Preparing for the Worst and Best- Case Market Scenarios | ETF Trends

My wife recently received a humorous book as a gift titled The Worst-Case Scenario Survival Handbook: Expert Advice for Extreme Situations. The book describes in detail how to act if faced with a variety of unpleasant or dangerous situations.  Chapters range from “How to Leap from a Motorcycle into a Car” to “How to Escape from Quicksand.” We enjoyed learning “How to Fend Off a Shark,” “How to Win a Sword Fight,” “How to Jump from a Building into a Dumpster,” and “How to Land a Plane.” The chapter titled “How to Escape from a Bear” got me thinking about how to help investment portfolios escape and survive from a market correction or bear market.

Most of us do not expect to have to “Wrestle Free from an Alligator” or “Survive Adrift at Sea.” However, investors with even an intermediate time horizon should expect to experience market pullbacks, corrections, and even bear markets.   Back in August of 2017, I wrote an article titled “It’s Time to Review Your Market Correction Checklist.”  I suggested a market correction checklist should include the following questions:

  1. Is the investor’s time frame consistent with the portfolio allocation?
  2. How would the portfolio (and each allocation, strategy, and position) potentially respond to a 10% or 20% decline in U.S. Equities?
  3. Have you made specific allocation or strategy decisions that would lead you to expect the portfolio to decline more or less than the market?
  4. How will the active fund manager or the passive index rules respond during a market correction?
  5. How will the financial advisor respond during a market correction?
  6. Is each position the right size within the portfolio?
  7. How will the investor or client respond during a market correction?

I concluded the article with the comment, “Whether a correction happens soon or is still years away, it is time to review your market correction checklist.  In our opinion, the ideal investment allocation is the one that the advisor and client can live through.”

In the spirit of The Worst-Case Scenario Survival Handbook, it is worth contemplating how to act when faced with a variety of market or economic conditions that may positively or negatively impact an investor’s portfolio.  In the list of seven questions above, we could replace references to “market correction” with other market events or economic conditions.  What if we experience sustained, above-trend inflation?  What if the market rallies another 20%?  What if higher tax rates become the law?  What if interest rates rise 1%?  What happens if interest rates decline from current levels?  What happens if the U.S. Dollar declines or increases in value?  It is valuable to analyze how an investment portfolio and its components will respond before we are faced with the actual scenarios.

Part of what made The Worst-Case Scenario Survival Handbook humorous is the improbability of facing scenarios like “How to Escape from Killer Bees” or “How to Fend Off a Pirate Attack.”  It is important to guard against “over protecting” portfolios against unlikely, transitory, or short-lived economic or market “worst case scenarios.”  An investor with the capacity for risk and a long horizon should be careful about the potential long-term performance costs associated with shielding a portfolio from market volatility.  Conversely, risk averse investors with shorter time horizons should consider ways to protect portfolios given the fact that unlikely and improbable events are happening more frequently than statistics or economic models would suggest.  While it is important to consider how investments can survive the worst-case scenario, it is also important for long-term investors to consider how to benefit from the best-case scenario (and the many variations between the two extremes).

Long-term investors will experience a wide range of positive and negative market scenarios, and thus would benefit from the protections and opportunities that come from asset class and strategy diversification. In January of 2019 (on the heels of the Q4 2018 correction), I wrote a follow up article titled “The Correction Came.  Now What?”  It is worth reviewing the conclusion of this article:

“My observation has been that the level of advisor/investor concerns during the correction has been highly correlated to investment timeframe. Investors with a truly long-term horizon have felt less concern than those with short-term needs for their investment funds.  No one enjoys market declines, but investors with portfolios that have done what they expected them to do during the correction are far more likely to weather the storm.  Corrections have a way of either confirming the alignment or exposing mismatches between investment allocation and investment horizon. Corrections are an appropriate reality check on risk and return assumptions that underly every investment portfolio.

We continue to believe in positive, long-term investment returns. We continue to believe corrections and bear markets will be a part of an investor’s long-term market journey. We continue to believe there are many appropriate and useful investment allocations and strategies that can be combined in a way that benefits an investor. We continue to believe that a correct understanding of asset class and strategy characteristics will assist in avoiding destructive tendencies of investment euphoria or despair.

The correction came. Now what? …the same advice you would give your children is true for all of us as investors: Be disciplined. Do your homework. Show grit and persistence.  Learn to recognize the difference between “real” and “fake” information. Don’t worry about what others are saying. Be kind. Recognize who has your best interests in mind and who you can trust. Over time, good outcomes follow good behavior.”

While we are unlikely to have to fend off sharks or land an airplane, as long-term investors we are highly likely to face a wide spectrum of economic and market conditions.  There is not a handbook that will outline exactly what to do in each scenario.  If there was such a handbook, it could be summarized as follows: properly allocated and carefully managed investment portfolios combined with disciplined investor behavior are most likely to survive and flourish through the wide variety of scenarios sure to be part of a long-term investment journey.