By Liz Ann Sonders, Charles Schwab & Co., Inc.
It’s time for another reminder about the perils of panic.
Asset allocation, diversification, and rebalancing are as close to a “free lunch” as you can get as an investor.
In a world where time horizons have shrunk precipitously, think longer term.
If markets are good at one thing, it’s reminding investors that they don’t go up uninterrupted forever. The U.S. stock market went over 1,000 trading days between its 2011 correction and the one we’re in the midst of presently. Normally, corrections — defined as declines of at least 10% — occur about once a year.
We’ll have plenty of shorter-term commentary on the latest market moves, but this piece is longer-term and more evergreen in nature. It serves to remind investors that neither panic nor greed is an investment strategy and that the best foundation to help protect a portfolio against the unpredictable is having — and sticking with — a long-term strategic asset allocation plan.
Mindset matters: Strategic trumps tactical
Individual investors should rarely, if ever, react in a purely emotional fashion to a dramatic short-term move in the market. As intriguing as it may seem to try to catch bottoms and get out at tops in order to reap big profits (or so you think), the “tactical” (or shorter-term) approach to investing has its limitations … and its risks. That said, if you’re a regular reader of our shorter-term commentary, we’ve been in the neutral camp (neither over- nor underweight) on U.S. stocks all year — our most cautious stance in the past several years.
We believe it’s the “strategic” (longer-term) asset allocation decision — and the ability to stick with it through the discipline of rebalancing — that will ultimately reap the greatest rewards. These decisions are not a function of short-term market gyrations or forecasts (mine, yours or anyone else’s), but are tied to your risk tolerance and long-term goals. Developing and maintaining the right long-term asset mix is by far the most important set of decisions an investor will ever make.
Never before has information about the global economy and markets been more readily available and disseminated. As a result, global markets have become highly interconnected. In turn, our reaction mechanisms are heightened, and investor time horizons have shortened dramatically — but not necessarily to our advantage. Yes, the long term is really just a series of short-term events, but it’s how we react to them that decides our ultimate fate as investors.
Asset allocation and diversification: Investors’ “free lunch”
Many investors assume that their position along the risk spectrum from conservative to aggressive is largely based on their age and time horizon. But a more important factor is risk tolerance. Also important is judging the difference between an investor’s financial risk tolerance (the ability to financially withstand volatile markets) and emotional risk tolerance — a spread that’s often quite wide and acknowledged only during tumultuous market environments.
I’ve known plenty of older, close-to-retirement investors who thrive on the risk associated with an aggressive investment stance. I’ve also known plenty of young investors, with multi-decade time horizons, who can’t stomach any losses. Too often, investors use a rearview mirror to make investing decisions, by looking at past performance as a guide to future results. A mirror is a valuable tool but only when turned on yourself to judge your own circumstances — tolerance for risk, time horizon, income needs, etc. As I’ve often said, there are very few free lunches in investing. Asset allocation, diversification, and periodic rebalancing are as close as you get.
Risk tolerance: Know what you can stomach
Clearly, over the long term, given the better performance by riskier asset classes, a more aggressive allocation has historically reaped higher rewards in terms of returns. But there is a dark side to an aggressive posture’s higher returns — the risk taken in getting there. Aggressive portfolios’ higher historical returns have had a much wider range of returns (i.e., a higher standard deviation, with greater “drawdowns” and volatility) and, most importantly, are generated only through “stick-to-it-iveness.”
Many investors have learned the hard way that their tolerance for a big loss in the short term was less than they thought. And to maintain an aggressive allocation, they generally had to rebalance in favor of the asset class(es) that generated those steep losses and away from the asset class(es) that had weathered the storm.
Conservative investors should heed the lesson as well. A conservative portfolio’s lower historical returns have come with significantly less drawdown and volatility. For some, it’s worth the lower return for the sleep-at-night benefits. But the reality is that many investors want all of the upside when markets are performing well — but none of the downside when they are not. That is highly unrealistic.
We believe that rebalancing to maintain risk-tolerance-appropriate allocations is the best way to generate healthy long-term returns. Rebalancing is often the real test — a test that is administered more often during times of increased volatility. But the practical way to think about rebalancing is that your portfolio will tell you when it’s time to trim from or add to an asset class because of the appreciation or depreciation that’s occurred in various asset classes. You don’t need to rely on anyone’s forecast of what may or may not happen. Rebalancing forces us to do what we know we’re supposed to do, which is “buy low, sell high.”
Market timing: A dangerous game
It’s enticing to try to catch the next big investment wave (up or down) and allocate assets accordingly. But there are very few time-tested tools for consistently making those decisions well. Unfortunately, rearview-mirror investing — or performance chasing, either up or down — never seems to go out of style.
Time horizons: The longer, the better
Based on several well-known studies, the length of time that individual investors hold stocks, mutual funds and exchange-traded funds (ETFs) has shrunk precipitously over the past 50 years. Back then it was common for investors to have five-to-10-year time horizons, but today they are typically well less than a year, exacerbated by the proliferation of high-frequency/algorithmic trading firms. These firms are considered price-insensitive buyers and sellers — typically trading based on momentum and purely technical factors, with time horizons measured in nanoseconds. This is decidedly not a game individual investors should try to play. Individual investors should be price-sensitive buyers and sellers. We still strongly believe that over the longer term, fundamentals will define how markets behave.
Patience and stick-to-it-iveness
Admittedly, the development of a long-term strategic asset allocation plan isn’t the hard part — it’s sticking to it that often becomes the real challenge. Adding to underperforming asset classes and trimming outperforming asset classes goes against the emotions of fear and greed that often drive investment decision making. But if we learn from our mistakes, use our brains over our hearts and look to our portfolios as rebalancing guides, we can expect a more successful investing future and maybe even get a free lunch along the way.
Lawton Retirement Plan Consultants, LLC (LRPC’s) Monday Morning Minute is crafted to provide decision-maker’s with important information about the economy, investments and corporate retirement plans in a format that allows a reader to consume the information in less than 60 seconds. As an independent, objective investment adviser, LRPC has access to many sources of research and shares the best and most relevant information with its readers each week.
Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Advisory (RIA) firm providing investment advisory, fiduciary compliance, employee education, vendor management and plan design services to retirement plan sponsors. The firm currently has contracts in place to provide consulting services on more than $400 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or email@example.com or visit the firm’s website at https://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.
Additional Important Disclosures
Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly The S&P 500® Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity, and industry group representation The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Diversification strategies do not assure a profit and do not protect against losses in declining markets.