Diversification

It’s a Rough Day in the Market

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As I write this on March 9, 2020, market indexes across the board are down, some by as much as 9%. Coronavirus has made the market skittish enough over the last few weeks, to compound things Saudi Arabia announced massive cuts to the price of oil this morning, which actually seems kind of great (lower gas prices!), but markets have not reacted kindly. The response feels like panic. It’s certainly a bad day in the market, but I want to provide a little bit of context for all of this.

 

Here’s what you should know:

  • Unless you know the future or have inside information (unlikely, and illegal to trade on), you should be a long term investor. Short term market moves are pure gambles, and most often end up hurting investors. Don’t move money based on fear, which is all we hear in the news, especially on days like today.
  • Despite what pundits may be saying, no one knows what the market will do tomorrow. No one knows where the bottom of a downturn is, no one knows how long it will last or how quickly the market will come back. Don’t panic with your money, especially when the market is down.
  • Bad market days have happened before. On Black Monday (October 19, 1987) the Dow Jones Industrial Average dropped 22.61%, in one day! In order to crack the top 20 bad market days the Dow would have to lose 7%, but even if that does happen, we’ve seen the market bounce back from far worse.
  • The market bounces back quickly. When the S&P 500 loses 10% or more it recoups all losses within an average of about 4 months. The worst thing you can do is move money when the market is down and miss the bounce-back.
  • A limited number of great days in the market account for most of the great returns. A 20 year period between 1998 and 2018 included 5,040 trading days. If you missed the 30 best market days out of the total 5,040, you would have ended up with a slightly negative return over the 20 year period, $10,000 would have turned into less than $9,000. We don’t know when those great days will come (though we know they often follow bad days) but we definitely don’t want to miss them by being out of the market.
  • Markets move, but the general trajectory is up. If you’re invested for the long haul and you understand your risk tolerance, bad market days are no problem. They don’t even have to be stressful.

 

Here’s what you should do (or not do):

  • Don’t panic. This is not the first time we’ve had a bad day in the market and it won’t be the last. The worst thing you can do is move your money out of the market. In fact, bad days in the market are a great time to invest more.
  • Make sure you understand how and why you’re invested the way you are. The market will sustain losses, but an un-diversified portfolio stands to lose a lot more. On the flip side, a well-diversified portfolio can put your mind at ease.
  • Make sure your diversified portfolio has a systematic way of rebalancing. When the market is moving, a system for rebalancing will ensure that parts of the portfolio that are doing well are sold, and the parts that are down are bought. It’s an automatic ‘buy-high-sell-low’ feature.
  • Work with an investor coach. When things look bad, all the news and information surrounding you will only confirm your worst fears. An investor coach will keep you disciplined, make sure the accounts are rebalanced, and will ultimately guide you through turbulent markets to a successful outcome.

Year-end investor review

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We made it, another year is in the books and everyone has an opinion on where the market is going. My line of work involves me adamantly advising people not to try to predict markets, but even I have an opinion about what might happen in the future. Thankfully, there’s a difference between having an opinion and making a poor investing decision.

So where are we now? We’re coming off of a historically great period of market returns, especially in the category of U.S. large growth companies (the S&P 500, which happens to be the category we almost exclusively hear about in the news). Since U.S. large growth companies have faired well, so have investors, because the vast majority of investors have the majority of their investments in large U.S. growth companies. That’s great news right now. But it’s also a problem.

Large growth companies are historically one of the poorest performing asset categories in the free market. This holds in performance data going back one hundred years, but it also makes sense a priori. Large growth companies are inherently less risky than small and value companies, they stay in business longer, they seldom go bankrupt (it happens, just not as often), and their prices don’t fluctuate as significantly. Small companies are often younger, less established, and more susceptible to tough markets. Value companies are often distressed and sometimes never recover. These small and value companies default more often and their prices are more volatile, they’re riskier.

You’ve heard the principle, risk equals return. That applies here. It makes sense that as entire asset classes, small companies and value companies outperform large growth companies by a significant margin over time because their additional risk brings additional return. The fact that large growth companies have performed so well over these last ten years is great, but it also means that at some point we’ll see these returns balance out. Now, I would never pretend to know which asset classes will perform better or worse next year, that’s a fool’s errand which we refer to as ‘market timing.’ But I do know that most years will favor a diversified portfolio that leans toward small and value asset classes instead of a heavy weighting towards large growth companies. Next year the most likely circumstance is that you’ll be happy to have left your large growth company portfolio to get into a more diversified situation, which, incidentally, is true at the end of every year.

So the obvious question is how to diversify with a lean towards small and value companies. I’ve covered this before, but total market index funds won’t help you here, because of cap weighting total market funds are invested almost entirely in large growth companies. Index funds have become very popular over the last 20 years and, while they’re certainly an improvement over active funds, they’re inherently flawed. To get into an ideal portfolio takes an advisor committed to the academics of investing utilizing structured funds (a solution to the index fund problem).

Take the opportunity to review your portfolio as we head into the new year. The returns may look great, but that doesn’t mean you’re in a great portfolio.

Your 401k account is probably loaded up in the wrong asset class

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401k accounts good and bad. They’re mostly good because they provide an avenue for people to save and invest money for their future, but there are some things to watch out for.

Good stuff:

  • The main benefit of a 401k is that it allows you to invest qualified money. You could just invest money on your own, but investing in your 401k accounts means that you get some significant tax advantages (no capital gains on the growth of your investments and an income tax break). The same advantages apply to IRA accounts, but 401ks include two other significant advantages.
  • Many employers offer a matching contribution. For example, if you contribute a certain small percentage of your income (say 5%), the employer may kick in an additional small percentage into your 401k account (say 4%). That’s free money, and you should definitely take it.
  • 401k contributions are capped at $19,000 per year by the employee, employer contributions can exceed that. IRA contributions are capped at $6,000 per year. Not all of us are maxing out our qualified retirement accounts, but the larger cap offered by 401k accounts is certainly an advantage.

