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)

Year
 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.

Perspectives on Brexit: Remember the Forest

Perspectives on Brexit: Remember the Forest

There’s really no nice way of putting it. Friday was not a fun day for the majority of investors after the Brexit vote.

Following Britain’s decision to leave the European Union after a more than 30-year marriage, the S&P 500 index fell 3.59%, while European markets collectively suffered declines in excess of 11%.

The fallout from Brexit simultaneously illustrates two realities of investing:

  1. The interconnected nature of modern global stock markets
  2. The importance of genuine and broad diversification

While the majority of investors experienced losses on Friday, very few who were properly diversified suffered anything close to a double digit decline. Only those making narrow, concentrated bets felt that kind of pain.

More importantly, for an investor whose risk profile dictates owning a portfolio with less than 100% stocks (which is the case for the majority of investors), several asset classes they likely own went up on Friday. This list included US treasury bonds, TIPS, and international bonds.

Bad Benchmarking

For investors with an appropriate asset allocation and a broadly diversified portfolio, Friday was a perfect example of why it’s a bad idea to judge your investments against the commonly reported stock benchmarks (such as the Dow Jones Industrial Average, the S&P 500, or the FTSE).

If you do this, when markets go down you’re going to think your portfolio lost far more than it actually did. On the other hand, when markets go up you’re going to expect returns for risks you didn’t take.

Neither is good for your psyche.

Don’t Miss the Forest for the Trees

With all of that said, on days like Friday the single most important word for us to lean on as investors is perspective.

It’s rarely ever as bad (or as good) as it seems in the heat of the moment.

Getting to the heart of this post, we also need to avoid the risk of missing the forest for the trees. While the financial news media would have us think that the world is coming to an end following Brexit, Friday was simply one day in an incredibly long investment history.

In other words, it was simply one tree within a gigantic forest.

Zooming Out for Perspective

To help illustrate this, let’s take a look at the history of the S&P 500. The first chart below shows the performance of the index for the five trading days last week:

S&P 500 Index – 5-Day

5 Day Performance S&P 500

Not surprisingly the decline on Friday is both obvious and, apparently, quite significant.

The same is true for the last month:

S&P 500 Index – 1-Month

1 Month Performance S&P 500

However, when we look at the year-to-date chart, we start to see that while Friday’s losses weren’t fun, the declines essentially just rolled back the clock to the middle of May:

S&P 500 Index – YTD

YTD Performance S&P 500

Zooming out to a one year chart, it’s now pretty clear that just in the last 12 months we’ve experienced several ups and downs of equal or greater magnitude than what we witnessed on Friday:

S&P 500 Index – 1-Year

1-Year Performance S&P 500

However, even one year of returns represents just a handful of trees within what is a really large forest. Let’s zoom out further by taking a look at the five year and 10 year charts below:

S&P 500 Index – 5-Year

5-Year Performance S&P 500

S&P 500 Index – 10-Year

10-Year Performance S&P 500

While we can see Friday’s decline in the chart, you’d be hard-pressed to describe it as anything different than many other short periods of time since 2006.

Finally, if we really want to see just how tiny of a blip Friday was on the radar, let’s look at the logarithmic charts dating back to 1990 and then even further back to 1950:

S&P 500 Index (Log) – Since 1990

Since 1990 Performance_S&P 500

S&P 500 Index (Log) – Since 1950

Since 1950 Performance S&P 500

As the charts help us to see, the reliable wealth building power that comes from diversified investing means that short-term declines are outweighed handily by long-term returns.

On the Temptation to Respond

Over the coming days, weeks, and months, we’re going to hear an almost endless barrage of “what to do now” and “how to protect yourself after Brexit” on TV and in print media.

It can be tempting to want to “do something” in response.

However, shooting from the hip in following market events is never a good idea. Instead, we need to ask ourselves a few simple questions:

  1. Have I properly evaluated my willingness, ability, and need to take risk as an investor?
  2. Does my portfolio align with my risk profile? Is my asset allocation appropriate for my risk tolerance?
  3. Do I have a written investment policy statement that outlines these things and illustrates why my portfolio is appropriate for me?

If the above is true, then the best approach is the same as it has always been: Remain disciplined with your asset allocation, monitor regularly and rebalance when appropriate, and make changes to your portfolio only in response to your own path towards your goals.

On the other hand, if the above is not true, there’s no better time than now to review your risk profile and properly align your portfolio accordingly.

Whether markets go up or down from here is anyone’s guess. However, with the wrong asset allocation it’s a virtual certainty that you’ll be unhappy with the outcome.

Either because your portfolio is more risky than you’re comfortable with or because you’re invested too conservatively and won’t benefit enough from the growth of stocks to reach your goals.

