Since April 29 of this year, we’ve been in a downward spiral in the stock market that has caused a lot of investors to ask why in the world they deal with all this crazy volatility? Over the last decade it seems like every time you make some gains in the market, you end up giving them all back. Even though we haven’t officially hit the bear market status (-20%) as of this writing, it again poses the question as to whether you should be buying or selling right now. In my 30 years experience dealing with crazy volatility, there are three things that you need to be aware of. First, it starts with the true diversification of your different investments and how they’re mixed together. Second is to have some sort of mechanism that allows you to decide when to buy and when to sell. Finally it’s about understanding yourself and seeing the type of person you are when it comes to your emotional and intellectual decision-making in life.
If we start with diversification, then it’s key to understand your choices. One of my favorite books is written by a gentleman named Mebane Faber, The Ivy Portfolio. It’s a book that talks about how the Ivy League institutions invest their substantial assets to generate returns that will hopefully last in perpetuity. The five core groups that he does analysis on are stocks, bonds, international stocks, real estate and commodities. Of course, there are literally hundreds of different asset classes that exist today as seen by the recent rise in ETF’s (exchange traded funds) that have become a major component of the volume of the stock exchanges. Not long ago there were less than 20 of these index types of funds that can trade during the day just like stocks do. Now, there’s something close to 2000 exchange traded securities that are being traded in the markets, all driven by a particular type of asset class. You shouldn’t be overwhelmed by the massive number of choices, so come up with some combination of 5 to 10 of these major asset classes and do some homework on which ones you feel are the most critical to your investment objectives. Just promise me you’ll use at least 5 or 10 totally different asset classes.
The essence of Faber’s book is that over long periods of time these asset classes tend to perform similarly. It’s just a matter of doing some rebalancing to make sure that no one asset class gets too big to take down the others. I was recently reading an analysis and a publication entitled the “Horsesmouth” written by Craig L. Israelsen Ph.D. that confirms this same sentiment. It looked at multiple asset classes over the last 41 years using 17 rolling 25 year periods. In essence it shows that the internal rates of return on the seven asset classes that he used (cash, bonds, large US stocks, small US stocks, non-US stocks, real estate investment trusts and commodities) showed higher returns as you use more asset classes. By using too many asset classes, you can end up with what is termed “deworsification.” In some of the research that we’ve done we’ve also found that when we reduce our asset classes to less than 10, the long-term back testing works better. One of the most prominent index mutual fund families in the country, Vanguard, along with its founder John Bogle has been promoting the strategy for many years.
The second way to deal with volatility is to have some discipline mechanism to decide when you want to buy and when you want to sell. The Ivy Portfolio also talks about using 200 day moving averages as a tool to consider using as well if you want to be sensitive to the longer-term trends in the market. The experts call this technical analysis (nothing to do with technology stocks) which is simply looking at the average price of the security over some period of time (i.e. 200 days) and just use the charts to determine your decisions. That’s opposed to what we call fundamental analysis which focuses more of its efforts on the more mainstream aspects of a company like the management, the earnings, the market share or the industry they are in. I’ve mentioned this in the past in my March article when we were starting to deal with some of this volatility earlier in the year at that time our technical indicators were positive. Subsequent to that blog, our indicators moved rapidly down in May of this year and caused us to reduce our exposure to stocks. So the message here is that you can’t read an article on technical analysis and know what to do unless it’s very current. You have to have some up-to-date software or publications that keep you disciplined to monitor your current investments. I believe the world has changed in my 30 years of experience and a buy hold and hope strategy doesn’t work as well as a technical analysis tool that helps get you out of the way in this new internationally interconnected world.
As I mentioned above, the founder of Vanguard, Mr. Bogle, isn’t a fan of trying to time the market. I will admit that I am fond of technical analysis as it helps me manage risk in volatile times. I find it is extremely helpful in protecting client’s assets, especially those who are at or approaching retirement with their need for capital preservation being much higher.
The final and most important component to dealing with the crazy volatility is to know thyself. We all have our own ways of making decisions as nature versus nurture. We don’t know whether the genes are going to make a decision or whether the environment we grew up in will dictate what we do and how we react to the world. It’s hard to figure out whether the left brain or right brain is calling the shots on our decisions. I will say that when times are not volatile then intellect will prevail when times are consistent, solid and expected. When were in the middle of a volatility firestorm like we’ve seen over this past summer, then our nature is to go back to our deepest roots where it’s fight or flight. It’s even harder when the markets are reacting to political rhetoric in the US, companies afraid to hire, consumers afraid to spend, tension in the Middle East, currency wars, Asian countries trying to control inflation as well as sovereign banking irregularities in Europe. There will always be problems in the world and with are more connected media and communications, it becomes more frequent, critical and destructive as we try and use our intellect over our emotions. That means you should subscribe to a diversification model and maybe even some technical analysis to get out of the way when the truck is coming.
My 30 years in the business has shown me three type of people, those who have disciplines and abide by those different disciplines in good and bad times, those who are in denial and simply ignore the situation and wait for it to go away and the majority seem to be looking for some direction and leadership during the tough times. All three of these strategies can work; you just have to know which one of these most closely resembles you. If you’re broadly diversified, then you can wait it out when it comes to volatility. If you use disciplines that allow you to ride the storm and don’t go against your instincts, you’ll be okay. If you’re looking for leadership and direction then find someone that you can trust to help walk you through the rocky times. I just happen to be very lucky because I understand the markets by living through them and seeing emotional mistakes making it harder for people to be successful. It also didn’t hurt that I married a psychologist!
Stock investing involves risk including loss of principal.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
The fast price swings of commodities will result in significant volatility in an investor’s holdings.
Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors.
An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors.
No strategy assures success or protects against loss.
Dave Caruso, CFP®
Certified Financial Planner™
Coastal Capital Group