How to Respond During the Next Market Decline

The S&P 500 finally broke its streak of positive annual returns in 2018, missing out on a 10th consecutive year without a decline.

S&P 500 Index Annual Returns (2008 to 2018)

Annual Return
2008 -37.0%
2009 26.5%
2010 15.1%
2011 2.1%
2012 16.0%
2013 32.4%
2014 13.7%
2015 1.4%
2016 12.0%
2017 21.8%
2018 -4.4%

As you can see in the chart above, prior to 2018 the last time we ended the year worse than we started it was 2008, when the market dropped -37.0% in the midst of the financial crisis.

In fact, the run from 2009 through 2017 matches the nine year economic boom of the 1990s and the two stretches are the longest of their kind dating back to 1926.

During a period of record growth, it’s easy to forget that stocks can, and do, go down. Often, the market moves with astonishing velocity, catching the vast majority of investors by surprise (like it did in the fourth quarter of last year when the S&P 500 index dipped -13.5%).

It’s for this very reason that the single most important decision we make as investors is our asset allocation (i.e. the ratio of stocks vs bonds). More than anything else, this decision is the best way to align our risk profile with the potential for decline in our portfolio.

However, even for the few of investors who get this right, a bear market can still be an extremely challenging time.

And since we don’t know in advance when volatility may come knocking, it’s a good idea to be prepared well before the next market decline takes hold.

To help bring this point home, let’s look at the three general phases that individual investors go through on their path to, and through, retirement and how best to respond:

Accumulators (Young and Mid-Career Investors)

How to Respond

  • Ignore the headlines proclaiming the world is ending
  • Avoid the temptation to sell. Remain invested. Rebalance and tax loss harvest according to your plan.
  • Keep saving. Increase your contributions if you can.

Here’s a simple fact: A bad bear market when you’re a young investor is essentially meaningless in the grand scheme of things.

It probably won’t feel like this when it happens, but a 30%, 40%, or even 50% decline when you’ve got $25,000 invested will be nothing more than a blip on the radar by the time you retire.

In reality, lower stock prices are actually a very good thing if you’re actively contributing to your investment accounts.

Lower prices mean that you get to buy more shares for the same dollar investment than you could before. In turn, owning more shares means that your portfolio will compound even faster in dollar terms as the market recovers.

Ultimately, if you’re a freshly minted college graduate or you’ve only been in the workforce for a few years, the amount you contribute matters far more than short-term performance.

For folks in their 30s and 40s, the middle of your career means higher earnings and an even greater ability to save. By this time the hope is that you can consistently put away a large percentage of your income every year, while also satisfying your short-term goals.

Accordingly, your bear market mindset should also be centered around the opportunity to acquire even more ownership in the world’s companies and to do so at a bargain, sometimes even fire sale, prices.

The reality that a bad stock market is actually good for accumulation-phase investors is one of the greatest ironies in all of personal finance. When you find yourself in the middle of this kind of opportunity, don’t let it pass you by.

Near- and Semi-Retirees (Protectors)

How to Respond

  • Regularly review and update your financial plan
  • Ensure your asset allocation is aligned with your plan and risk profile
  • If necessary, implement a pre-determined alternative to get back on track

If you’ve got five years or less to retirement, you’ve probably already done the bulk of your savings. Certainly the hope would be to continue contributing according to your plan, but now the focus really changes.

Whereas early in your career the amount you put away typically far outpaced how much your portfolio grew in any given year, now the reverse is often true.

For example, even a modest 4% return produces an $80,000 gain for an investor with $2 million saved. That’s more than four times the maximum 401(k) contribution for 2019 of $19,000.

There’s simply more dollars at work.

This fact pattern means that it’s critically important to review your financial plan, ideally well in advance of a market decline.

The primary goal should be to refine your retirement projections and revise your asset allocation so that you’re only taking as much risk as is absolutely necessary for your plan to succeed.

