There's Always Something To Worry About
There will always be something to worry about, but with the right portfolio design and disciplined approach, you can whether almost any storm.
By SJS Investment Services Senior Advisor Kirk Ludwig CFIP, AIF®.
When it comes to the financial markets, there’s always something to worry about. In today’s “uncertain” market, people are worried about the COVID resurgence, stock market valuations, long-term trend of inflation, the Fed’s plans on monetary and fiscal policy, potential tax law changes, and debt ceiling negotiations. Many investors become so worried about risks and uncertainty that they sell out of the market.
Yet risk is the nature of markets, and that’s a good thing! Can you imagine a stock market with nothing to worry about? It would essentially mean there would be no perceived risk for investors. What’s the expected return for investments with little or no risk?
The One-Month Treasury Bill is considered one of the lowest risk investments available in the public markets and carries an annual yield of 0.03% as of October 12, 2021.[1] In this case, the expected return for little or no perceived risk is near 0%. There’s a simple rule in investing – risk and return are related! If you want return, there must be a level of risk you’re willing to accept.
Source: Avantis Investors, Bloomberg, as of 30-Sep-2021. The US Treasury yield curve compares the yields of maturities from short-term Treasury bills (<1 year) to long-term Treasury notes and bonds (>10 years).
People dislike risk because they are worried about the uncertainty of the future. Yet from a broadly-diversified investing perspective, the greater the uncertainty, the higher the risk. Investors expect to be appropriately compensated for accepting risk. An investor who owns a One-Month Treasury Bill understands there’s very little to worry about when it comes to volatility, and agrees to give up expected return for the comfort of safety. We want stock market investors to understand that while the value of their investments can drop rapidly at times, investors tend to benefit significantly from this risk in stocks over the long-run.
For example, when COVID-19 first started spreading in the US, the S&P 500 fell roughly 34% from February 19, 2020 through March 23, 2020.[2] Even before the US reached its highest spike in COVID cases, the market started rebounding, and this year has continued to set new record highs.[2][3] As of October 12, 2021, the S&P 500 is up roughly 95% since the lows set on March 23, 2020.
Even with their knowledge of financial history, some investors are currently worried that the US stock market is overvalued. The Price / Earnings (P/E) ratio of the S&P 500 is around 25, which places this time period in the top 5 percentile of historical market valuations since 1930.[4] However, not all sectors of the US economy have equally high valuations. For example, the mega-cap growth space, driven by the FAAMG stocks, has a P/E around 39.[5] Conversely, the small value space, which is heavily weighted with financials and energy companies, has a P/E around 14.[6] As this accompanying graph demonstrates, the valuation spreads between growth and value stocks are near record highs around the world.[7]
Source: “Are Value Stocks Cheap for a Fundamental Reason?”. AQR Capital Management, 30-Aug-2021, aqr.com. Spreads are constructed using the Hypothetical AQR U.S. Large Cap, International, and Emerging Valuation Theme Models, and are adjusted to be dollar-neutral, but not necessarily beta-neutral through time. For illustrative purposes only and not representative of an actual portfolio AQR currently manages.
General market commentary doesn’t always capture the full picture of the markets. When you dig further into the details, you’ll often find a different story.
Given all of this information, we do not anticipate a major stock market correction in the short-term. But markets are unpredictable, and it’s possible a stock market correction may occur. If so, we don’t think that you should be alarmed, because stock market corrections are relatively common.[8] Since 1946, the S&P 500 has experienced a 5% drawdown every 7 months on average.[8] Similarly, 10% corrections have occurred every 22 months, and 20% corrections every 76 months (6.33 years) on average.[8] Despite all of these corrections, the S&P 500 has continued to march onward, returning 11% annually since 1946.[4]
In summary, there’s always something to worry about, but it’s rare that a well-known issue causes a major stock market correction. Most issues are well-known and analyzed by markets participants at every moment. Typically, it’s a surprise event that serves as the catalyst for a market selloff. Despite all of the surprise events of the past, global stock markets have remained resilient and have rewarded investors over the long-run.[9]
We believe that the best course of action for managing unexpected events is through controlling what you can, such as broad diversification with the appropriate balance of growth and stability in your portfolio. You can use market volatility as an opportunity to rebalance to your target asset allocation. As certain asset classes increase in value, you can look to reduce exposure, and as asset classes decline in value, you can look to add; the simple notion of selling high and buying low. There might also be an opportunity for tax loss harvesting.
By focusing on the long-term goals of your portfolio, you can reduce the temptation of making major changes based on short-term news events. There will always be something to worry about, but with the right portfolio design and disciplined approach, you can whether almost any storm.
Important Disclosure Information & Sources:
[1] “Daily Treasury Yield Curve Rates“. U.S. Department of the Treasury, 12-Oct-2021, treasury.gov.
[2] “S&P 500 (^GSPC)“. Yahoo Finance, 12-Oct-2021, finance.yahoo.com.
