Fourth Quarter 2018 - How do you ride a bull and a bear?Submitted by Alsworth Capital Management, LLC on February 7th, 2019
Now that we have traveled 365 days around the sun to start a new year, we have the opportunity to look back at the previous year and use that information to help set a course for the next. What stands out the most about 2018 was the return of volatility, as well as the fact that every major asset class experienced negative returns, to varying degrees. After a blockbuster 2017, international stocks sold off early in 2018 and never recovered. They ended the year down about 14%. This sell off was largely attributed to the fact that the tariff war trade policy was showing signs that it would persist longer than many investors had expected, driving valuations lower and negatively impacting foreign currency exchange rates. After a period of hitting near daily new highs, the US stock market sold off 10% in March, representing the first real correction in a nearly 10-year long bull market. However, investors had not given up on US stocks and continued to “buy the dip” and drive the market to new highs again, through the end of the third quarter. Then, seemingly out of nowhere, the US stock market sold off nearly 20% and ended the year with many investors shell shocked and staring at a potential bear market. Thanks in large part to the market boost from the tax cuts heading into the year, the S&P 500 Index managed to end the year down only 4.5% from point to point, but this figure hides the fact that there were selloffs of 10% and nearly 20% during the year.
It has been ten years since the last major market correction and that one was historic. Since the recovery that started in 2009, we have had an incredible long period of slow, but positive, economic growth and reasonably calm financial markets. Up to this point, many investors have gotten accustomed to seeing returns without discomfort. However, that is not how markets work. This is a good opportunity to remember that the only reason we can expect to earn any rate of return on investments is because we are assuming risk. When we invest in a CD at the bank, we lock up our money for a period of time, but we have FDIC insurance up to certain limits to protect against the bank going bankrupt and failing to pay us back. There is liquidity risk of not having access to your cash without some hassle and early withdrawal penalty. However, this isn’t a significant risk, so we can’t expect a significant return. The next step up is to invest in bonds. You could purchase bonds issued by large corporations that lock up your money until the maturity date of the bond. In exchange, they pay you a coupon interest payment. With these bonds you are giving up access to cash, as well as taking on the risk that the corporation goes bankrupt and can’t pay you back. The next step up is to invest in stocks. With a stock there may be dividend payments, but the company has no obligation to continue them. The board of directors can easily vote to drop or eliminate the dividend payment. In the event the company fails, the employees, pension plans, vendors and bond holders are all paid before the stockholders. Everything the company owns can be sold to satisfy those claims and there is rarely anything left over for stockholders. The risk here is much higher. However, the returns can be expected to be higher too. As a stockholder, you own a fractional share of a company and the value of your shares should reflect the perceived value of the company. If the company does very well, like Amazon or Microsoft, your shares could go up in value. If something changes, like Apple having a hard time selling phones in China, the value of your shares can drop to reflect this new information. Nobody can predict the future to know exactly what is going to happen that could impact a company’s ability to make profits. None the less, investors jockey positions on how eager they are to buy or sell shares, based on new information as it comes in. Inevitably, this is going to cause up and down gyrations in the value. It is similar to how the value of a house might go up and down, only you don’t get daily valuation reports, let alone second by second appraisal values on a home.
I have spent over 20 years obsessing about markets and studying finance. My insecurity about not understanding what makes financial markets tick, led me to this field. Realizing that everyone is impacted by financial markets but, may not have the time or interest to obsess about it, led me to becoming a financial planner. First and foremost, my goal is to help people avoid unnecessary risk because they don’t understand the risk they are assuming. An overly aggressive portfolio can be financially ruinous. A secondary aim is to help people avoid risks that they aren’t being properly paid to assume. This means avoiding overpriced assets. A third order goal is to take informed risks that may provide excess returns.
Most of us need to accept some risk, because we must earn enough return to meet our financial planning goals. In a perfect world, we could calculate that risk/return tradeoff and ride the market like a dolphin skimming smoothly and exhilaratingly across the water. Unfortunately, the caricature of the market is not a dolphin. It’s a raging bull, fighting with a maniacal grizzly bear. How do we ride a bull, let alone a grizzly bear? We start by building a sturdy saddle and loading the pockets with lead bricks. The most obvious brick is cash. The more cash bricks we add, the heavier the saddle and the smoother the ride. Less buck up high returns, but also less downward lunge declines. Cash is a blunt object and we try to do a little better by buying bonds instead. We can tweak the ride as well, by picking the right animal to match the conditions. Mixing characteristics of different markets like US small company stocks with Indian, South Korean and French stocks can help smooth the ride as well. The competing characteristics of different markets results in parts of the portfolio moving in different directions at different times and reacting to different stimulus. This is nuance in portfolio management. It isn’t as effective as the blunt force of bricks in the saddle but, it can have a meaningful impact.
Our portfolios are all very broadly diversified into many asset classes. We regularly tweak the exact makeup, based on what we think is cheap versus what we think is expensive. We aren’t always going to have it just right, especially in the short term, because we can’t predict the future. However, we are confident that over time, by avoiding overpriced assets and being unafraid of accepting risk in markets that are cheap, we can add value. In 2017, our international positions added more upside buck to the portfolio. In 2018, they provided more downside lunge. However, the offsetting amount allocated to cash and bonds kept our portfolios within our target 12-month downside range. I talk and write a lot about the nuance of tweaks here and there, because I enjoy the topic and I want to make sure you understand what you own. But, the first order of portfolio management is determining how much risk to assume overall. We believe we are well positioned for the coming year and for an unpredictable future. However, if you find that you are anxious with last year’s markets and you are adjusting your spending or financial plan as a result of the declines, I highly recommend that we meet and discuss it. Your portfolio was constructed with the expectation that similar market declines are normal and will inevitably occur at intervals over time. It is the nature of investing. If you are driven to make emotional decisions as a result of the 2018 experience, it likely means we underestimated your tolerance for risk and we may need to add more bricks to the saddle to keep you riding along your financial plan.
As always, we appreciate the trust you have placed in us. Please feel free to set up a meeting to discuss your portfolio and your financial plan at a time and place that is convenient for you.
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
The views and opinions presented in this article are those of Shane Alsworth only
Investments are subject to market risks including the potential loss of principal invested.
Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Sources: Morningstar/Ibbotson data, Ned Davis Research, BCA Research, Litman Gregory Research