A year ago, this week the S&P 500 index was hovering around 2,400. This index tracks the largest and most successful companies in America. After achieving an all-time high of 3,300 in February 2020, this index quickly contracted by 30 percent in the span of 30 days last March. This was by far the most violent and swift contraction on record. The reason for this was likely the uncertainty surrounding a new virus quickly spreading across the globe.
Today, the S&P 500 index is around 3,900. Think about that for a moment. 3,300, then 2,400 and now 3,900. So, what did you do (or not) with regards to your investments last year? Liquidate to cash, purchase fixed income, stop contributing to your investments, or purchase more? It’s hard not to react when toilet paper became more coveted then a seven-figure account balance. What lessons may we learn from this and how may it prepare you for the next inevitable market contraction?
It’s important to recognize markets contract and expand overtime often without reason or explanation. Attempting to make a prediction on what’s going to happen next is not a good use of your time. “More money has been lost preparing for a correction then in the correction itself” said famous investor Peter Lynch. He’s on the money as I’ve seen this play out many times in my 25 years as a financial professional. It’s human nature to think action or reaction is necessary on our part when the spaghetti hits the fan. How can we just sit still and ride out these large price swings?
It starts with having a date specific duration specific plan that stretches to your age 100. When you pull back and view your accounts beyond a single trading day or year perspective takes shape. Who cares what happens today or tomorrow if you and those you care about have a detailed plan on where you are headed? Having a destination and moving in a direction you select allows you to avoid reacting to temporary and frequent market contractions.
I did say age 100? Yes, I did. For many who repurpose their time in their late 50s or 60s, this will equate to four decades or more of living and spending. In order to give yourself a raise each year through retirement you will have to embrace the bumpy ride in account values that will take place. There is no product or strategy to eliminate volatility and still grow your money long term. By accepting volatility in your accounts, you are paying the necessary price for companies to make permanent advances over historically long periods of time. It’s both price appreciation and annual dividends paid by companies that may hedge rising costs to and through retirement. This doesn’t make it easier to accept your fluctuating account values, it is what’s required in order for you plan to work. What else does your plan need?
Part of your plan must include cash reserves for these most certain market contractions. How much cash depends on your sources of income at retirement and what makes you feel good. There is no one size fits all, it’s personal preference. Cash plays a significant role in being available when it no longer makes sense to withdraw from your investments during periods of downward volatility. A common mistake investors make is attempting to squeeze return out of their cash holdings. Triple leverage cash funds or other opaque products attempt to woo investors into having their cake and eating it too. Spoiler alert, cash should be available to you with no strings or costs attached. It’s the return of your money that matters with cash as opposed to seeking a return on it. A comprehensive plan will outline what cash needs to be available and will of course include room for error.
Investment growth and diversification makes your plan possible. Having a portfolio completely comprised of the S&P 500 index is not diversified. This is speculating not investing. It’s important to own small and medium sized US companies in your portfolio along with companies based outside the US. Think small, medium, and large companies all over the world run by really smart men and women. The exact percentages in each investment will be determined by your financial plan and input by your planner.
See, it’s your financial plan that drives your spending and living long term and that also directs your investments. Too many investors think managing the portfolio or outputs is what it takes to become successful. What it really takes is managing inputs into a goal-based plan. This determines how much income is possible each month as you’ve repurposed your time. The hierarchy of a financial plan is most certainly goals, then a plan designed around those goals, and finally your portfolio which reports back to your plan in support of your goals. This can be a lot to manage on your own, that’s ok and why we’re here to help.
The alternative approach is seeking a large sum of money that does not contract and expand overtime. Think bonds or other debt instruments that aren’t as price sensitive as diverse companies. You will have a smoother ride watching your account idle for a number of years when investing in a majority of fixed income. It seems common for large firms and their advisors to direct their clients to hold twenty, thirty or more percent of their total portfolio in these investments. Why is that? I believe the truth reveals itself in talking with these prospective clients often unhappy with their current approach. Many share that their advisor talks at them with charts and graphs with a focus on outputs and returns. Where’s the plan? A better approach we implement in each conversation is talking with our clients on what their expectations are and helping them understand through on going education the difference between risk and volatility. A real risk we all face in a 40-year retirement includes outliving our money. When you hold excessive amounts of cash and fixed income this risk may become a reality.
There is difference between risk and price volatility that often is not understood or explained as it should be. This is often a result of advisors managing portfolios for their clients without a plan. Without a plan that is updated annually and a tough loving planner for accountability it’s common for most investors to believe portfolio outcomes are of primary importance. This leads the conversation astray on investments, timing, and other distractions and away from what matters.
Today, this is evidenced by the overwhelming percentage of investors who have allocated themselves solely in target date retirement funds. The truth emerges overtime with these investments which contain an increasing percentage of fixed income. Sooner or later investors realize they must liquidate principle to pay for property taxes, make gifts to the grandkids, or pay for a large family vacation. That’s the beginning of the end and when all the lights go out. Depending on when investors realize their mistake will determine if its recoverable from or fatal.
Costs of living are increasing slowly overtime and owning a majority of fixed income in your portfolio is like riding a bike with a slow tire leak. Sooner or later, you’re going to have to change your tire tube in order to keep enjoying your ride. Doing so earlier will make the ride so much more enjoyable and the journey possible.
Don’t be surprised by market contractions or fearful of when the next recession takes place. Successful investors understand having an updated plan may allow them to turn their focus long term while still spending with purpose today and feeling confident in their decisions. Interested in a personalize plan? Reach out as we’d be happy to chat with you.