Simply put, while a stock-heavy portfolio might be appropriate for some investors during this stage, most of us are not in a position to handle a 50% decline with retirement just a few years away.

It’s also important to discuss the “what-ifs” and to stress test your plan using scenario-analysis and Monte Carlo simulation.

Having a good plan in place before market disruption means you’ll be well-positioned to handle all but the most extreme sequence of events without forgoing your opportunity to retire.

Accordingly, the primary response to a bear market in this phase is to review and update your plan to determine whether any changes are required. If you need to work a little longer or consider trimming your vacation budget a bit, now is the time to figure that out.

Don’t put yourself in the position of quitting your job without a proper plan even if you have a seven figure portfolio. $1 million doesn’t go nearly as far as some investors would like to think.

Retirees (Distributors)

How to Respond

  • Review your withdrawal rate and your retirement plan at least annually
  • If your plan requires it, temporarily reduce your withdrawals until the market recovers
  • Defer large expenditures that would require an outsized distribution from your portfolio

By the time you’ve reached retirement, the game plan is usually pretty clear: don’t run out of money.

Hopefully you’ve saved enough that your asset allocation only requires a modest weighting in stocks in order to satisfy your goals.

You’ve also lived through numerous business and market cycles so you’ve seen stocks go up and down countless times.

Thus, you might assume that even a bad couple of years isn’t the end of the world and you can just to “sit tight” like you have before.

While avoiding the temptation to get out of the market is generally good advice, retirees face an acute risk that other investors do not as a result of the following realities:

  • Since you’re not working, you may be heavily (or entirely) dependent on your portfolio for income.
  • Taking large withdrawals during a bear market can mean that you’re forced to sell investments at depressed prices.
  • While eliminating stock market risk might sound appealing, doing so can actually have a devastating effect on your portfolio’s ability to survive your lifetime.

The above fact pattern means that retirees need to be particularly careful in the years immediately before, during, and after their retirement date.

The combination of discontinued employment, a severe market decline, and withdrawals that exacerbate the decline of your portfolio is what is known as “the perfect storm of retirement”

When all of these factors hit at once, the storm can sometimes be bad enough to capsize your “retirement boat” unless you take immediate corrective action.

Often this means temporarily reducing your portfolio withdrawals or deferring things like home improvements or vacations. For some retirees it means that part-time work may need to become a part of the conversation.

Whatever the case is, it’s far better to attack a situation like this head on, rather than burying your head in the sand. The facts are the facts regardless of when you decide to assess the damage.

Hopefully, with a sound plan and the right stock/bond mix, you’ll be in better shape than you thought. However, even the best plans are rarely “set it and forget it.” To be successful, you still might need to make some adjustments to confidently stay on track.

Closing Thoughts

As a financial planner, one of the things I focus on with clients is making sure they have the proper expectations for risk and return in their portfolio.

Part of that responsibility means constantly reminding folks about the other side of the investment coin. In other words, when markets are down, we stress the importance of sticking to our plan and prioritizing what we can control.

Conversely, when markets are good, like they are now, I probably sound like a Debbie Downer. Markets are hitting new record highs nearly every day and I’m talking about how to handle the next 2008.

Sadly, most investors won’t plan ahead and will find themselves in the middle of a bear market without any clue as to how to respond. If you’re reading this in 2019, hopefully you’ll take action so you can be the exception to that rule.

The President and Your Portfolio: Does it Matter Who is in the White House?

The President and Your Portfolio

Click on the image below to enlarge it

Growth of S&P 500 Under Republicans and Democrats

Undoubtedly most of America was surprised by the outcome of Tuesday’s presidential election. For some “surprised” is an understatement of course. Their feelings are probably better described with words like shocked, stunned, or outraged.

For others, the surprise was welcomed. Given the polling leading up to election night, millions likely cast their vote fully expecting their candidate to lose only to wake up to a stunning victory.

Regardless of your political views, the sun did rise on Wednesday morning. Incredibly, it also followed suit by rising on Thursday and on Friday as well.

