3 Things Investors Should Know Now

A bright spot during this surreal time has been the opportunity for more frequent and substantial communication with friends, family, and clients, as well as having this blog where I can share information and opinions that might be helpful as we navigate this new (and hopefully temporary) reality. I’ve had many conversations about portfolios, ways to navigate this bear market, and additional financial steps to take during this slowdown.

From an investment standpoint, I’ve focused on three key points:

  1. Markets tend to recover before economies do

    Global economic activity is contracting sharply as the world tries to flatten the curve through social distancing.

    I can’t predict the extent of the potential economic decline, nor the exact timing of the slowdown and eventual recovery, nor do I think anyone else can. Read 7 Things (I Think) I Know for more about this.

    I do know that stock markets are a leading indicator of future economic activity, which simply means that stock markets move in anticipation of economic events down the road and not after they have been confirmed. Therefore, just as this stock market sell-off is signaling slower economic activity, the market typically begins rebounding before the economic slowdown bottoms out.

    This is a round-about way of saying that you can’t wait for signals in the form of actual economic data to tell you when to get in or out of the stock market.

    You need to have an investment plan that is not dependent on economic signals telling you when to get in and out of the markets, and it’s likely going to have you buying stocks even as the economic headlines and data look ugly.

  2. An investment plan is important

    Trying to time the markets to avoid short-term declines can’t be done. It’s time in the market, not timing the market, that delivers the best long-term results. Your investment strategy should have been built with a clear understanding of your financial situation, and most importantly, when you will need to withdraw assets from your portfolio and in what amounts. If done correctly, your asset allocation was structured to avoid having to sell a meaningful amount of stocks at a loss when markets decline to meet your spending needs. For example, investment grade bonds have held up very well during this bear market. Investors can take profits in them for spending money to avoid having to sell stocks that have declined in value.

    What should you do instead of market-timing?

    At some point, if the decline is severe enough it can and should be viewed as a buying opportunity.

    You don’t need to jump into a modest decline, such as an average calendar year -14% correction. However, when you get to a more substantial pullback or bear market, such as a 20% to 30% drop, these have historically presented excellent buying opportunities. At these levels, you will rarely regret adding to stocks in a long-term portfolio. The extent of the buying opportunity will depend on the severity of the decline, but the disciplined investor with a proactive strategy is in great position to take advantage of stock market weakness and buy cheap stocks. This is known as rebalancing, and it’s explained below.

  3. Portfolio rebalancing

Investment portfolios (except for those that are 100% stocks or bonds) typically have a target percentage for different asset classes like stocks, bonds, and alternative investments. As markets move and investments perform differently from each other, portfolio weights stray from their initial targets. Portfolio rebalancing involves selling what you have too much of relative to the target weightings and buying things that have pulled back and are underweight.

There are two basic ways you can handle rebalancing: time horizon and threshold. Time horizon simply means that at pre-determined periods, say annually, portfolios are automatically rebalanced back to target. Threshold rebalancing means establishing a pre-determined percentage that you permit an investment to be above or below the target before you rebalance. I prefer this approach. An example of how this works is the case of stocks and bonds during the recent decline. As stocks sold off and bonds either appreciated or held their value much better by comparison, the stock weight in portfolios dropped to the point where you would want to rebalance back to pre-determined criteria. Rebalancing here means buying stocks to get them back up to target level and selling bonds to get them back down to target level.

Once you decide on threshold rebalancing, a critical question is how narrow or wide a band you use to trigger a rebalance. For example, you could establish a narrow band (say 2%) on your stock investments. If a 2% band is used for your stock investments, the typical volatility of stocks would trigger rebalancing twenty or thirty times a year. I advocate using wide bands, which means letting your winners win and losers lose for a period of time before rebalancing. In the case of stocks, waiting for a bear market (20% drop from the peak) can make sense. Research shows momentum in markets, and being patient can have its rewards. By using wide bands on the downside, you wait for stocks to drop 20% before rebalancing and buying more. If the decline continues, as this one did, you can rebalance again at pre-determined wide thresholds. For example, at 30% (which we saw) and 40% declines (which we have not seen yet) you could rebalance again. No one will perfectly time the bottom in a market decline, but I believe adding to stocks after big sell-offs will reward long-term investors.

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