Market Volatility: It Has Its Benefits
“Everybody has a plan until they get punched in the mouth.”
– Mike Tyson
The month of October hasn’t been kind to many investors. What started off as a series of body blows eventually culminated with a swift uppercut last Wednesday, October 15th. A minor move upward, followed by a weekend of football and my 1 year old daughter’s birthday party gave me a moment to digest what transpired over the previous week. As investors, we all know that ups and downs are part of the process. Even what feels like large swings, although unsettling, is just the efficient way in which individuals and entities across the globe express their opinions on risk versus return in the capital markets.
One benefit to periods like this is that it lets us honestly evaluate if we have been swimming without bathing suits. When the tide goes out, mistakes can easily be exposed. This is the time your own portfolio should be looking itself in the mirror and confirming its own plan…
Revisit your expectations:
Nick Saban can’t win the BCS every year. The S&P 500 Index can’t repeat 2013 every single year either. Expectations of market performance are ok when looking at 10 and 20-year time horizons. Annual expectations may simply cause you undue stress and make you prone to mistakes. Now is a good time to seriously ask yourself what your investment goals are within your portfolio. If you are looking for aggressive growth, then you must be prepared to mentally (and financially) handle these kinds of market swings. If you start to lose sleep over it, then consider a more conservative approach.
Benefits of diversification:
We preach it a lot at our firm, but proper asset allocation and diversification proves its mettle in times like these. Yes, having a diversified portfolio means you’ll most likely not capture all of the near 30% S&P 500 Index rally like last year. It also hopefully means you won’t capture 100% of the decline of a single index either.
Understand your investments:
When new clients come to our firm, we spend time educating them not only on what is in our portfolios but also what currently exists inside their own legacy portfolio. A portfolio of 12 stocks that went up 33% in 2013 is actually rather unimpressive when you look at the risk- adjusted return. The performance of a portfolio is only as good as how much risk you had to take to get there. Owning 12 random stocks is a heck of a lot riskier than owning 500 of the strongest ones in the world, and thus you should expect to be compensated for taking on that increased risk. Another issue we see a lot with new clients is their love affair with Master Limited Partnerships (MLPs). In our low rate environment, some MLPs have been a great investment, however many investors consider them to be like bonds due to the high yields they pay out. We believe they behave more like equities. This has a profound impact on the way one views a proper Stock-to-Bond portfolio mix. While the MLP argument is lost on some folks during bull markets, it only takes a swift pullback like the one we’ve seen recently to force them to understand what this asset class truly is.
Get a handle on leverage:
Some investors employ the use of margin accounts. At large brokerage firms, clients are sometimes sold a solution called “Asset Based Loan” accounts. These allow you to borrow against your taxable investment portfolios at low interest rates and use the funds how you see fit. Some investors buy more stocks. Some buy a vacation house or pay for a wedding. No matter the situation, it’s important to know what this leverage does to your portfolio. Having an outstanding loan balance further emphasizes the swings in your portfolio’s performance. Gains can feel even better than they would have, and losses feel much, much worse. Significant margin borrowing can possibly result in a margin call, forcing you to either pony up more cash or sell some of your investments (triggering a taxable event) to pay back the loan. Furthermore, if you are being recommended the use of a loan account by an advisor, think about whether or not that advisor is being compensated anything additionally from your borrowing activity.
Avoid the media!
When the market is in disarray it’s easy to seek answers in outlets such as Yahoo Finance or CNBC. These media entities love this. Their job is to trump uncertainty, encourage you to take action NOW, and recommend you hang on their every word until this whole thing blows over. Pundits didn’t allocate your portfolio; so don’t expect them to help you during a sell-off either. Talk to a trusted investment professional, and even consider not looking at your portfolio for a week or so.
The markets are a fickle beast:
My colleague (and CFA charter holder Blair DuQuesnay) commented the other day that market gains are often a steady grind, but when the market falls it’s like gravity taking over. It sure feels like that lately. One reason why losses are generally twice as hard on investors from a mental standpoint is that they occur so rapidly. All of our emotions over the last 6-12 months, the joy we’ve felt in seeing account values grow has suddenly disappeared. It’s like crossing the finish line first only realizing you forgot the baton…
Take solace in knowing that markets, over time, have gone up. Does this mean every single investment goes up? Of course not. This is why making sure your house is in order before the next rally is critical. If you believe your strategy is structurally sound, you’ll always be better prepared to weather these minor tempests in the sea of investing.
– H. Clark Gaines Jr. (on twitter @Clarkgaines)