[3] “COVID-19 Projections”. Institute for Health Metrics and Evaluation, healthdata.org.
[4] “S&P 500”. Morningstar Direct, January 1930 - September 2021.
[5] “CRSP US Mega Cap Growth Index“. Morningstar Direct, 30-Sep-2021. The CRSP US Mega Cap Growth Index includes the largest U.S. companies, with a target of including the top 70% of investable market capitalization, ranked by various metrics to consider valuations.
[6] “CRSP US Small Cap Value Index“. Morningstar Direct, 30-Sep-2021. The CRSP US Small Cap Value Index focuses on the bottom 2% - 15% of US stocks by market capitalization, ranked by various metrics to consider valuations.
[7] “Are Value Stocks Cheap for a Fundamental Reason?“. AQR Capital Management, 30-Aug-2021, aqr.com.
[8] “Putting Pullbacks in Perspective“. Guggenheim Investments, August 2021, guggenheiminvestments.com.
[9] “Stocks for the Long Run”. Jeremy Siegel, 2014, Wharton School Press.
There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.
Statements contained in this article that are not statements of historical fact are intended to be and are forward looking statements. All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.
Indices are not available for direct investment. Index performance does not reflect the expenses associated with management of an actual portfolio. Index performance is measured in US dollars. The index performance figures assume the reinvestment of all income, including dividends and capital gains. The performance of the indices was obtained from published sources believed to be reliable but which are not warranted as to accuracy or completeness.
Hyperlinks to third-party information are provided as a convenience and we disclaim any responsibility for information, services or products found on websites or other information linked hereto.
Suggested Reading
Why Do Investors Underperform?
We want to emphasize six aspects of investor psychology - also known as cognitive biases - that tend to hurt investor performance, and what investors can do to address these biases.
By SJS Investment Services Investment Associate Bobby Adusumilli, CFA.
Over the past 40 years, advances in investment offerings and technology have provided investors with far more opportunities to invest in stocks and bonds compared to the past. From their laptops, people can now invest in markets all around the world. Mutual fund and ETF expense ratios have been decreasing, with many index mutual funds and ETFs approaching a 0.00% expense ratio.[1] Congress has created tax-advantaged accounts such as IRAs, 401(k)s, 529 plans, and HSAs to encourage people to invest while saving on taxes over time.[2] And more recently, many brokerage firms no longer charge trading commissions on stock and bond trades.[3]
Given all of these advances, you would think that investors have gotten better at earning their fair share of investment returns. However, you may be surprised to learn that most stock and bond investors in the US still significantly underperform the market averages.
For example, as of 31-Dec-2019, DALBAR found that the average equity mutual fund investor underperformed the S&P 500 (a benchmark for the US stock market) by nearly 5% annually over a 30-year span.[8] For a $100,000 initial investment, that’s a 30-year ending portfolio balance of $437,161 for the average equity mutual fund investor compared to $1,726,004 for the S&P 500.[4]
What explains this underperformance? We think that part of the explanation is that many investors trade too much, as well as pay too much in transaction fees (including bid-ask spreads), high expense ratios, and unnecessary taxes. However, we think a bigger part of the explanation relates to investor psychology. In particular, we want to emphasize six aspects of investor psychology - also known as cognitive biases - that tend to hurt investor performance, and what investors can do to address these biases.[5]
Overconfidence
Overestimating our skills or circumstances, which interferes with our ability to make good decisions. For example, when evaluating a particular investment, an investor may feel really confident that they have a much better analysis than the general market.
Loss Aversion
The tendency to be driven more strongly to avoid losses than to achieve gains. For example, even when presented with better investment opportunities, an investor may decide to keep holding a stock that has declined in value until it can be sold at a gain.
Confirmation Bias
The tendency to seek out and interpret information that confirms or strengthens our existing beliefs. For example, after making an investment in a particular stock, an investor may actively search for news and analyses that support the decision to invest, as opposed to considering other news or alternative analyses.
Recency Bias
Believing that recent events are more likely to occur than they actually are. For example, a year after a major stock market downturn, many investors still avoid investing because they believe that another major downturn is likely to happen in the short-term.
Endowment Effect
The tendency to place more value on an investment that you own compared to the price it can be purchased / sold at on the open market. For example, particularly for an inherited stock or stock in the family business, an investor may value their shares more than the current market price.
Optimism Bias
The belief that our chances of experiencing negative events are lower and our chances of experiencing positive events are higher than the averages. For example, many investors believe that if they just have good returns over the short-term, they will be much happier and better off in the future.
What Can You Do About Your Cognitive Biases?
Cognitive biases are easy to write about, but hard to actually prevent from negatively impacting our investment returns. Based on our years working with clients, we find that the below actions tend to help investors achieve better investment returns:
Define Your Circle Of Competence, And Don’t Stray Beyond That
There are many different investment styles that have helped people become wealthy over time. However, because there are so many investors competing to find the best investments, many top investors only focus on one particular style of investing that they understand really well, and don’t even consider other potential investments. This frees them to focus on what they do best, and ignore everything else.
