After two years of calm markets and steady gains, volatility has returned to U.S. stocks.
Last Thursday the Dow dropped 10.4% below its high of 26,616.71 on January 26th, putting it in official correction territory. Thursday’s drop was followed by a rebound on Friday and Monday, with more volatility at Tuesday’s market open. There’s debate and discussion about what’s causing the swings – global growth, inflation fears, Treasury bonds issued to finance deficit spending – but yields on Treasury bonds are rising and U.S. stocks are working to find equilibrium.
When you’re heading into rough water, you need to feel confident about the boat you’re in. At TAAG, we’ve spent years developing our investment philosophy and the methods we use to design and manage portfolios to carry people though the different stages of their lives. Given the current market environment I thought it would be a good time to review our approach, and how it helps you in times like these.
The most important factor in your investment return is your asset allocation. After getting to know you and what you need your money to accomplish for you in the present and future, we divide your portfolio among cash, bonds and stocks.
After several years of excellent stock market returns, it’s been difficult to be enthusiastic about holding bonds. When stocks were at market lows in 2009, it was hard to stomach a stock purchase. We understand the emotions behind investing, so we provide a longer-term perspective to determine the right allocation to both accomplish your goals and allow you to stay-the-course when we have 1,000+ point drops in the market.
Once we’ve agreed on the appropriate balance of cash, bonds and stocks, the next step is to spread the risk among your investments. Holding only a few, large U.S. companies and hoping they outperform everything else is a high-risk strategy that doesn’t pay off over the long-term.
The world is made up of many markets, with economic cycles that don’t necessarily match the United States. Large companies are more impacted by global changes such as import tariffs but provide more stability. Smaller companies can grow faster but are more vulnerable in an economic downturn. For these reasons and many more we diversify your stock holdings between international and U.S. stocks, large and small companies, and real estate.
In TAAG’s portfolios, bonds act as shock absorbers against the jolts the stock market can deliver, so we stick to high-credit-quality bonds that mature in less than 7 years.
Short-term bond funds are better protection against inflation, as they can keep pace with interest rate increases as bonds mature and are replaced with higher-yielding ones. High-credit-quality means you have a greater likelihood getting back what you invested. The low interest rate environment we’ve experienced over the past several years made high-yield (junk) bond rates tempting, but during times of market turbulence they drop in value like stocks, as concerns about their issuers’ ability to meet debt payments rise. Last week the U.S. junk bond market suffered along with stocks.
We sometimes refer to the bond portion of TAAG portfolios as the ‘mattress money.’ While these bonds will rarely provide a stock market level of return – outside of times of financial crisis when a ‘flight to quality’ occurs – they stabilize portfolio returns and act as a resource for cash flow and rebalancing when stocks are in negative territory.
Once the portfolio is allocated and spread among a wide variety of investments, the next critical decision is when to sell. We want to repeatedly defend, or capture, the gains you’ve earned before they go away, and set them aside for the next planned withdrawal or investment in another asset class. But when is the right time to sell?
This is a question that’s tripped up many an investor. Holding on to your ‘winners’ until they become an oversized portion of your portfolio leads to larger losses when they inevitably drop in value, as no investment appreciates indefinitely. But selling out too soon – when the television talking heads tell you everyone ‘knows’ the market is about to fall – forces you to miss out on opportunities for gains that can’t be recaptured.
We provide many examples of predictions gone wrong in our blogs, but one that seems particularly timely is the Barron’s panel of experienced investment experts that convened on January 14, 2017 and presented a nearly unanimous consensus that 2017 was going to be a bad year for both U.S. and global stocks. We know how that turned out.
TAAG’s strategy for buying and selling doesn’t rely on predictions or gurus. Once we’ve divided and diversified your portfolio, we rebalance back to the asset allocation we agreed on in your plan whenever your holdings exceed or fall below the limits we’ve placed on those portfolio components. Specifically, whenever a holding is 20% above or 20% below your target allocation, we may sell or buy to get you back in balance.
I say ‘may’ because there is more to it than just auto-rebalancing. We keep track of your planned withdrawals, major up-coming purchases, deposits you are about to make, and whether a trade will create a short or long-term gain. In short, we look at your specific situation to determine if the trade should be made in your portfolio.
We also pay attention to market volatility. During the Great Recession, there were days the market experienced wide swings, and trades could have been placed every day if we had only followed the rebalancing metrics. But tax considerations and transaction costs, along with the fact you would have ended up in essentially the same place you’d started in a very short period, kept us from acting on every trade, each and every day. This is where investing experience comes in, and we can’t provide you with a formula for that.
Last week we reached an official correction in the Dow. If we go back to December 31, 2016 and measure returns for every asset class through today, you’ll find we’ve still made significant gains, even with the recent drops we’ve experienced, but it doesn’t appear that market volatility is going away any time soon.
We may be in very choppy water in the coming months, but we think you’re in the right boat to weather the storm.