Prepare For Bear
“The chief task in life is simply this: to identify and separate matters so that I can say clearly to myself which are externals not under my control, and which have to do with the choices I actually control. Where then, do I look for good and evil? Not to uncontrollable externals, but within myself to the choices that are my own..” Epictetus, Discourses 2.5.4-5
I believe investors can create an opportunity for themselves simply by having an awareness of what is within their control, and what is not. In a world where irreducible uncertainty exists in the market, optimizing the controllable and letting go of everything else usually leads to better outcomes and greater peace of mind.
Predicting stock market reactions to potential future macroeconomic events is clearly not within anyone’s realm of control. As the legendary Seth Klarman said, "Macro worries are like sports talk radio. Everyone has a good opinion which probably means that none of them are good."
The last eight years have been kind to US stock investors. From March 1, 2009 through March 31 of this year, the S&P 500 is up nearly 215% with only two significant drawdowns to note (2011, 2016.) I have no idea if we’re near a market peak, or in the middle stages of a secular bull market. An uncertain future should always be treated with a great deal of humility.
I see or speak with dozens of prospective clients and retirement plan participants each week. Through those discussions, one thing has become clear. When statements are increasing in value quarter after quarter, year after year, inertia sets in. Investors begin evaluating success based on accounts going up, instead of by the process of how money is being allocated.
In many cases, this environment has led to some of the very fundamental pillars of successful investing being ignored. Said another way, this bull market has provided cover to flaws that usually become apparent when the market starts trending in the other direction. Let’s probe a bit more.
Below are some of my favorite considerations (along with a few words of commentary.)
1.) Where is your education coming from?
In my opinion, this is the single most important factor on the list. The number one job of a financial adviser is to educate their clients on what is of importance, and what is not. If your filter (adviser) is not of the highest quality, nothing else really matters.
2.) What is the overall investment philosophy? If money is being managed on your behalf, what does the Investment Policy Statement (IPS) stipulate? Is there an IPS?
The IPS serves as guardrails for the portfolio and enforces discipline, strategy and goals-based investing. Said another way, it holds the individual managing your money accountable to the agreed upon objectives and risk tolerance.
3.) Am I, or is someone on my behalf, reacting to short-term noise with long-term money? Has my retirement account at some point over the course of the last five years been moved in and out of a money market fund because of (Ebola, recession fears, the Fed, fiscal cliff, Brexit, China, presidential elections, etc.)?
This would not be considered a viable risk management strategy. These trades tend to be intellectually lazy recommendations that have probably led to costly mistakes. At best, any positive outcome based on these types of recommendations will be the result of random luck. There is and will always be danger lurking around the corner – and you should invest anyway. Retirement and education funding needs do not stop because of ongoing world events.
4.) What are the expectations for the portfolio in a down market? What type of rebalancing will take place?
In my opinion, many investors take on too much risk in their portfolios, in part because the ‘here’s what the downside looks like’ conversation is never had, leaving many caught off guard when it happens. Drawdowns are the price of admission for future returns. If you’re not prepared to handle them, then you should be in a more conservative portfolio.
5.) Is a well-constructed global portfolio being avoided to chase U.S. stock returns?
Many investors avoid diversified portfolios based on past performance. This is probably as true today as it has ever been, as most global indices have under performed the U.S. markets for years.
6.) Are bonds absent from your asset allocation as a means to avoid interest rate risk? If that’s the case, what part of the portfolio will provide downside protection in a bad market?
A de minims amount of high quality bonds in your portfolio tends to be a non-issue in an up market. Bonds should be used first and foremost as a diversification tool – not for capital appreciation. Higher rates lead to higher yields, which eventually offsets any price hit and should improve the total return of the bond over time.
7.) If there is significant trading activity in my account, how much additional tax is being created? Is asset location being considered for taxable accounts? Who is responsible for paying the trading fees?
Trading activity creating unnecessary taxes for a client fall into the ‘absence of value’ category. Remember that the only returns that matter are real and after-tax.
8.) Have I been sold a product (REIT, variable annuity etc.?) If so, was that vetted by a non-interested third party? There is a reason most financial products are sold and not bought. Get a second opinion.
9.) If I’m in a position where I’ve accumulated enough wealth to support my future spending needs, why would I take on more risk than I need to in my portfolio?
Poor stock market performance during the early retirement years can have a massive impact on future outcomes. If you’ve ‘made it’, do not expose yourself to so much equity exposure that you may have to get rich a second time.
10.) On the flipside – have I avoided investing completely because it makes me nervous?
To completely avoiding investing is a means to go broke slowly. Although no stock exposure may feel good during a meltdown like 2008, it can be detrimental to the long-term success of your portfolio. Over the course of decades (which is the time frame most of us should be using to evaluate investments) stocks have historically been an advantageous tool to outpace inflation. It’s critical that your portfolio can support your future spending needs.
11.) What are the contingencies in my overall plan? Are my goals and wealth accumulation numbers in tact? Portfolio performance is not linear. If I am five years away from retirement and we experience a sub optimal market, what adjustments will need to be made for me to stay on track?
This is real financial planning. Certainty is oversold, while the need for course corrections is not talked about nearly enough.
In closing, the lack of sound investment fundamentals, hidden in the weeds of a bull market, will show itself in full force over the course of a full market cycle. Having a process will not eliminate the inevitable ups and downs of the market, but it will serve you significantly better than no process at all.
Ultimately, the responsibility lies with you. If you’ve been doing this on your own and aren’t sure where to turn, look for professional advice. If you’re having money being managed on your behalf, make sure you’re holding that person accountable and vetting any recommendations accordingly.
The next direction of the stock market is largely an external event outside of your control. The process of how your capital is being allocated is an internal choice within your control. Moving forward, try focusing on the latter.
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Sources:
https://dqydj.com/sp-500-return-calculator/
The Daily Stoic
