The stock market has delivered a very volatile week to investors, perhaps striking a nerve not felt since 2008. As I write this, the S&P 500 has dropped more than 5% in a week and almost as much today, causing many investors to recall the sickening downturn of what some called “The Great Recession.”
Since 1980, the average intra-year decline for the S&P 500 has been -14.2%, even though annual returns were positive for 27 of those 35 years, or 77% of the time.
The S&P 500 has more than doubled in value from March of 2009 , and we have gone more than 1,400 calendar days without as much as a 10% correction. This is the third longest stretch in over 50 years without such a decline. Since 1928 the S&P 500 has experienced a 10% correction almost once per year with an average recovery of 8 months.
Corrections of 20% or more for the S&P 500 have historically occurred at the end of market cycles. In the short run the S&P 500 has pulled back 5% an average of four times per year, or about once per quarter. In fact, the S&P 500 has experienced a 5% or greater pullback every year since 1995. Drawdowns of 2%-3% occur far more often, at least monthly on average. As such, pullbacks alone should not be a reason for panic.
In times of increased volatility such as we have experienced, it’s important to revisit these important lessons that are the underpinning of a successful investment strategy. (more…)
In this four-part blog series from Merriman Research, we’re offering our thoughts on the following important investment questions:
- When evaluating your investment returns, what benchmark(s) are relevant?
- What is the rationale for diversification?
- How should your investment time horizon be considered?
Investors may overlook the fact that these questions are highly interrelated. To properly consider any one, you must understand the context the other two foster. We’ll just have to jump right in to explain. If you missed Part 1, start there and come back.
Part 2: Thoughts on diversification – Why is it a good thing?
Investors tend to appreciate diversification in bad times, but not so much in good times. Investors like the idea of diversifying to mitigate losses, but don’t like diversification when it suppresses gains. Just look back at 2013 – the S&P 500 was up 32.4%, but any version of a “diversified” portfolio would have gained much less. A balanced benchmark, along the lines of a 50%/50% stock/bond split, was up about 15% (if we just blend the returns of the S&P 500 and the Barclays U.S. Aggregate).
“Why should I diversify?” a balanced client may ask. The answer is “To control risk” and we only need to look back to 2008 for an example. That year, the S&P 500 declined 37%, whereas a 50%/50% balanced benchmark was down only 16%. (more…)
Recently, our Research Team of Dennis Tilley, Rafael Villagran, and Alex Golubev got together with Financial Advisor Mark Metcalf to discuss our TrendWise Investment Program. Many of the program’s details were covered, including the following:
- Harnessing market momentum using objective data
- Rules based trend following
- Limiting subjective interpretation
- Dealing with whipsaw trades
- Small/Value tilt in the program
The return-centric environment in which we live too often gives little credence to an equally important measure – risk. Professionals and individual investors alike can often quote the return of a given stock or index, followed by silence when asked to recite its relative measure of risk. The financial crisis shouted to us the importance of understanding and controlling risk. If you did not hear the call – and hopefully you did before the fall – it’s not too late to answer it.
Two quantifiable means of controlling risk are diversification and asset allocation.
Proper diversification stretches well beyond your region and your country of residence. It has little to do with individual stock positions or individual sectors. It consists of all types of stocks – large, small, value, growth, etc., which are located all over the world. Global diversification is the goal.
Diversification is equally important for bond allocations. A bond portfolio consisting of high-yield bonds differs from one invested in U.S. treasury bonds. Obtaining an adequate amount of diversification on both sides of your portfolio is essential in controlling your risk.
Asset allocation speaks to the percentage of stocks and the percentage of bonds in your portfolio. While the specific mix has many variables, age and retirement goals are often large factors. Each investor’s situation is unique and there is no “one size fits all” solution. A good place to start is by answering the following questions:
- At what age do I begin adding bonds? 40? 45?
- How often do I add bonds and how much do I add?
- What is an appropriate allocation once I am retired?
If you are struggling to answer these questions, it may be time to seek professional guidance. The answers are essential to your long-term investment success.
Investor discipline is a less tangible but equally important component of risk mitigation.
As stocks outpace bonds, a portfolio’s risk increases. At some point, there will be a need to sell the stocks to buy bonds and maintain the target allocation. In essence, this follows the golden rule of investing – that is to sell high and buy low. The same logic holds within each asset class of the portfolio, such as when international stocks outpace domestic stocks or small cap stocks outpace large cap stocks.
I can almost guarantee that when the time comes, rebalancing will not feel like the natural thing to do. Why, for example, would you want to buy into an underperforming asset class? Despite our rational brain, loading up on the winners will feel like the right thing to do at that moment. There are two questions you must ask yourself:
- Do I have the discipline to rebalance my portfolio?
- What mechanical process will I use to rebalance?
Your long-term investment success hinges on your answers to these questions. If you do not know how to answer them, seek guidance.
Investing is about risk and return. Understanding how much risk you can afford to take and how much risk you’re willing to take is the key. Quantitatively, two ways in which we control risk for clients is through diversification and asset allocation. Keeping clients disciplined in their goals and executing on a well thought out rebalancing process is another, less tangible means of controlling risk.
As Warren Buffet famously said, “It’s only when the tide goes out that you learn who’s been swimming naked.”
Merriman does not include a specific allocation to gold in our standard portfolios. This article, by Bryan Harris of Dimensional Fund Advisors, discusses why gold has not been an ideal long-term investment. It includes the following key concepts:
- Gold has done well since the year 2000 and in the 1970s, and can potentially be a safe haven during times of political and economic stress. However, for the entire period of 1971 – 2011 gold performed worse than the S&P 500, U.S. small-cap stocks and non-U.S. stocks on an inflation-adjusted basis.
- From 1980 – 1999, gold experienced a negative return after inflation of -6.5%, vs. strong positive returns for stocks.
- While gold has held its value against long-term inflation, there have been extensive periods when gold did worse than inflation. Gold is also much more volatile than inflation, and can add substantial volatility to a portfolio.
- Unlike stocks, which are productive assets which generate growing levels of income and dividends over time, gold has no cash flow and costs money to own.
For more detail and some illuminating graphs, please see the article.