Bad stuff:

  • 401k accounts offer a limited number of investing options, and they’re almost never great. 401k Plan sponsors (employers) are typically concerned with one thing when choosing a plan: cost. If the plan seems expensive it will be harder to explain to the board, regardless of the value or benefits of the portfolio and the advisor.
  • Your money is locked up for as long as you work at the company. You’re stuck with the options available and you can’t move the money elsewhere unless you leave or retire.
  • Investors have little to no help deciding which funds or options to use within the 401k so they end up in default options, which are usually target dated funds. You may have seen these funds that end with a future year, like 2045, which you’d be in if you were expected to retire sometime around 2045. A target dated fund is not the worst investment you could be in (which isn’t saying much) but it’s far from ideal. A target dated fund will load you up in U.S. large growth companies (essentially the S&P 500), sprinkle in some international large growth companies, and decide what percentage of your money should be in bonds based on the target year. Unfortunately, in the history of the market, large growth company asset classes are among the lowest-performing of any asset classes over time. A target dated fund is usually made up of index funds (along with their inherent problems) so at least it’s not active, but it will sacrifice large amounts of return over time because of its poor diversification.

Don’t be afraid to use your 401k account, especially if your employer offers a matching contribution (again, free money). But if you’ve obtained the maximum matching contribution, think about investing additional money into a better portfolio through an IRA. Unfortunately, your 401k is probably loaded up in the wrong asset class.

What does ‘efficient market’ mean?

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‘Efficient market’ is one of the most important terms to understand when it comes to investing. It’s important because what you think about the efficiency of the market will dictate how you practically invest your money, which will shape your retirement and legacy.
So first, what does it mean? If the market is efficient it means that stock prices react to news and information really fast. For instance, news breaks that a company has committed fraud, and the stock price of that company falls immediately. It also extends to any small bit of news or public sentiment regarding the market or specific companies. Market prices are always moving based on new information and perceptions, and they move almost immediately upon receiving that new information. Those are signs of an efficient market. The speed at which information travels today has only made the market more efficient.
So why does that matter? Well, if the market really is super efficient, it means that picking stocks is futile. Think about it, if the market prices react and update immediately upon receiving new information, the only thing you can do to beat the market is to guess right. Unfortunately market guesses are less like investing and more like gambling. So if the market is efficient, the entire way you’ve previously thought about investing is not only impractical, it’s basically a roll of the dice. Instead of trying to beat the market, an efficient market would suggest you own the whole thing as efficiently as you can. You would diversify and hold stocks instead of research and pick stocks.
There is another important thing to recognize about investing in relation to the efficient market: people do beat the market sometimes, they sometimes pick the right stocks and get better returns than the market as a whole. It’s not often, somewhere around 90% of stock pickers underperform the market every year, but that leaves around 10% who seem to be doing something right. That 10% either figured something out, found some inefficiency in the market, or they got lucky. The thing is, it doesn’t really matter if they’re smart or lucky, and there’s not really any way to empirically test it anyways. Because the market is efficient, if a smart person does find an inefficiency it will close up before long, and if a lucky person gets lucky, they’ll also get unlucky at some point. Either way, by the time you’ve heard about their success, it’s too late. People who have beat the market in the past are much more likely to underperform the market in the future than to beat it again. In fact, they’re more likely to underperform even their contemporaries in the future. Any way you cut it, in an efficient market it simply doesn’t make sense to try to find or profit from market inefficiencies, regardless of whether or not they really exist, or to what extent.
So if the market is efficient, to whatever degree you agree, don’t try to beat it. Instead, own the efficient market as efficiently as possible.

Fishing and diversification

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I love salmon fishing. I love all sorts of fishing, but salmon fishing is special. Instead of the romantic image of fly fishing in a river, or the flashy idea of big-time bass fishing, or even the nostalgic memory of fishing off a rowboat with your grandpa, salmon fishing is more like a battle. Forget everything you know about traditional casting and reeling, salmon fishing involves rigging up multiple fishing rods, attaching them to downriggers and various mechanisms for getting the lures down deep, and a slow troll on open water. The key to catching fish has nothing to do with technique or sport, it’s about setting a broad array of bait covering many different depths. We call it a ‘spread.’ If you only had one or two rods you’d be poorly served, it’s simply not a sufficient level of depth diversification. Ideally, you want 8 to 12, or even 15 to 18 in the case of professional charter boats. Here’s a quick visual:

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Notice how the lines are prudently spread across varying depths? Investing is the same way! Stick with me here; the water is the stock market, the lines/rods are investment dollars, and the different depths are asset classes. We don’t know which depth, or depths, will produce fish, we just know the fish swim all over the place and that if we’ve got a good spread (lines at different depths) we’re bound to catch something. Same with asset classes! We know that they all perform over time, but we don’t know which one is going to hit next year or which one will be best over the next 5 years. So we own all of them. Imagine how dumb it would be to have one line out in the water trolling for salmon, it makes no sense. Even if that one line is set at the depth that has produced the most fish over the last few weeks, it still doesn’t make sense. Fish move around all the time, why would you not want to cover the whole water column/stock market? Just like downriggers and multiple lines ‘enable the whole water column to be covered when trolling,’ diversification allows you to own the whole market when investing! No guesswork, no hoping, no predicting, no gut feelings, no casting lots, no anxiety, just well balanced, widely diversified investments. I’m not saying it’s easy, salmon fishing is a lot of work, but when you’re eating your salmon dinner at the end of it, you’ll be glad you diversified.