March 23, 2020 marked the low point of the pandemic induced market crash. On that day, the S&P 500 reached a low of 2,192 before closing at 2,237. This marked a nearly 34% decline from a then record high set just weeks earlier on February 19, 2020. To put this in perspective, if you had $100,000 invested in the S&P 500 on February 19, 2020 you would have seen the value decrease to $66,000 in just over 1 month. Since that date, the S&P 500 has returned nearly 70% and set multiple new record highs. As I type this, the $100,000 would now be worth $117,750.
To sit here a year from the bottom and claim to have known where we would end up would be a lie from anyone who dared to make such a claim. March 2020 was a scary time. We were all living in a world we could barely recognize, unsure what the future held as we adjusted to lockdowns and restrictions put in place to try and slow the rapidly spreading virus. No one can reliably predict the future of markets, but to suggest one year returns of 70% over the course of the next 12 months would have made even the most optimistic of prognosticators raise an eyebrow.
So how do we manage portfolios when the potential exists for a 34% decline, followed by a 70% rally over the course of just 13 months and 4 days? In the following I’ll use this recent history as an example to highlight TAAGs investment and trading philosophy.
Crystal ball anyone?
We start by admitting to ourselves and everyone else that no one knows what the future holds. This is especially true when it comes to investment markets. You’ve probably heard us say before that if we knew what the stock market was going to do, or what would happen to interest rates then we’d likely be exploiting that knowledge from a beach somewhere. What we do know is that investments tend to increase in value, and we can predict the returns of a well-diversified portfolio with more accuracy over the long-term. There is no need for market timing or trying to pick which companies are going to outperform the market.
Determining a target allocation
Our investment process begins with identifying a target allocation for each account that is based on the goals and financial plan of the individual. We combine our planning process with a client’s risk tolerance. From there we agree on a target investment allocation that will allow us to maximize the probability of success of a client reaching their financial goals. For example, the target allocation for a retirement account belonging to a 45-year-old client may have a growth-oriented allocation of 80% stocks and 20% bonds/cash. We document the target allocation in an investment policy statement and review it with clients on a regular basis to reflect changes in their goals, life stage, or risk tolerance.
Implementation and Monitoring
Once a target allocation is established, we move to implementing the investment plan. At TAAG we utilize highly diversified and low cost mutual funds and ETFs. We ensure global exposure to avoid being over concentrated in any one country or region. In our example, the 80% allocation to stocks may be allocated 54% to the United States, 36% to developed international countries and 10% to emerging markets. We also diversify among large and small companies across the globe. After initial trades are executed, we monitor all accounts on a weekly basis to identify discrepancies between the current allocation and the target allocation.
Rebalancing
As market prices change, the asset allocation of an account inevitably drifts away from the initial target allocation. Asset classes that perform well represent a larger percentage of the account, while underperforming asset classes fall below their target allocation. Our weekly monitoring and rebalancing process dictates when to make an adjustment back to the target allocation for an account. To continue with our example, a 30% decline in the S&P 500 from February 19, 2020 to March 23rd, 2020 may have caused a 10% target allocation to decline to 7%. This would trigger a BUY signal in the account to increase the U.S. large cap exposure back to the target allocation of 10%. By following this sort of disciplined process, we manage accounts without the temptation of trying to time the market or allowing the emotions of investing to dictate trading activity.
Long-term Impact
We think there are several long-term benefits to setting a target allocation based on an individual’s goals, utilizing low cost, diversified investment vehicles, and following a disciplined approach to investment management and rebalancing. First, we ensure the investment allocation is directly tied to the real-life goals of our clients. Secondly, diversifying across multiple asset classes makes for a smoother investment experience and more predictable long-term returns. Limiting fees allows for the positive impact of compounding returns to be maximized and has a huge impact on portfolio value over time. Lastly, our rebalancing approach leads us to naturally BUY LOW and SELL HIGH. Followed repeatedly, this allows accounts to recover from downturns more quickly, and also recognize gains from positions that have performed well.
Acknowledging our limitations, spending time to think about an appropriate level of risk to take, identifying a target allocation, and following a disciplined implementation and rebalancing process is certainly not as sexy as following the latest meme-stocks, or day trading on the latest earnings report. However, it’s a proven and effective way to invest for the long-term and maximize the probability that someone reaches their financial goals, whatever they may be.