Posted by: Thomas F. McKeon, CFA on June 17, 2020
Do you know the best way to navigate and withstand market volatility without damaging your return potential?
Prudent investing reduces to a very few important decisions and inputs:
Once these have been reasonably well-defined, the following decisions will implement the investment program to accomplish the above.
These are not inconsequential questions. Recent events make this painfully clear.
Between the pandemic, economic stress due to lockdowns, the sharpest market break (and relief rally) in history, and civil unrest, the news flow has certainly been unsettling. We are all in uncharted territory. And this is exactly why an investment plan and policy is so necessary.
As we write this the S&P 500 is down about 7% from its peak in February and down only about 4% from year-end 2019. These are market declines that most long-term investors have endured before and would not give them too much cause for concern. That compares to the S&P 500 being down 35% year to date in late March, with no clue as to what came next, and global pandemic news growing worse by the hour. Investor anxiety at that point was quite high. Recent market peak in February through today is less than four months. Had you been on a space mission over that time with no access to earthly news, most investors would not give current prices more than a passing thought…a normal selloff on the way to higher highs.
The Big and Critical Idea
The single most important decision an investor has to make is how much risk—how large a portfolio drawdown—can he tolerate over the long-term, through all market environments. This will in turn inform the decision about how large an allocation to the risky asset class—stocks—a portfolio can and should make.
There is no right or wrong answer, only what is right for each individual investor.
Imagine a two-asset portfolio: stocks and cash. Stocks are the risky asset with hypothetical long-term returns of 10% annual. Cash currently has an effective return of zero, but a sometimes welcome characteristic of price stability. Now imagine two investors: Risky Rhonda and Mickey Milktoast. Rhonda allocates 80% of her portfolio to stocks, Mickey allocates only 20% to stocks.
Rhonda’s long-term expected return is thus 8% (80% x 10%) while Mickey’s is 2% (20% x 10%). The tradeoff is that Rhonda’s maximum drawdown in a market down 30% is 24% (80% x -30%) while Mickey’s max drawdown is 6% (20% x -30%). There is the basic math of the return and risk calculation.
Structure IS the Strategy
The cardinal sin of any investor is to decide to go from having Rhonda’s allocation to Mickey’s allocation AFTER the 30% decline. Rhonda’s portfolio had been exposed to (and endured) the risk and drawdown of a risky portfolio, but can now only earn the diminished return of the risk-averse Mickey portfolio. This is the worst of both worlds. Allocated now post-selloff to be risk averse, this portfolio will take more than ten years to reach it’s previous high water mark. Left alone, Rhonda’s portfolio would take only 3.5 years to reach its previous high water mark.
Please recognize that this simplistic scenario does not take into consideration any other factors that would impact forward returns: higher returns stemming from depressed prices, prudent policy driven re-balancing, and numerous economic variables. But the basic math is accurate, and shows how destructive of portfolio value that emotion-driven decision is.
The Most Critical Question
How much risk can you tolerate through all markets? That is the most important question. Whether the answer is a lot or a little, if you can refrain from becoming more risk averse AFTER a market decline, you will have avoided the single activity most destructive of long-term portfolio returns.
Moreover, if you can identify your highest static exposure to stocks, while observing normal re-balancing policies in down-markets, you may even enhance your long-term returns by adding to your risky asset exposure while prices are at a steep discount. That is the benefit of policy and structure: eliminating emotion-driven decisions and methodically rebalancing at favorable prices, both high and low.
This essay is not meant to scold or chastise any investor behavior…only to reaffirm the importance of asset allocation and getting it right before market risk presents.