If You Don’t Like the Weather, Wait Five Minutes

weather volatile markets

“If you don’t like the weather, wait five minutes.”

That’s one of the first things you hear when the subject of weather comes up in Denver. While that’s a slight exaggeration, it’s not terribly far off.

Case in point: Last Tuesday afternoon. The high temperature was a beautiful 72 degrees. My wife and I went out on a walk with our son early that evening and the weather was bordering on perfect.

Standing outside, you’d have no idea that the scenery was going to change so drastically in less than 12 hours. With the sun beaming down on your head, the prediction for a few of inches of snow the following day might have seemed like an April Fool’s joke come early to an out of town visitor.

However, if you’ve ever spent any time in Colorado, you know that the weather can turn on a dime. In this case, a few inches of snow quickly became nearly a foot and a half, as we saw blizzard-like conditions nearly all day on Wednesday. Denver International Airport shut down for the first time in almost a decade and the freeways turned into parking lots.

The Futility of Forecasts

From what I can gather, none of the meteorologist’s weather models even came close to predicting the magnitude of the storm. Instead, the news channels were scrambling that morning to provide reports on road closures and how many flights had been canceled.

While clearing my driveway for the second time on Wednesday, I couldn’t help but find parallels between the crazy weather we sometimes have here in Colorado and the challenging markets that we often face as investors.

Although weather forecasters in Denver have notoriously poor track records, my experience has been that at least they are directionally correct most of the time. In other words, while they were way off with the volume of snow we got last Tuesday, at least they predicted snow.

Unfortunately, the same cannot be said for our investment forecasting friends. Their predictions are often so bad that the weather equivalent would be like calling for buckets of rain on a day that turns out to be 80 degrees without a cloud in the sky. Needless to say, such forecasts aren’t even worth the paper they are written on.

Putting that aside, instead of diving into the quantitative aspects investing today I thought I would share a few quick tips for managing through weather in Denver that apply equally as well to successful investing. If you keep these tips in mind, you’ll be in good position to stand firm through both volatile weather and volatile markets.

Tip #1: Be Prepared in Advance

Most people that live in climates that can experience sudden changes in weather know that it’s a good idea to take some basic steps of precaution. During the winter months, that means stashing some extra non-perishable food in the house, storing a warm blanket in your car, and keeping your gas tank at least a quarter full at all times. Of course, these things should be done before you actually need them because you’ll be hard pressed to track them down in the middle of a snow storm. Undoubtedly, however, every time you watch the news after severe weather you realize just how many people fail to prepare in advance.

The same type of basic preparation applies to your investments. Since we don’t know where markets are going in the near-term or when they will shift directions, we simply can’t follow a “just-in-time” approach to investing. Instead, we need to determine the proper level of risk for our portfolio at the outset so that when the unexpected inevitably happens, we’re well positioned to successfully manage through it.

This type of preparation is critically important when we’re talking about growth as well. For example, while international and emerging market stocks had a rough third quarter last year, they responded with very strong returns in October. Without continued allocations to a wide range of asset classes, we run the risk of missing out on positive returns.

Tip #2: Dress in Layers

A timeless principle of living in Denver is to always be prepared for a wide range of temperatures by dressing in layers. After seeing a few days with 30 or 40 degree swings, you understand just how good this advice is. So when you reach into your closet before heading out the door, you learn pretty quickly that it’s a bad idea simply to “grab a heavy jacket” because it’s January. While that would probably be good to have at 7am, you might find yourself sweating through it by the afternoon.

The same principle of dressing in layers applies to your portfolio as well. We call it diversification. While a diversified portfolio doesn’t guarantee any specific return or eliminate risk, it does ensure that you aren’t going to experience the extreme swings that are so common with a single stock or even a single asset class. Most importantly, when you invest in a wide range of global asset classes, you not only have the ability to reduce risk, but you can also increase your expected returns. That’s a win-win.

Tip #3. If You Don’t Like the Weather, Wait Five Minutes

Having discussed weather quite a bit already, this tip doesn’t need much of an introduction. However, in my view, it’s probably the most important one for us as investors. The reason is because in the heat of the moment, it can seem like the world is falling apart when stocks are in decline. Every news headline is negative and the tone of every pundit is dire. It truly seems like an economic catastrophe in the same way that the Denver storm was a weather catastrophe last week.

However, in the same way that things improved in short order weather-wise (most of the snow was melted in a few days and it was 66 degrees yesterday), the same can also be said for a bear market. While it may not happen in five minutes, in the grand scheme of things, stock market declines are a handful of fallen trees in an otherwise beautiful forest. For that reason, the next time it seems like the financial world is coming to an end, just pause and remember that brighter days are right around the corner.