The basic message of this post is to stay calm, develop a plan for long-term investing, and diversify your investments in accordance with a long-term financial plan.
The outbreak of a novel virus and fears of its global spread triggered one of the largest drops in the stock market in history at the end of February. While this is disconcerting to say the least, it reminds us that we need to plan our portfolios to be diversified so they are less volatile in good times and bad. While this won’t guarantee against loss, a diversified asset allocation positions a portfolio by being invested in a variety of asset classes that may lose less during a correction and may be the winners during a recovery. It makes sense to have a financial plan that includes a game plan that helps in case of a market recession. According to the National Bureau of Economic Research, the great recession began in December of 2007, and the S&P 500 fell 777.68 points or down about 38.5% in 2008. While timing the drop and getting back into the market is tempting, it is exceedingly difficult to time the market due to the unpredictable growth spurts that one is likely to miss out on. If one was in an S&P index fund, despite the losses, new highs began again in December of 2012. A diversified portfolio could smooth these wild springs and not only keep your investment goals on track, but also provide some measure of peace of mind.
Peter Lynch, the famous investor who managed the Magellan Fund at Fidelity Investments from 1977 to 1990, once said that investing is about time in the market, not timing the market. He also noted that “far more money has been lost by investor trying to anticipate corrections, than lost in the corrections themselves.” The wisdom of many successful investors is to be patient, don’t try to time the market, and invest according to a financial plan that diversifies your portfolio according to your specific goals, needs, and priorities. Another good idea is to have an emergency fund of liquid investments or savings that can cover 3-6 months of living expenses, so you don’t have to sell investments during a downturn.
How does one diversify and create an appropriate asset allocation? This is where working with a financial advisor can help. At HFS, we can help you determine an asset allocation for your various goals and provide an investment policy statement that will guide your investment strategies into the future.
There are many ways to categorize investments. You may have heard of the 60/40 approach with 60% of investments in equities/stocks and 40% in bonds/fixed income. This is one way to do it, though not generally how we approach asset allocation at HFS, but it is useful for describing diversification and asset allocation. Within the world of stocks, we can categorize stocks into large-cap, mid-cap, small-cap, mega-cap (for those new companies with close to a Trillion-dollar evaluations!). Then there are the types of stocks, are they growth stocks, value stocks, or blended stocks? Where are the companies located, and where do they do most of their business? Are the companies based inside or outside the U.S.? If they are international, are they in emerging or developed markets? What sector of the economy are they in? Are they financials, technology, consumer cyclical, utilities, industrials, etc.? While there are many choices, an asset-allocation model helps refine the choices and what proportion of your portfolio should be allocated to a particular type of equity.
In the fixed-income portion of a portfolio, are bonds tax-free municipal bonds, corporate bonds, federal government bonds, sovereign foreign government bonds? Do you buy individual bonds or bond funds and ETFs? Are they for ultra-short term, short term, intermediate, or long-term bonds? With interest rates so low, alternatives to bonds may have a place in your portfolio. There are substitutes for bonds that provide stability to portfolios by providing income and low correlations to the stock market. Annuities may have a place. What about gold? Or what about CDs and cash in the bank? With a financial plan, these choices begin to make sense as potential components of an asset allocation model.
The simple fact is that each of these categories are asset classes and every year the performance of each asset category can be compared with other asset classes. Guess what? Each year one asset class out performs the others, and it is almost never predictable. So, don’t simply chase the latest growth stock or go all-in on a particular sector. While active investing can be very rewarding, it should be done in the context of an asset allocation model that takes into consideration your specific risk tolerance, capacity for risk, time-horizon, and other characteristics.
To learn more about diversification, I like the tables available here: Legg Mason Equity and Fixed Income Class Returns. If you would like to discuss your financial plan, please contact us for a free consultation!