By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management
We believe the greatest challenge facing investors when navigating financial markets is behavioral. The old credo of ‘buy low, sell high’ is easier said than done as evidenced by the annual Dalbar study which highlights the gap between benchmark and investor returns.
Behavioral economics teaches us that investors feel the pain of a loss roughly twice as much as the euphoria of gain. This divergence can lead to emotional decisions that could potentially derail a sound financial plan.
Intuitively, investors know that during periods when markets are down and valuations are cheap, the opportunity is often the highest. These times usually end up being the best time to buy and the worst time to sell. Conversely, when equity markets are reaching new highs and valuations are expensive, it simply feels much better to invest in a rallying bull market.
Having the data on market corrections can go a long way in providing some perspective during volatile times by focusing on the number and depth of historical drawdowns and the timing of subsequent recovery. In addition, having the proper asset allocation before a market drawdown can be the most valuable tool in planning and weathering difficult markets. Investors can and should use proper asset allocation to ensure that the range of returns of their portfolio is within a band that limits the potential downside and provides sufficient upside to meet their long-term investment goals.
Understanding historical volatility is a good place to start the process. Behavioral economics teaches us that we adapt to our environment by projecting the current environment into the future. For instance, periods of high and/or low volatility can give investors a false sense of what is typical and lead to flawed assumptions about what the volatility regime may look like in the future. Investors might project today’s relatively high volatility into the future and assume that the markets will continue to behave this way. Within the context of historical market environments, today’s volatility may be a return to normalcy after a particularly quiet 2017 (exhibit 2).
Providing a perspective on the frequency, depth and duration of market drawdowns is as important as understanding a targeted rate of return. After all, it’s much more important to have a plan in case of emergency than it is to have a plan in case of utopia. Great planners plan for base-case, best-case and worst-case scenarios. As the following table suggests, even asset allocated portfolios can experience significant drawdowns (exhibit 3). We think it is crucial to have a frame of reference to help understand what can be expected in terms of the historical magnitude of drawdowns and the time to recovery. There is a large distinction between the types of drawdowns, be they a pullback, a correction, or a bear market.
Thinking about risk in terms of standard deviation and beta is helpful when constructing portfolios, but we prefer to use drawdown when looking at risk tolerance from an investor perspective to assist in determining the appropriate asset allocation. More specifically, having a sense of the worst-case, frequency, size, timing and average days to recovery of various allocations may provide some perspective in selecting a portfolio an investor can live with through difficult market conditions.
Knowing that a 35% equity and 65% fixed income asset allocation experienced very few typical market pullbacks and no corrections or bear market environments since 1989 may be an important factor for investors whose primary goal is the preservation of capital. Equally important, the more aggressive equity investors would have experienced greater drawdowns in terms of size and depth but often had a much quicker recovery with the exception of bear markets. The old adage that ‘time in the market is more important that timing the market’ is certainly appropriate in this instance and it’s easier to follow when starting with the right asset allocation.
This article was written by Gary Stringer, CIO, Kim Escue, Senior Portfolio Manager, and Chad Keller, COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.
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 be taken as an 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.
MSCI ACWI Index – This Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI Index consists of 23 developed and 23 emerging market country indexes. Net total return includes the reinvestment of dividends after the deduction of withholding taxes, using a tax rate applicable to non-resident institutional investors who do not benefit from double taxation treaties.
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.