Ignore the Scary Headlines and Stick to Your Plan

2016 is off to a historically poor start, with the S&P 500 down 9% from its May 21 record of 2130.82 as we write this commentary. Although corrections of 10% are fairly common, below the surface, the picture looks even worse. Through January 13^th, the average stock in the index is down more than 20% from its 52-week high. This is probably why it already feels like a bear market to many investors (the common definition of a bear market is a decline of 20% or more from a recent high).

When stocks begin to fall hard after a lengthy bull market, it inevitably leads to some anxiety and soul-searching, which may trigger a need to do something about it. So it is important to remember a few things:

Bull markets last five times longer than bear markets.
Assuming that we are indeed in a bear market, and if you’re wondering how long you might feel the pain, this Forbe’s article reminds investors that since the Great Depression, bear markets last about 18 months on average with some lasting only 6 months or less. Bull markets on the other end last 97 months on average. We’re already 8 months into the current correction—the S&P 500 peaked back in May 22, 2015. If this market downturn is of the 2008 type (started in October 2007 and ended in March 2009), then we can expect it to last another 16 months. If it’s closer to the 2011’s version, it could already be over.

Importantly, patience has been historically rewarded. Some of you have been consistently invested in equities since the 1980s or 1990s, and your portfolio has benefited from your fortitude. Even with a flat 2015 and the biggest bear market since the Great Depression in from October 2007 to March 2009, for those who stayed the course over the past 10 years, the compound annual return on the U.S. stock market still exceeded 7%.

Annual change in U.S. Stock Market:

S&P 500 Total return including dividends

The Impact of a Worst-Case Scenario on Your Portfolio Is Cushioned.
Your portfolio is not invested 100% in the stock market. While stocks may be falling, you also own bonds, cash, and other less volatile investments. Bristlecone’s average portfolio is diversified across 13 different investment categories—40% of which are not equity-related—including an increasing percentage of assets that don’t fit neatly into  stock or bond categories such as preferred stocks, arbitrage funds, etc. These asset classes rarely fall simultaneously, or to the same extent. Additional cushion comes from the  equity in your home and the value of your future earnings (or if retired, pension and/or social security income).

Let’s imagine for a minute, a bear market with a loss of 40%, and that your portfolio is made up of 60% in US stocks, with the balance in US treasury bonds and cash—which historically have held their value during stock panics. Your portfolio would suffer a decline of 24%. If the market only goes down 20%, your overall portfolio would go down 12%. This can definitely be upsetting, especially viewed in dollars rather than percentages. However, if you were invested 60% in the stock market to begin with, it means that your investing time horizon is rather long (certainly long enough to allow time for the market to recover). 2009 saw some investors in their 70s sell all of their stocks, even though they were likely to live another 20+ years. A number of them missed the subsequent rebound, and as a result their portfolios are on a permanently lower growth trajectory, raising the prospect of difficult lifestyle adjustments in their senior years..

You Do Have a Plan.
Your goals for investing in the first place have not changed. At some time in the past, when you were less anxious, you agreed with our recommendation to construct your portfolio a certain way in order to reach your goals. You knew that stocks involved risk and that the returns they have traditionally delivered, above and beyond what cash and bonds do, was the potential reward for your decision.

Nothing about recent market events suggests that the fundamentals of capitalism have changed. So neither should your confidence in the long-term ownership of the pieces of the companies that make up the U.S. economy.

None of this is to dismiss the real issues that we are facing today. But there are solid reasons to adopt a tempered outlook and to believe that we will work our way through the current challenges, just as we’ve worked through serious challenges in the past. The truth is that the same boring principles that made sense last month, last year, and five years ago still make sense today, irrespective of what the market is doing.

What this means for your portfolio
To help navigate through the ups and down, it is important that we repeat the three core principles that we employ in constructing portfolios: Diversification, re-balancing and risk management:

Diversification
In prior comments, we used data from Nobel Laureate Robert Shiller, suggesting that U.S. stocks were expensive by historical standards. Shiller compares US stock prices to average earnings for the past 10 years, adjusted for inflation. By that standard, even after the drop in stocks in early January, the price-to-earnings ratio is 24x, 50% more expensive than the historical average of 16x earnings. Some people have made some valid arguments about the extent to which they are overvalued, but fundamentally, no one is seriously arguing that US stocks are cheap by historic measures.

This doesn’t mean that stock prices will collapse, but as we’ve said before, it means that our expectations for short to intermediate returns for US stocks remain lower than historical average. It does also call for caution: this is why we recommend including bonds in portfolios in order to provide greater stability as high quality bonds are much less volatile than stocks. Another option is to look at stocks in Europe, Japan, or other foreign markets that trade at lower valuation levels than comparable U.S. companies.

Re-Balancing
A key lesson from successful investing is the importance of not just starting with a portfolio that is properly allocated across investment categories, but maintaining that allocation as markets rise and fall. As a result of the strong performance by U.S. stocks over the past three years, we have reallocated funds along the way by selling US equities and reinvesting in cheaper foreign stocks, in bonds or other less volatile assets such as preferred shares or arbitrage strategies.

Otherwise, portfolios that had the right balance three years ago would be out of balance today, with an overweighting to US equities. Rebalancing out of the best performing categories avoids an overweight that can lead to greater downside risk than was built into the original portfolio.

Today, and during market declines, expect us to take advantage of categories or investments that have declined sharply in price and incrementally add to them.

Controlling Risk
We design portfolios with the goal of providing clients with the returns they need to achieve their goals, while taking the least amount of risk when looking across a full-market cycle (typically 5 to 10 years). This required rate of return is your most important benchmark. Ultimately, every client’s needs are unique, and our goal is to develop the portfolio that is right for your personal situation and your risk tolerance.

Some investors cannot handle the stress of investing in stocks, and perhaps you are counting yourself in that camp today. But try to give this more time, and consider the alternatives: there is no investment that can deliver the kind of returns that stocks can, without their own risks and accompanying anxiety. An alternative is to save a lot more in safer investments like cash or certain bonds. Most people don’t have enough income to do that easily, so settling for lower returns will mean a combination of working longer and living modestly.

If we have not talked recently, and you feel the need to do so before your next scheduled review, please do not hesitate to reach out.  We welcome the opportunity to review any updates to your financial circumstances, and we want you to be comfortable with the portfolio we’ve designed to meet your long term goals.