Ever since the financial crisis, we have been fed a constant drip of bearish market predictions calling for the next precipitous market drop. After the precipitous drop that the S&P 500 index suffered in the 4th quarter of 2018, the frequency of doomsday predictions has ticked higher. Before making any rash decisions with our investment portfolios, we must remember that the media is concerned about getting “clicks” and not maximizing the long-term returns of your investment portfolio. Remember to Tune Out the Noise.
Now that the market has corrected substantially, with the S&P reaching a peak-to-trough drop of 20% on an intraday basis, what is an investor to do? Is it finally time for a recession and substantial market drop, or is this just another correction that investors should buy? Should you opportunistically increase your exposure to equities or run to the safety of cash? The answer to those questions is not a simple yes or no, but it depends. It is also not a binary decision that involves selling all of your equities and going purely to cash.
Before we dive into some of the items that you should consider, let us establish that everyone’s risk tolerance, goals, time horizon, and liquidity needs are different. This means that two people can reach two different conclusions as to the appropriate course of action in a given market environment. Also, everyone should work with a reputable investment advisor to construct an investment plan that incorporates all of the items mentioned above. Only after having a plan in place, should you proceed with any meaningful investments.
How does your current asset allocation line up with your target?
If you were lucky enough to enter the 4th quarter of 2018 underweight equities, this is a great time to move closer to a neutral position. Prices may have further to fall, but with cheaper valuations you are likely to be rewarded in the long run. Ideally, we would wait until the bottom has been reached, but timing the market perfectly is extremely difficult and often a losing strategy. If the economy continues to grow, equities should perform well after the depth of the correction in late 2018.
For those who are overweight equities relative to long-term targets, the January rally has given you the ability to trim cyclically sensitive positions or any individual positions that you do not feel comfortable holding for a few years. It does not feel good to sell after prices have dropped, but trimming exposure back to your long-term target may help you stay the course in the event that prices fall further. The biggest risk to your long-term investment performance is the failure to stay invested during periods of markets stress.
Investing is complicated…Contact us for help determining the right long-term asset allocation for you.
Does your risk tolerance need to be updated?
Ironically, investors’ risk appetite tends to be highest when prices are near their peak and lowest when markets are at their nadir. This is because we tend to extrapolate recent performance into the future. If the market has recently gone up, we feel that it will continue to do so. Furthermore, stories of successful investments amongst our peers evoke our own greed and promote excessive risk taking. The fight or flight response served us well in the days of the hunter-gatherer, but it leads to irrational and harmful behavior when investing.
Take a moment to consider how you felt during the recent correction. Could you have stuck with your portfolio if the market fell another 20%? If not, maybe your asset allocation is too aggressive for your risk tolerance. Alternatively, if you took the correction in stride and were looking to “buy the dip”, maybe you are taking too little risk in your portfolio. Contact us to conduct a review of your risk tolerance.
We cannot stress the importance of conducting a personal risk assessment before constructing your investment portfolio enough, because Risk Matters!. The best way to achieve long-term investing success is to put together an investment plan that you can tolerate in all market environments, good and bad, and programmatically rebalance as your asset allocation drifts away from the target.
What is your time horizon?
Before making any investment decisions, make sure that you have an emergency fund large enough to cover 3-9 months of living expenses. Your unique situation will determine whether 3 or 9 months is appropriate. A sole breadwinner with a family to support will require a larger emergency fund than a 24-year-old, single individual with strong employment prospects. These funds should be held in cash or cash-like investments that are readily available.
Also, if you have any large financial goals or obligations in the next few years, those funds should also be earmarked for lower risk investments. For example, if you plan on purchasing a home in the next two years, the down payment funds should not be invested in illiquid or risky assets. Only after setting aside enough funds for these items should you consider buying risky investments.
Summing it all up…
In conclusion, the market correction at the end of 2018 provides us with a fantastic opportunity to reassess our investment strategy. While valuations have come down from their lofty levels, the correction was justified as it was sparked by concerns about the economy. Take a moment to consider your current investment plan and take this opportunity to correct any weaknesses that may exist. In the long-run, this will likely be another speed bump, so stick with your plan and do not make any dramatic decisions without first talking to your investment advisor.