This is both an exhilarating and nervous time for investors. They are excited about the record-breaking market performance. Since September 2011, the gains have been relatively steady without a 10% pullback. However, this is twice as long as usual. Many investment strategists expect the “shoe to drop” on a market downturn. Should we sell now to lock in gains, or hang in for the long haul?
A 10% pullback does not necessarily mean that the market is in trouble. In fact, it indicates a healthy financial market. If the market only went up and never went down, we would probably not receive the higher returns associated with the market because we would be taking no risk. We don’t know what will trigger the next pullback – it could be a global conflict, or it could simply be hedge fund managers cashing in some of their holdings to lock in short-term gains.
Benefits of a Globally-Diversified Portfolio
There is one important distinction to keep in mind — when money managers forecast a 10% pullback, they are generally talking about major indices like the Dow Jones Industrial Average (DJIA). However, the DJIA reports on only 30 companies, all of which fall into one asset class (large company growth). It also contains no bonds.
This is very different from the globally-diversified portfolio that many Certified Financial Planners™ would recommend. A diversified account could hold over 9,000 different company stocks, represent 15 asset classes, and have a significant proportion of bonds. Because it is just the opposite of “putting all your eggs into one basket,” this strategy helps to remove some of the volatility of the market. The inclusion of bonds gives important downside protection because bond values typically go up when stocks go down.
What this means bottom line is that if the DJIA goes down 10%, a globally diversified portfolio will go down much less. Then, when the market recovers from the pullback, a diversified approach can bounce back much quicker because it didn’t go down much in the first place.
It may be counter-intuitive, but periodic pullbacks in the market can enhance long-term returns. In order to have good performance in an investment, you want to both buy low and sell high. Selling high happens when we rebalance our clients’ accounts quarterly. Usually in a three-month period, a few asset classes will do well and jump up in value. At the end of the quarter, we sell some of these high-flyers in order to lock in gains. However, to buy really low we need pullbacks from time to time in order to scoop up stocks at a bargain.
Benefits of Investing for the Long Term
Many hedge fund managers have been burned by the market in the last couple of years because they made large bets on short-term returns. Some hedge fund managers bet on interest rates going up sharply, which did not happen. They also bet on strong short-term growth in Japan and in emerging markets (like China, India and Russia), which also did not materialize. Short-term trends are apt to be remarkably unpredictable.
By comparison, average investors like you and me look for long-term market performance. Fortunately, long-term performance is much more reliable than short-term trends. An investment strategy like Modern Portfolio Theory gained its popularity and success precisely because it provided more consistent returns and offered more downside protection for long-term investors.
An important benefit of having a long-term view is that the speed advantage of high-frequency traders becomes largely irrelevant. They use high-speed fiber optic cables that feed directly into their computers so they can make trades milliseconds ahead of other investors. This gives them additional tiny gains on thousands of trades per day, but this advantage comes mostly out of the pockets of day traders who try to compete against them. Long-term investors build value over a three- to 25-year time horizon, and the milliseconds have little impact.
When the Shoe Drops, Don’t Run
Down markets are a normal part of the investment process. Since 1926 we have seen down markets 27% of the time.¹ Another downturn will happen again. When that happens, you are more likely to be done in by hasty, emotional decisions than by the performance of your investments. When the shoe drops, the best course of action may be to stick to your long-term plan.
¹ There were 24 down calendar years out of the 88 total calendar years tracked by the S&P 500.
The opinions expressed above are solely those of Kondo Wealth Advisors, LLC, (626-449-7783 [email protected]), a Registered Investment Advisor in the state of California. Neither Kondo Wealth Advisors, LLC nor its representatives provide legal, tax or accounting advice.