However, it’s undoubtedly true that the election of a political unknown results in a lot of uncertainty. At the same time, many others would argue that putting a career politician in the White House wouldn’t be good either.

Ultimately, most Americans agree that the government status quo hasn’t worked and many were desperate for a new direction. For some that meant Bernie Sanders. For others, the choice was Donald Trump.

Don’t Let Your Politics Decide Your Portfolio Strategy

The purpose of my discussion here is not to offer thoughts on the direction of the country or my views about the election itself.

In fact, I regularly remind my clients that I do not allow my politics to drive my investment decisions or my recommendations. As we’ll discuss in a moment, doing so is dangerous to our wealth.

Likewise, I encourage my clients to do their best to keep their emotions about any news subject, political or otherwise, in check. Instead we should place as much of our focus as possible on what we can actually control.

When it comes to this election (or any other), it’s perfectly acceptable to have strong positive or negative feelings. However, making drastic decisions about our investments based on those feelings is a slippery slope. Evidence demonstrates that such actions can be far more dangerous to our portfolio than whoever takes control of the Oval Office.

With that in mind, let’s get to the purpose of this post, which is to put this election in perspective by reviewing history.

While Government Policy Can Impact Returns, We Shouldn’t Give the White House too Much Credit (or Blame)

As the chart at the top clearly illustrates, markets have rewarded investors across many political administrations, both Republican and Democrat.

There is no clear pattern that suggests that stocks do better under one party versus the other. Nor do we see any reliable opportunity to time the market based on who is in the White House.

Instead, the takeaway from the chart above is actually quite simple: Over the long-term, investors have greatly benefited from stock market returns regardless of the ebbs and flows of political control.

For those that have embraced this perspective, the rewards have been substantial: The S&P 500 Index has increased by approximately 10.0% per year from 1926 through 2016.

Conversely, we know from extensive research that those who believe they are smarter than the market (on the one hand) or who fear it (on the other), rarely succeed when they take action based on emotion.

Instead, they add risk, increase expenses, raise their tax bill, and typically underperform the very investments they buy and sell.

While it’s tempting to allow our often strong political feelings to influence our investment decisions, it’s better to remain politically agnostic as it relates to our portfolio. Instead, we should focus on designing the right portfolio for our specific needs and remember that returns are not dependent on any particular party or candidate.

Whether you’re feeling victorious or defeated this week just know that this country is resilient and so is the stock market. Inevitably, both will likely surprise us again in the not too distant future.

No, Preferred Stocks Are Not a Replacement for Bonds

Preferred Stocks

Typically I don’t spend much of my time attending investment and wealth management conferences. For the most part these events are just organized sales platforms for fund and insurance companies to pitch their latest products to advisors (who then turn around and pitch them to their clients).

Count me out.

However, I make exceptions if a sizable percentage of the content is academic research, for example, or if there is a greater emphasis on topics such as index investing or tax-efficient portfolio management.

Last week I decided to spend part of my Tuesday afternoon at the Private Wealth Mountain States Forum that was held here in Denver. I was invited as a guest speaker on a panel discussion entitled Fixed Income: Identifying Liquidity Risk and Finding Yield to provide some commentary and perspective on the bond markets.

With interest rates remaining persistently low, it wasn’t surprising at all that this topic found its way on to the forum’s agenda. Investors are clamoring for yield and turning to asset classes such as preferred stocks, REITs, and junk bonds to find it.

Likewise, I also wasn’t surprised to find myself playing the role of the “lone wolf” on the panel. While my panel colleagues were preaching the typical active management talking points of “picking your spots” and “avoiding overbought” assets, I did my best to serve as the voice of reason for those that were interested in listening.

My goal in attending was to hopefully save a few souls from being tempted by the allure of “outsmarting” the market (with the help of a high-fee manager of course). Reviewing my notes following the forum, I thought it would be helpful to share what I covered during my speaking time on the panel.

