long term precisely because they can potentially decrease in value more than most other asset classes, whereas a risk-free Treasury bond yields relatively little because you know you will get your money back with interest. For most investors, a truly risk-free portfolio is unlikely to provide enough growth to allow them to achieve their goals and objectives over the long term.
Some investors ask – why not own stocks when the market is going up and sell to safer investments when a correction is imminent? The reason is that no one can predict when a correction will happen. Many try, but almost everyone fails. The good news is that you do not need to be able to predict when a correction or recession will occur to be a successful investor over the long term. What is needed is a proper asset allocation that reflects your specific goals and objectives and the discipline to stick to this investment strategy. This is difficult for investors. According to a study by JP Morgan, for the 20-year period ending 12/31/18 U.S. stocks earned an average of 5.6% per year and U.S. bonds earned an average of 4.5% per year, but the average investor earned a mere 1.9% per year. This is because the average investor tries to time the market by buying stocks when things look great and selling stocks when things look bad, and they routinely fail to time this properly.
Today, the worries are about China and a trade war. Next year it will be another concern, two years after that a different concern, and so on. Recessions and market corrections will continue to happen over the course of our lives and are a regular part of the economic and market cycles. We do not need to know why they will happen in the future to understand in advance that they will happen, and that the timing is unknowable. This is not to say that changes should never be made to a portfolio. Over the past year, we have kept international weightings to a minimum, trimmed small-cap weightings in favor of large-cap domestic stocks, and sold some high-yield bond exposure in favor of highly rated mortgage-backed securities. Additionally, most clients’ portfolios should become more conservative over time. However, the time to make major changes to a portfolio’s allocation is when it aligns with changes in a client’s time horizon or goals and objectives, not in anticipation of expected market events.
At Condor Capital, one of the most important functions we perform is working with clients to determine the proper asset allocation for them. While changes to this overall allocation should be relatively infrequent, we are constantly reviewing the assets held within our clients’ portfolios to ensure the investments align with our continuously evolving outlook for the markets and economy.