S&P500

How to Invest in Uncertain Times (part 1)

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The market has been rocked. In the last two weeks (March 3-16, 2020), the S&P 500 has lost over 22% of its value. It’s the fastest 20% descent we’ve ever seen, and no one knows exactly where the bottom will be (or if we’ve already hit it). The market has moved in percentage multiples, both up and down, every day last week, an incredible level of volatility. The leading cause, which still feels surreal, is the propagating Covid-19 virus which has led to mass closings and increasing restrictions. Suffice it to say, it’s been a crazy couple of weeks.

In many ways, we’re in uncharted territory, which means we’ve got questions, like how are we supposed to respond to all of this? What’s the right thing to do when we’re confused about what’s happening? To add some clarity, I’ll offer up a few investing principles throughout this week.

 

Market timing doesn’t work.

  • No one knows what the market will do tomorrow. Many make predictions, but no one really knows. Don’t try to guess where the bottom is, or when we’ll hit it, or when to pull money out of the market, or when to put the money back in. The market is efficient.
  • Let’s say you really want to get out of the market because you don’t believe we’ve hit the bottom yet and you’re not interested in sticking around to find out. In order to successfully time the market you have to get two bets right: you have to get out of the market before it hits the bottom, and you have to get back in at or very near the bottom. The odds are not favorable.
  • A market study conducted at the University of Michigan measured returns from 1963 through 2004 (a period of 42 years). They found that 96% of the positive returns over that period came from 0.85% of trading days (90 out of 10,573 total trading days).
  • Another study done by A. Stotz Investment Research observed a 10 year period, from November 2005 through October 2015. After running the data through several simulations, they concluded that if you missed the 10 best market days over the specified 10 year period, you would stand to lose, on average, 66% of the gains you would have captured by staying in the market.
  • When the market moves up, it moves up quickly. Whenever your money is on the sidelines, you risk missing some of the best days the market has to offer. So stay invested, don’t panic, and anticipate the rebound.

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.

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.

Index bubble

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This passive investing/index bubble idea from a Michael Burry interview continues to circulate. The idea has appeal, not the idea that another recession is imminent, but the idea that we could accurately predict one coming, and that the cause could actually make sense to us. The argument is fairly simple. A larger percentage of people are buying index funds, especially the S&P 500, than ever before. Index fund investors tend not to analyze each company in the S&P 500, they simply buy the index which owns all of them. So Burry worries that since fewer and fewer people are conducting analysis on company fundamentals, the prices of these companies are going to be inflated by virtue of the simple fact that they’re included in an index, not because they’re good companies that people believe in. That makes sense. The question then, is how much analysis and trading do we need in order to maintain a decent level of price discovery in the market? If index funds stifle price discovery, how do we avoid a bubble? Here are a few responses:

  • Even a small amount of price discovery (studying fundamentals, making trades, supply and demand) makes a huge difference for prices to reflect value. We don’t need large swaths of the market conducting analysis.
  • If 100% of invested assets were in index funds the price discovery argument might hold some weight. You would have to assume that there would be almost no company fundamental analysis happening, not an unreasonable jump but still an assumption. However, the truth is that only about 45% of invested assets are in index funds, and there’s still a host of investors and dollars outside of passive index funds working to set prices.
  • Index investing actually adds data to the market, it contributes to price discovery. Instead of contributing data on specific stocks, it contributes to larger market sector data as people commit dollars to different indexes across the world, which is helpful market data.
  • Despite the growth of index fund investing, global stock trading volume has actually remained about the same over the last ten years. People use passive vehicles to actively trade. Many index fund dollars are in ETFs among the most traded funds on the market. Just because money is in index funds does not mean that it’s passive. The activity all contributes to price discovery.
  • Some passive investors (like us!) actually do use some fundamental analysis in constructing portfolios (structured funds). And even our passive investors occasionally make trades; in order to rebalance, when they make contributions or withdrawals, etc. Even the most passive investors contribute to price discovery.
  • If the market was losing efficiency and price discovery as a result of growing index fund investors, we would expect to see an uptick in active money manager performance. Active managers would find the mispriced companies in the index and reap corresponding rewards. But the data shows no improvement, active managers have performed slightly worse over the last three years than before.

Despite the uptick in index and passive investing, price discovery is as strong as it ever has been in the stock market. Michael Burry’s comments on the index bubble are interesting and even sound plausible, but upon close inspection look misguided. Passive investing is still the way to go, though you do have permission to dump those index funds.

Index issues (part 2)

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Alright, so we know passive investing trumps active investing, and we know that index investing, while passive, has some serious deficiencies. So what’s left?
We want to own the market passively, but that doesn’t mean we’re restricted to index funds. There is a much more responsible way to allocate money to different companies and sectors – structured funds. Structured funds deal with each of the index funds issues:

1. Instead of an arbitrary grouping of companies, a structured fund can make it’s own set of rules to decide which companies are in an asset class or fund and which are not. The S&P 500 is 500 of the largest companies in the U.S., but what if that’s not the best way to own the U.S. Large growth asset class? The same question can be asked of any index. Instead of abiding by the arbitrary index rules, a structured fund makes its own rules based on a century of market data. Just like the S&P 500 has rules to decide which companies are in and which are out (largely based on that 500 number), a structured fund has a set of rules that a company has to meet (size, profitability, book to value ratio, etc.) in order to be included in that fund. It’s still passive (in fact, often more passive than index funds), the rules are what determine which companies are in and out not an advisor’s gut feelings, but it’s a different type of investing. And it’s based on actual market research instead of arbitrary measurements.

2. We know that small companies outperform large companies over time, but indexes, by necessity (because of cap-weighting), own the least amount of the small companies. Even small company indexes like the Russell 2000 (which owns the smallest 2,000 companies in the U.S.) have much more money invested in the larger several companies than in the smaller hundreds of companies. If you’re in a target dated fund (the ones with a year at the end) in a 401k or a total U.S. market index fund, you’re missing out on the best returns the market has to offer because of cap-weighting.

3. Structured funds are not as cheap to own, and they’re much more scarce than index funds. You’ll probably have to work with an advisor to gain access to them. They rarely let investors put their finger on the trigger. Over time, these funds outperform traditional index funds because they’re designed to maximize return. An index fund would have to pay you to achieve similar returns, even after the additional costs of structured funds are considered. And because investors can only access them through an advisor, the likely-hood that investors consistently realize the returns (instead of hopping in or out or all around at the wrong time) increases significantly.

Often times index funds are the only decent option available (this is true in many 401k accounts), but when the options are open, a good advisor offering good structured funds is the best option.