Remember the Purpose of Fixed Income in Your Portfolio

Yes, it’s true. Interest rates are historically low. That isn’t really breaking news. In reality, we’ve been in a declining rate environment since the early- to mid-1980s. The yield on the 10-year treasury is currently hovering around 1.60%. In 1981 it peaked at more than 15.0%!

Undoubtedly, declining rates have hurt savers and made it more difficult to earn a respectable income from “safe” investments. However, this fact pattern doesn’t change the primary role that fixed income should be playing in our portfolios. The first obligation of our bonds is to dampen the volatility of the stocks that we own and to reduce the downside risk of our overall portfolio. Don’t ever forget that!

Simply put, even for the most conservative of individual investors, it’s typically a poor idea to invest all of your eggs in the fixed income basket. Instead, it’s generally wise to include at least a small allocation to equities in our portfolio both for purchasing power protection (i.e. managing inflation risk) and for tax efficiency (stocks can take advantage of long-term capital gains rates).

Accordingly, while the majority of retirees would prefer higher interest rates for their bond investments, they are likely still reliant on the stock portion of their portfolio for countering longevity risk and keeping their tax bill in check. This leads me to my next point…

Yield is Not a Replacement for Principal Protection

Some investors assume that because a particular security or asset class has a “high yield” that by itself means that it can serve as a replacement for the existing bonds in their portfolio. This line of thinking varies of course, but a lot of investors have convinced themselves that a higher yield equates to greater safety for the investment.

Repeat after me: High yield is not a replacement for principal protection!

To illustrate this, take a look at the chart from Morningstar below (click to expand):

Preferred Stocks and Other High-Yield Asset Classes

The chart shows the performance from April 2007 to February 2009 for five ETFs representing the following asset classes:

  • High-yield bonds (HYG – iShares iBoxx $ High Yield Corporate Bond ETF)
  • US REITs (VNQ – Vanguard REIT ETF)
  • Energy Stocks (VDE – Vanguard Energy ETF)
  • Preferred Stocks (PFF – iShares U.S. Preferred Stock ETF)
  • US Bonds (BND – Vanguard Total Bond Market ETF)

As you can see, the “bond alternative” asset classes experienced declines ranging from 34.21% for energy stocks to 69.80% for US REITS. By comparison, the broad US bond market was not only quite stable, but it actually increased by a modest 2.15% during this same period.

I don’t know about you, but I’d much rather stick with even (very) low yielding bonds, than trying to add yield with an asset class that can decline as much or more than my stocks. Simply put, the very asset classes that many investors are chasing as they hunt for yield are the exact opposite of “safe bond equivalents.”

Don’t kid yourself otherwise.

A Total Return Approach is a Much More Efficient Way to Create Income

Lastly we need to remember that we do in fact have some control over when and how we take distributions from our accounts. There is no rule that says we must rely only on the interest-earning assets in our portfolio for income. Rather, we can use a combination of interest, dividends, and capital gains in order to generate the cash we need for withdrawals from our portfolio. This approach is what is commonly known as “total return” investing.

Let’s say, for sake of argument, that the combined interest and dividend yield for a $100,000 portfolio is 2% (or $2,000). However, our target withdrawal rate for the year is 3.50% (or $3,500).

Where does the additional money come from?

Let’s assume that in addition to the 2% yield (the income return), our portfolio also increases in value by a modest 3% (the capital return). To generate the additional “yield” we can simply sell $1,500 of our portfolio (hopefully at long-term capital gains rates) and then withdraw it, along with the $2,000 of interest and dividend income, in order to reach our $3,500 target.

Of course in some years our portfolio may actually decline in value. However, in other years our portfolio is likely to increase in value by much more than 3%. As a result, the strategy becomes to use the “excess returns” we get in the really good years to provide for withdrawals in the not so good years.

Ultimately, total return investing can be a much more flexible and tax-efficient path to generating portfolio income. Likewise, in a low rate environment, it may be the only path to provide the returns we need.