November 2, 2017
Renewed optimism about economies and markets has led to an unusual calm. Global stock markets have gone up in practically a straight line since the post-Brexit vote correction ended in mid-2016, and here in the US, markets are by many measures the calmest they’ve been in decades.1
As a result, right now many people are feeling like investing is easy and without risk. This is, of course, not the case: at some point, markets will fall and fear will come to the forefront again.
Being invested in the markets means being exposed to occasional declines. And that’s ok. A focus on fundamentals, value, and diversification has historically allowed investors to earn nice long-term returns while avoiding the much more problematic possibilities of failing to keep up with inflation over time or taking permanent losses. Those outcomes are often the result of investing in bubbles or highly overvalued investments, and that’s why we’re so focused on avoiding those areas of the markets.
Fairly valued investments often hold up better than the markets as a whole during the declines, but, most importantly, they can be expected to bounce back after a decline. But investors still have to endure the unpleasant downturns. The capacity to endure is one of the main keys to long term success — and it’s also one of the biggest challenges.
When in the midst of a downturn, there’s no telling how much longer it will go on or how much deeper it will go. Headlines are always most gloomy right before markets turn around. By definition, a market bottom is actually the moment when the most people have decided to get out, but it also turns out to be the best time to get in! We believe that getting caught up in the headlines and trying to time such things is a losing game in the long run. It’s a focus on value, along with the willingness to properly prepare for the downturns, that enable us to endure them when they come.
Investors are much more likely to successfully weather a normal downturn if they have the perspective that such volatility is normal and inevitable, and that downturns are not reliably predictable in terms of timing, duration, or depth. The reality and proper mindset is that going through corrections and bear markets is part of the price that we sign up to pay for the chance of the good long-term returns that reasonably priced investments have historically delivered.
Having the right perspective on market ups and downs can help prevent panic selling, but it’s also important to align your portfolio risk with your internal tolerance for volatility. This can be done by allocating your portfolio so that it will likely stay within a range of ups and downs that you are comfortable with. If risk alignment is done properly, and expectations are set for how volatile your investments might be, then in the midst of a normal downturn it will be clear that the experience is part of the normal, albeit sometimes unpleasant, course of events.
The above can all be condensed down to these three important steps for dealing with potential market risk:
- Diversify amongst reasonably priced investments and avoid the overpriced. This can help decrease the severity of the downturns, and makes it more likely that losses will be recovered.
- Accept that you will have to endure downturns. Don’t try to time the market to avoid them, because this is too unreliable and generally detrimental over time. Rather, internalize that downturns are normal and inevitable and that the reasonably priced investments are likely to recover in time.
- Prepare for downturns by aligning your portfolio risk with your internal tolerance for volatility. A failure to do this leads many to reach their “panic point,” selling out of the market at a detrimental time.
It will be nice if recent market gains continue on for a good while, and they may well. But the time to prepare is not when caught in the middle of a storm. We think it’s valuable address these issues during the good times to be sure that your bases are covered before the blue skies eventually turn to grey.
1 — For example, the 1-year average volatility of the S&P500 is currently the lowest it’s been since the mid-1990s. (Source: Sundial Capital Research). And if the number of 1% daily changes to the S&P500 continues at its 2017 pace, this will be the lowest year for 1% changes in over 50 years! (Source: Investech Research)