Olympic Training for Your Portfolio

I published this post for our company’s newsletter a couple weeks ago.  While the Olympics are over (and with disappointing overall results), these training tips for your portfolio are timeless.  Enjoy!

After building an ice rink in my backyard this winter, my daughter has taken an interest in ice skating.  When she’s not skating circles around me, we have enjoyed watching the Olympics together from the warmth of our family room.  She has enjoyed watching Highland Park native Jason Brown’s rendition of Riverdance and the U.S. figure skating team.  Meanwhile, I’m looking forward to more snowboard tricks and hockey.  No matter the sport every athlete needs to prepare, practice, and be patient to do their best.

These important traits also lead to success as an investor.  Fortunately, Mr. Market has provided smooth sailing for stock investors for the past two years.  It has been the equivalent to eating donuts and drinking pop all day, but still being able to maintain an Olympian’s physique.  The downside to this easy ride is investors can become complacent and overreact to market swings when they return, and they will.  Donuts and pop will catch up to you, eventually.

To help you PREPARE for the inevitable correction (what is that anyways?), I will share some information about the current bull market and what a pullback could mean to your portfolio.  The more prepared you are for a correction or bear market, the easier it will be for you to Practice your investment strategy, and be Patient for your plan to work.

Prepare

First, let’s start out with the basics.  A correction is defined as a 10% stock market decline following a previous 10% increase.  The S&P 500 (large U.S. stocks) reached an all-time high of 1,848 on January 15th.  A 15% decline would put the S&P at 1,570.  So even after a mild correction, the market would still be almost 2.5 times higher than the 2008-09 Financial Crisis bottom and equal to the 2007 pre-crisis high.  The idea of a correction does not sound as dramatic as the talking heads on CNBC and the internet make it, does it?

Remember those donuts and pop?  As of January 30th, Bespoke Investment Group reports that the market has gone over 835 days (27 months) and increased 68% since the last correction.  Do you remember when Standard & Poor’s  downgraded the U.S. debt in 2011?  It has been that long without a correction.  The market averages a correction every year, but it is approaching 2.5 years without one.  During this time, the stock market has climbed the “wall of worry” – hurdling debt limits, sequester, tax increases, stagnant employment, the Affordable Care Act, and QE tapering to name a few.  Are there any more hurdles ahead of us?  Government debt and high under/unemployment are the two nagging obstacles to the market and economy, but these are not an imminent concern.

The recent period without a correction is also the fifth longest run since 1928!  The only longer periods ended in 2007, 1997, 1987, and 1966.  Unfortunately, the subsequent periods after these corrections did not bode well for future returns.  So a correction sooner than later may be good news!  The table below shows the months before each correction, year of the correction, price of the S&P 500 before the correction, and the years it took for the market to permanently recover and exceed the pre-correction price.  The most important observation to me is despite corrections, wars, inflations, and bubbles, stocks have doubled every 10 years on average!

Months Before Correction

Correction Year

S&P Price Pre-Correction

Years to Pass Correction High

55

2007

1,565

6

84

1997

983

12

38

1987

336

3

35

1966

94

12

Price information using S&P 500 Index from Yahoo! Finance

The Years to Pass Correction High is also attention grabbing.  It took a dozen years to permanently exceed the highs from the 1966 and 1997 pre-correction levels.  The 1966 period preceded the Nifty Fifty stock market bubble, oil crisis, and rising inflation of the 1970’s – a difficult time to recover.  The double bubble of Dot-com and Housing caused the market to take so long to finally exceed 1997 levels.  While the 1987 run-up ended with a single day decline of over 20% known as Black Monday, the market recovered quickly and actually had a positive return for the year.  It is too early to say the market has permanently moved above the 2007 high, but the S&P 500 did reach that level in early 2013.

The fact that we are overdue for a correction does not mean it is imminent and a bear market (price decline of 20% or more) will ensue.  As you can see in the table above, many bull markets have continued to run without interruption.  When the correction does happen, it may not even result in a big decline.  According to blogger Barry Ritholz, there have been 27 corrections since 1945 and only 12 have turned into a bear market.    Perhaps the only thing worse than going through a correction or bear market is sitting in cash for another two to four years while stocks prices continue to climb like they did in 1997.

Now that you are prepared and knowledgeable about corrections, what should an investor do with their portfolio?

Practice

Simply owning a diversified portfolio with a fixed allocation to stocks and bonds will put you in a better position than most.  Investors who are able to continue saving during a correction benefit from picking up more shares for their money.  If you are not able to save, rebalance!  Selling what has done well and buying what is on sale can improve your portfolio returns over time.

Following a risk managed investment strategy may help avoid the big portfolio declines and provide an investor with more peace of mind by systematically avoiding investments that are declining in value.  This type of approach will not track “the market” like a traditionally diversified portfolio, but it may be a preferred approach for clients looking for more stability from their investments.

For either approach, using low-cost index funds and ETFs are our preferred investments – the equipment, like ice skates.  After you get the equipment, are you going to focus on managing risk (figure skating) or rebalancing (speed skating)?  Both sports use skates, but in different ways.  Finally, having the equipment and attempting the sport is worthless unless you have a clear idea of what you want to achieve.  From an investment perspective, some common goals include a comfortable retirement, college education, legacy for your family and charities, etc. Practice is the purposeful combination of objectives, strategy, and tools.

Patience

Whatever investment approach you use, it will not work as you expect every time.  It can take years for your preparation and practice to pay off.  For example, countless studies have shown that rebalancing improves portfolio returns over time.  However, you may buy an investment that is “on sale”, but the market may discount it further until the price finally recovers.  This characteristic can make it difficult for investors who want to mitigate losses in their portfolio.  On the other hand, a risk managed approach may work better at mitigating the losses, but can miss the sharp and unexpected positive moves in the market.  Patience is required for any successful investment strategy.

While you don’t need to spend the same amount of time training to be an Olympian, any investor will benefit from time spent preparing, practicing, and being patient with their portfolio.

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