Create Strategies And Systems That Do The Work For You
Instead of making a new decision each time you have money to invest (which is often stressful and time-consuming), you can instead create a strategy and system that automatically makes the decision for you. For example, many of our clients benefit from the below investment process:
Invest in broadly-diversified, low-cost, tax-efficient global mutual funds and ETFs.
Maximize contributions to tax-advantaged accounts, such as IRAs, 401(k)s, and HSAs.
Dollar-cost average: every time you have money to invest, immediately invest according to your pre-specified asset allocation.
Have a pre-specified and largely automated rebalancing strategy.
Cap Your Downside Risks
As investor Warren Buffett says about investing: “Rule Number 1: Never lose money. Rule Number 2: Don’t forget Rule Number 1.“ When deviating from a well-crafted and implemented investment strategy, much more can go wrong than can go right. We generally advise for investors to limit all of their niche investments to less than 10% of their overall portfolio. Additionally, we encourage investors to have an emergency fund with six months' worth of expenses, as well as all appropriate insurance coverage, in order to protect themselves in case something happens to them or their investments.
Respect The Averages, And Only Deviate From Your Plan If You Actually Have An Advantage
Many studies have found that investors who buy and hold broadly-diversified, low-cost, global index mutual funds and ETFs outperform the vast majority of investors over the long-term.[6] Investing in stocks and bonds is extremely competitive. As a result, if you don’t have a particular competitive advantage, or if you are not able to spend the necessary hours to do thorough research on a regular basis, then you probably won’t benefit from attempting to time the market or investing in niche investments.
More Money Probably Won’t Make You Much Happier
Through his research, Nobel-Prize-winning psychologist Daniel Kahneman has found that while being poor makes people miserable, for most people with a basic level of wealth, more wealth does not significantly increase day-to-day well-being.[7] Once an investor has a good investment strategy in place and reviews this strategy periodically, spending more time analyzing investments is unlikely to significantly improve investment returns or make someone happier over time.[4][6][7]
Summary
As the data shows for the majority of people, investing well over the long-term is tough.[4][6] By understanding ourselves better and creating well-thought-out & systematic investment processes, we think that investors are more likely to earn their fair share of investment returns over time.
Important Disclosure Information & Sources:
[1] “Pay Attention to Your Fund’s Expense Ratio“. Jean Folger, 27-Oct-2020, investopedia.com.
[2] “The Basics of a 401(k) Retirement Plan“. Mark Cussen, 29-Mar-2021, investopedia.com.
[3] “In the race to zero-fee broker commissions, here’s who the big winner is“. James Royal, 04-Oct-2019, bankrate.com.
[4] “2020 QAIB Report”. DALBAR, 2020, wealthwatchadvisors.com.
[5] How to Decide. Annie Duke, 2020, Portfolio / Penguin.
[6] Unconventional Success: A Fundamental Approach to Personal Investment. David Swensen, 2005, Free Press.
[7] Thinking, Fast and Slow. Daniel Kahneman, 2013, Farrar, Straus and Giroux.
There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.
Statements contained in this post that are not statements of historical fact are intended to be and are forward looking statements. Forward looking statements include expressed expectations of future events and the assumptions on which the expressed expectations are based. All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.
MarketPlus Investing® models consist of institutional quality registered investment companies. Investment values will fluctuate, and shares, when redeemed, may be worth more or less than original cost.
Advisory services are provided by SJS Investment Services, a registered investment advisor with the SEC. Registration does not imply a certain level of skill or training. SJS Investment Services does not provide legal or tax advice. Please consult your legal or tax professionals for specific advice. This material has been prepared for informational purposes only.
Certain advisors of SJS may recommend the purchase of insurance-related products. Certain advisors of SJS are licensed insurance agents with various insurance companies and may receive additional compensation for such transactions.
Indices are not available for direct investment. Their performance does not reflect the expenses associated with management of an actual portfolio.
The S&P 500 Index is a free float-adjusted market-capitalization-weighted index of 500 of the largest publicly traded companies in the United States.
Bloomberg Barclays US Aggregate Bond TR USD Index measures the performance of investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM passthroughs), ABS, and CMBS.
Inflation represented by the US Bureau of Labor Statistics Consumer Price Index All Urban Seasonally Adjusted, which is a measure of the average monthly change in the price for goods and services paid by urban consumers between any two time periods. It can also represent the buying habits of urban consumers. This particular index includes roughly 88 percent of the total population, accounting for wage earners, clerical workers, technical workers, self-employed, short-term workers, unemployed, retirees, and those not in the labor force.
Hyperlinks to third-party information are provided as a convenience and we disclaim any responsibility for information, services or products found on websites or other information linked hereto.