When your investments are going up, it’s easy to picture how you’ll react when they go down because you don’t really feel it. Not at that moment. In fact, you’re feeling pretty good, what with your investments going up and all. It sure is different when the actual down period hits, though, isn’t it? We are ten months into this current stock market downturn and a traditional diversified portfolio of half stocks and half bonds is down roughly -18%. Our corresponding portfolios at Cadence are down a fair bit less than that, but more on that later. Ten months into the 2007-2009 crash and this same portfolio was down around -8%, because though stocks were down about the same after the first ten months as they are today, bonds were down a lot less. It’s pretty natural, then, to wonder whether or not we should make some kind of strategy change.
Strategy changes at this point in a downturn usually center around getting more conservative to lose less if the downturn continues. I am happy to say that this move is pretty easy to pull off successfully, provided of course you can tell me when the various asset classes will start their recoveries and how aggressively they will do so. Unfortunately, without that information, getting more conservative now, or trying something else to hedge your bets, is far more likely to lock in losses and ultimately cost you more than staying the course.
What are the most common moves investors make when trying to protect themselves further during a downturn?
Going to Cash: The most obvious, and used, strategy when it comes to getting more conservative is to sell assets and keep them in cash until the dust clears. The only way this works is if you get back into whatever you sold at a price lower than when you first sold it. It seems easy to do, but very, very few people are actually able to do that. Because asset prices zig zag on the way up the way they did on the way down, the vast majority of people do not have the confidence to get back into their investments until they believe there is no more downside possible, and that is almost always at a price that is higher than when they sold out of their investments. If any investment you sold loses another -10%, will you have the confidence to buy it back at that point, or will you fear it will continue going even lower and hold off? Most people just end up locking in losses when they go to cash; the current inflationary environment only compounds that. With inflation as high as it is right now, your cash investments will be losing real value to the tune of -8% per year until inflation comes down a fair amount.
If your main motivation for going to cash is to be protective as opposed to considering the current downturn as an opportunity, then the likelihood of your feeling comfortable enough to reinvest in what you sold at the right time is extremely small. If you’re feeling uneasy about the stock and bond markets when they’re down -15 to -20%, don’t think for a moment you’ll suddenly feel comfortable investing when they’re down more than that. That is why most people who go to cash for protection during a downturn lose.
Going to Bonds: Instead of selling stocks and/or bonds and going to cash, some people opt to sell stocks and increase their bond allocations, figuring their stock investments will lose more than bond investments would and that bonds would be a good place to hide while waiting for the stock market to bottom out. Like the going to cash strategy, this only works if you buy back into stocks later on at a price lower than where you sold them, but this move has the added complexity of also needing your bond investments to hold their value relative to stocks. With cash, you knew what you were getting: pretty much zero growth, but at least it can’t go down in price. With bonds, you run the risk they’ll go down while stocks go up, which is the opposite of what you want.
One aspect specific to our current downturn is that some bond categories are down just as much as stocks are. How much protection are you getting by selling out of the S&P 500 index, down around -19% on the year, and putting that money into high grade corporate bonds, which are down around -22% on the year? One seemingly more sensible option is to sell out of stock and/or bond positions and put those assets into short-term Treasury Bills yielding around 4% on an annualized basis. But even there, that only works if what you’re selling doesn’t go up more than that 4% after you make the move. Who is willing to bet high grade corporate bonds can’t go up by more than 4% over the next six to twelve months? Again, without that crystal ball telling us when things will bottom out and how quickly they will rebound, you are left having to wait until you feel comfortable switching back out of bonds, and that is almost always at a point that locks in losses.
Betting Against the Market: There are other moves an investor can make to protect their portfolios from further loss that are less mainstream and require a fair bit of experience. Buying protective puts and shorting the stock market are two such moves, though both require varying degrees of up-front expenses and carry asymmetric levels of risk, especially in the case of shorting the market. Once you venture away from the mainstream to get your protection, the more you may be ratcheting up the risks you’ve been trying to protect yourself from, which is why they’re more complicated than just going to cash or loading up on bonds. Buying protective puts that do not pay out just reduces your potential portfolio recovery, and having your market short move against you can carry even worse financial penalties. For investors who are nervous about their portfolio losses and looking for ways to protect themselves going forward, adding elements of increased risk at that point does not really accomplish the goal of reducing risk; it just introduces newer, additional risks.
It is very difficult to time these kinds of market moves because you have to get both directions right: you have to both get out AND back in at good times, and most fearful investors that change strategy mid-crash wait too long to get out, and too long to get back in. People who went to cash for a couple years in the fall of 2008 locked in permanent portfolio losses as high as -20%. It’s easy to look back now and say had you done that, you would have gotten out and back in at good times, but it is never as obvious in the moment as it seems in hindsight. It is far better to allocate appropriately before a crash even starts and reduce your losses that way than to try and make a strategy change midway through.
So, where does that leave us?
We Cadence advisors have been concerned about equity valuations and the moves that have been made to keep the economy growing for some time now. As a result, we have tended to recommend more conservative allocations for our clients, as well as incorporating non-traditional assets into those allocations to be both more protective as well as selectively more opportunistic. Our use of alternative investments, like gold and managed futures to name a couple, has helped reduce our exposure to stocks and bonds during their difficult year, and has helped reduce portfolio losses. Our allocation toward energy helped us find a market segment that was actually positive on the year, further reducing portfolio losses. While traditional 50/50 stock/bond portfolios are down close to -20% on the year, our corresponding portfolios are down around half of that, give or take a couple percent.
Were we to try to get even more protective with our portfolios from here, we wouldn’t be left with options that actually guarantee we would reduce our chances for loss. Going to cash and allocating even more to bonds may feel safer at the moment because they do not typically lose as much value as quickly as stocks can, though many bond categories this year are down just as much as stocks, but over the longer term you still have to get back into the aggressive investments at the right time to make the move pay off more than trusting your initial strategy. Buying protective puts and shorting the market are additional options that carry their own costs and risks, and both have to be timed right to pay off, just like going to cash.
Having portfolios based on asset valuations and tolerance for loss, as we have been doing for years, does not shield us from all losses, unfortunately, but the assets we own that have lost value to this point in the year have as much potential to rebound quickly as anything we may be tempted to shift into to make up portfolio losses quicker. We will shift portfolios into more protective allocations, as we have done before this year, when valuations and systemic risks call for it. Likewise, we will shift portfolios into more aggressive, opportunistic allocations when valuations and market conditions allow in the future. As a result, the moves investors may feel tempted to make in a moment like this to get more “protective” have already been made and have already reduced losses. It’s never fun to see portfolio losses, but these losses do not mean a strategy based on asset valuations isn’t working. Trust the process.
Editor’s Note: This article was originally published in the November 2022 edition of our “Cadence Clips” newsletter.
This blog is provided for informational purposes and is not to be considered investment advice or a solicitation to buy or sell securities. Cadence Wealth Management, LLC, a registered investment advisor, may only provide advice after entering into an advisory agreement and obtaining all relevant information from a client. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
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