The last 75 days have been a unique time not just across global capital markets, but around the world. COVID-19 has upended families and businesses, disrupting nearly all of our standard routines for the foreseeable future. For those that have been in tune with their investment portfolios, or perhaps are students of the market, the activity we have seen has been nearly as unique as the pandemic that has caused its fluctuations. Market’s have seen some of their largest declines and rises in decades, all within an 8-10 week span. During this period, the broader U.S. market (and most global markets) officially entered bear-market territory after a historic decade-long bull run. Consider the following:
In March of 2020, the S&P 500 saw three of its nine worst single days of performance on record since 1950.
Two of those three days in the above point were in the top three of the single worst days since 1950.
March of 2020 was also the third-worst month on record since 1950.
From it’s peak in mid-February 2020, to the most recent trough in late March 2020, the S&P had decreased over 35%.
Yet still, for the month ending April 30, 2020, the S&P 500 was only roughly 15% off of it’s all-time high value from mid February, as it recovered a sizable portion of March’s decline. What does this tell us about what to expect next? Absolutely nothing for certain in the immediate future. If anything, it likely suggests that broader markets may pull down a bit in the near-term after having such a hard bounce upwards from it’s recent trough despite discouraging economic realities. However, if we can stretch our timeline out a little longer, and take the long view, there are reasons to be encouraged.
We often say, history doesn’t necessarily repeat itself, but it often rhymes. This is absolutely true when it comes to the history of capital markets. The cause of any given market sell-off is unique in its causation and reason for occurring, yet the reaction of the market from a behavioral perspective is always highly similar. We saw this quite clearly in March as asset prices decreased across the board, with equities and bond prices falling in tandem - a telltale sign of a market panic as investors fled to cash. Now much of this was for good reason - a global pandemic emerges that shuts down global economies? It makes sense that those who may have a need for near-term liquidity would scramble to cash, rather than face the uncertain prospects of the markets. At the same time, we’d argue they should have never been allocated in that nature to begin with if they’d need to scramble to cash during a downturn (an entirely separate conversation). The reason a panic occurs - as it has repeatedly over time - is because it feels different and uncertain. Yet over time, capital markets recover and investors are rewarded if they assume appropriate, diversified risk.
Our philosophy is to take a complete wealth management approach centered around planning and risk management, to construct an intentional and diversified portfolio.
A Thought exercise
Consider the following scenario - you are an investor with a well-diversified portfolio of 70% higher risk assets and 30% lower risk assets. Assuming this portfolio has been constructed in conjunction with a real financial plan to determine your tolerable risk-return profile needed to support your financial plan. If markets fall and the higher risk side of your portfolio falls by 10% to make up only 60% of your allocation - what do you do? There are four obvious options:
You can go to cash to avoid any further pain and decrease further risk of immediate loss.
You can do nothing and take a purely passive approach.
You can reassess and alter your investment allocation and risk-return combination.
You can rebalance your portfolio in accordance with your original portfolio design.
The correct choice depends on you as an individual and what you need from your portfolio. Assuming no significant changes to a financial plan, we would likely recommend option 4.
Option 1 creates a difficult situation for an investor - not only will their cash yield them essentially zero-nominal return, and actually a negative return after inflation, it has triggered the difficult task of not just selling at possibly a market low, but also needing to predict when the right time to re-enter would be. Consider the last 2 months - if an investor sold in the middle of March 2020, they would have just missed the most recent rebound in global equity markets. Now, global equity markets may decrease going forward given the vast economic uncertainty, but still, markets would not only need to retest the lows from March, but the investor would also need to have the confidence to then reinvest at a level at which they previously had already sold-out - all while sitting idly in cash in the meantime.
Option 2 and Option 3 may be viable options for some, and is likely better than Option 1, but may still not be the recommended course of action for most. If the value of a portfolio has fallen during a market downturn, the market has naturally already de-risked you beyond your risk tolerance profile. If anything it may be an opportunity for tactful tax loss harvesting and rebalancing into depressed asset classes at lower valuations to bring your investment targets back in alignment with the original portfolio design.
Option 4 properly re-risks investors and ensures they maintain diversification benefits that add up over time.
diversification benefits - winning while losing
Over any given period of time, having a diversified portfolio like in Option 4 above, can feel frustrating. You rarely will ever see increases as large as the overall market, and when the market goes down any meaningful amount there is a high likelihood that a diversified portfolio will decrease in value as well. This begs the question, why invest in such a manner then? The charts below help articulate the benefits of diversification over time.
Source: JPMorgan Asset Management, Guide to the Markets, April 30, 2020.
This first chart above from JP Morgan Asset Management displays the relative performance of various asset classes for each year since 2005, as well as 2020 year-to-date and annual return/volatility figures for the entire period since 2005. Over time, no single strategy or asset class performed better than any other each and every year. However having a proper blend of equity factors in an allocation produced reliable results and minimized volatility. You will see that the blended asset allocation still returned 6.6% annualized returns over the entire period, while reducing the volatility risk along the way, as it was always somewhere in the middle, but over the entire time period had the third least volatility behind cash and fixed income.
If we stretch this out a few years further back to the year 2000 we can see the benefits are even more pronounced. The chart below from BlackRock displays relative performance of a 100% S&P 500 portfolio vs. a Diversified Portfolio consisting of roughly 60% equities and 40% bonds over various periods of time from the last 20 years (through March 31, 2020).
Source: BlackRock, Student of the Market, April 2020
Our biggest takeaway from the chart above is that everything is relative. We are always comparing performance relative to something else, and for many U.S. investors they compare themselves to the S&P 500 (incorrectly so in many cases). As BlackRock wisely points out, in alternating descending sequences, the diversified investor may have the following emotions “I lost money”, “I didn’t make as much”, “I lost money”, “I didn’t make as much”, “I’ve lost money”. Yet, in the end, the diversified portfolio has still provided a higher total return, while assuming much less risk.
So what do markets hold next for investors? It would be reasonable to assume that there could be turbulent times ahead given the significant economic headwinds around the globe due to COVID-19. At current valuations, a case can be made that future expected returns may be limited for some time unless the underlying economy improves. Bond yields are already at historic lows, and equities are already generally trading above their historical valuations. As such, a reasonable decline in the coming weeks and months is not out of the question. Now, more than ever, having exposure to various types of asset classes, and sub-asset classes and styles, in a portfolio is key to adding additional dimensions of returns and gaining diversification benefits while mitigating risk.
So while the market remains uncertain moving forward as it always is, we are still confident that the tenets and principles of sound portfolio management - including thoughtful and deep diversification - should hold-up over time. Remember: In the long run - Diversification wins, even when it feels like losing.
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