The large declines in global stock and bond markets reflect a lack of confidence in the financial system that has its roots in failed US home mortgages. Credit has become extremely difficult to obtain as banks are unable to sell non-performing assets, shun new business loans and hoard cash. An unprecedented infusion of capital from government has had little effect so far in breaking the logjam. However, much of the government’s actions are yet to be fully funded and implemented. So it is still too early to tell what ultimate benefit these bailout packages will have.
Wall Street’s woes have affected Main Street as individual watch their home values decline and retirement accounts shrivel. What should you do about it, and how is Portfolio Solutions managing client accounts’ through this crisis? The short answers are that you should not make an emotional decisions based on current event, and we are continuing manage portfolios with an even temper and the steadfast discipline that you expect. In rough seas, we stay the course!
The Market Drop in Perspective
America has gone through several financial crises over the past century. Granted, this is a bigger than most. To put this in perspective, let’s look back just over the past 35 years at other credit crises and see how the stock market was affected:
1973 – 1974 S&P 500 down 38% US goes off gold standard and dollar plunges
1980 – 1982 S&P 500 down 27% Mortgages hit 20% as inflation reaches 15%
1987 – 1988 S&P 500 down 33% The Dow falls 21% on Black Monday in Oct.
1990 – 1991 S&P 500 down 19% Oil prices skyrocket as Iraq invades Kuwait
1998 – 1999 S&P 500 down 18% Credit markets freeze on Russian loan defaults
2000 – 2002 S&P 500 down 49% Technology stocks crash then 9/11 attacks
The S&P 500 is down 42% from its high point one year ago. The decline is large, but not as sever as the 2000 to 2002 bear market. It just seems larger this time because the decline happened over one year rather than three. For comfort, recall that stocks bounced back more than 30% in 2003. We do not claim to have knowledge of the future, but history tells us that after a steep decline the market often turns up very quickly and without a definitive reason. You do not want to be out of stocks when this occurs.
Cash Flows Continue Unchanged
People in retirement who are taking cash from their portfolios can have solace in that fact that the income coming from their investments has not gone down even though prices have. Stocks and bonds pay dividends and interest. Currently, the S&P 500 is yielding over 3% in dividend income and investment grade bonds are yielding 5% in interest. When your annual expenses can be covered by the cash flows from dividends, interest and outside income it makes it easier to ride out a bear market.
Should you change your strategy?
We have strived to articulate our belief that investors should not become emotional about their portfolios and change their asset allocation. Prices can be a roller-coaster ride in the short-term, however in the long-term, markets tend provide returns in balance with the risks. Changing your asset allocation is a major decision and can be compared to changing careers. There are several good reasons to change your asset allocation along life’s journey. Those changes require deep thinking and an even handed judgment, and should not be made in a time of duress. Below are three reasons we believe a person has a legitimate reason to make an asset allocation change:
1) Your target retirement goal is well within reach.
2) You realize that you will not need all your money during your lifetime.
3) You have realized that your tolerance for risk is not as high as you thought.
Consider a reduction to risk when you are within reach of your financial goal. That is the time to take your foot off the gas pedal and move into the middle lane. For example, assume you wish to retire in 3 years with $2,000,000 in retirement savings. If you already have $1,800,000 in savings, the rate of return you need to achieve your goal doesn’t require a high risk allocation. It may be time to permanently lower your equity exposure because you no longer need to take as much risk.
Second, a change to your allocation may be appropriate if you realize that you will not outlive your money. In that case, you are investing part of your portfolio for yourself and another part for the needs of those who will inherent your wealth. Your overall asset allocation should reflect the needs of both parties. Assume you have $2,000,000 in retirement savings. Your needs may be covered by $1,000,000 of amount and is allocated to 30 percent stock and 70 percent bond. The second $1,000,000 will be passed on to your heirs. Since heirs tend to be younger, they can be more aggressive. That portion receives a 70 percent stock and 30 percent bond allocation. Put together, an appropriate allocation for your portfolio is 50 percent stock and 50 percent bonds.
The last reason to change an allocation is because you have taken on more risk than you can handle. If you are not sleeping at night because you are worried sick about your portfolio, and you are on the verge of making an emotional decision to SELL IT ALL! then reduce your equity position by 10 percent. Give that some time. If you are still having emotional reactions, reduce by another 10 percent. The portfolio has an appropriate level of risk when you are able to think clearly. Once you find this level of risk, stay there, even when the market recovers.
What changes will Portfolio Solutions make?
We continue to man the helm and keep our clients’ ship on a steady course. That means rebalancing when the stock and bond allocation is off target by a meaningful amount. Simply put, we continue to sell a small portion of the bond portfolio to buy more stock index funds. That is prudent action that for any level headed long-term investor. We do not know when the market will stabilize or at what point, but we do know there are many excellent companies selling at very low prices and rebalancing takes advantage of that opportunity.
Times may be uncertain, but this crisis is not the end of free enterprise or the capital markets that our great nation was built on. In fact, the US dollar has strengthened through the crisis, and that means we are expected to emerge as a stronger nation because we have faced this challenge and dealt with it. Good luck and thank you for your confidence.
[Written October 12, 2008]