By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management
The recent market volatility has resulted in the fastest pace of stock market declines in decades. In response to this shock, many investors are now wondering about the way forward. During times of market stress, there is a tendency to seek safety as behavioral factors start to shade investment decisions. This can cause some to question the wisdom of the basic investment tenets of asset allocation and fuels the ongoing debate over whether to be fully invested in equities versus holding cash or other more defensive investments. Additionally, a bias to action during market downturns can be hard to resist for many investors. We think that it is important to consider both the raw market data and the behavioral impact these types of environments can have on individual investors.
For example, exhibit 1 shows the volatility experienced by various basic allocations across equities and bonds following the market decline during the 2007-2009 Global Financial Crisis (GFC). The chart illustrates that if one were to remain invested in 100% equities during the downturn and subsequent recovery, it would have taken approximately five years to fully recover. The Global Financial Crisis was a difficult time for many investors and the illustration assumes that an investor simply stayed the course and remained invested. However, we know that not every investor stayed invested and it’s extremely important to acknowledge some behavioral realities. Foremost, investors feel the impact of market declines at least twice as much as the euphoria of gains according to behavioral finance. As a result of the more powerful impact of market declines, investors often make emotionally charged decisions rather than purely rational choices. As the market effects of the GFC subsided, many investors bore those emotional scars for years and may not have been able to ride through the 2011 decline when the equity market again fell 20%. Assuming an investor simply stayed the course, it wasn’t until the spring of 2013 when an investor in 100% equites would have fully recovered from the GFC.
There are many ways to address some of the behavioral factors outlined and help investors sustain the inevitable market drawdowns. The first is to select an asset allocation that is consistent with an investor’s tolerance for risk. As illustrated in exhibit 2, the question of maximum drawdown should be a part of every conversation when determining the appropriate mixture of equities and bonds. It is also important to take a flexible approach to investment management that incorporates behavioral finance.
We believe investors should have multiple layers of risk management regardless of the targeted asset allocation mix in order to help mitigate market risks as well as the risks associated with the emotional errors resulting from investor behavior. The majority of our allocation is strategic to ensure we participate in the longer-term upward bias of the financial markets, but we also include a meaningful tactical sleeve where we can manage risk over the shorter-term. This approach allows us to invest opportunistically or defensively depending on the environment. Additionally, it provides us with the flexibility to position our Strategies across a broad array of themes and asset classes, including cash, to act as a shock absorber in a particularly volatile or event driven market. One of the biggest challenges an investor may face in a volatile market is the lure of cash, which is particularly true when the decision is framed as an “all-in or all-out” proposition. The natural tendency to completely exit markets and seek a safe haven can have disastrous effects on returns and ultimately prolong or prevent the eventual recovery. Becoming defensive based solely on emotion can really derail even the most well-constructed financial plans. We believe it can be beneficial to include strategies with built in processes to increase cash that is devoid of emotional responses. For example, our Cash Indicator methodology acts as a plan to raise cash in case of an emergency. This is analogous to the multiple safety systems in a modern automobile, which includes an airbag. Importantly, each of these risk mitigating systems work together to potentially help smooth the ride on the road to achieving an investor’s financial goals.
DISCLOSURES
Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management, LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested.
Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.
The securities identified and described may not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.
Data is provided by various sources and prepared by Stringer Asset Management, LLC and has not been verified or audited by an independent accountant.
Index Definitions:
Bloomberg Barclays U.S. Aggregate Bond Index – This Index provides a measure of the U.S. investment grade bond market, which includes investment grade U.S. Government bonds, investment grade corporate bonds, mortgage pass-through securities and asset-backed securities that are publicly offered for sale in the United States. The securities in the Index must have at least 1 year remaining to maturity. In addition, the securities must be denominated in US dollars and must be fixed rate, nonconvertible and taxable.
S&P 500 Index – This Index is a capitalization-weighted index of 500 stocks. The Index is designed to measure performance of a broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.