3 Things Investors Should Know Now

Covid

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 helpful opinions to navigate this new (and hopefully temporary) reality and invest well during Covid.

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

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 how bad the economic decline will get or how long the bear market will last. No else can either.

I do know that stock markets are a leading indicator of future economic activity. This means stock markets move ahead of the economy. They don’t react to economic news. They anticipate it. Therefore, just as this stock market sell-off is signaling slower economic activity, the market should rebound before the starts to recover.

You can’t rely on economic data to tell you when to get in or out of the stock market or how to invest during Covid.

An investment plan is important

You can’t time the market. 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 money from your portfolio and how much. If done correctly, your asset allocation was structured to avoid having to sell stocks at a loss to meet your spending needs. Investment grade bonds have held up very well recently. 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 to invest during Covid and other stressful environments?

At some point, if the decline is severe enough it’s a buying opportunity.

You don’t need to jump into a modest decline. Markets average an intra-year decline of 14% per year. However, a bear market decline of 20% or more has historically been an excellent buying opportunity. At these levels, you will rarely regret adding to stocks for the long run. The extent of the buying opportunity will depend on the decline’s severity, but a 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.

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 are underweight. It’s a great way to invest during Covid.

There are two basic ways you can handle rebalancing: time horizon and threshold.

Time Horizon and Threshold Rebalancing

Time horizon 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.

Patience Rewarded

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.


Suggested Further Reading

7 Things (I Think) I Know – In a time of uncertainty, it’s helpful to think about what we know and don’t know and work to find answers for the latter.

Investment Mistakes to Avoid

Heritage CEO Commentary on COVID-19