On the top 10 list of things to worry about, volatility is the 11th
For the past several months, US stocks whipsawed with each presidential tweet about whether Trump is adding tariffs or suspending tariffs, talking to the Chinese or ordering US companies out of China. We’ve seen some days where the Dow fell over 800 points, which once upon a time was a big deal, but amounts to a decline of only 3% in a year when the S&P 500 is up 20.6%. When the Dow fell 508 points in October 1987, that was a decline of 22.6% in a day!
Recently a client called with a very serious concern. He intends retire soon, is worried that Trump will drive the country into recession next year, and wanted us to put all his assets into bonds and cash.
I gently reminded him of the value of working with our firm – coaching you to ignore noise and focus on facts. Sure, the day to day fluctuations SEEM dramatic. However, since January 1st, 2018, US stocks are up 14.3%, which works out to an annualized gain of 8.3% over the last 7 quarters – right in line with long term averages. For curiosity, we ran a study calculating the total return of the last 7 presidents from Inauguration day through the equivalent of 9/6/2019, so approximately 700 trading days per president.
What we see is that stocks generally go up regardless of who the president is, regardless of politics, and probably would go up even if my dog was the president (that's Hudson, a very clever Labradoodle.)
As students of stock market history, we are not surprised because we know that stocks go up 9 years out of 10.
As human beings, we remember the brief times when stock markets were volatile (for example, 6 months in 2008-9) and forget the long stretches in between when stocks were flat to higher (for example, 2009 to the present.)
The #1 consideration we prioritize when making investments for our clients is: what is the chance money won’t be there when you need it? For example, if you had to pay a college tuition bill tomorrow, but all your funds were locked up in a 5 year CD, you would have a big problem. The problem has nothing to do with the investment risk of the CD (quite low) and everything to do with the liquidity risk – you can’t take your funds out for 5 years.
My client and I had a long phone conversation, and then I sent him this follow-up email (excerpted):
Dear X,
I understand your concerns about Trump.
However, I don’t want to lower your equity exposure further. You are worried about volatility risk, but on the top ten list of investment risks (see notes below) volatility risk is #11.
The #1 risk – longevity risk – is the chance that you outlive your money. I could convert your entire portfolio into bonds today, but then you would have to slash your future spending by 50%. That is totally unnecessary. In the 25 years that I have provided retirement income streams for clients, I have NEVER once had to cut a client’s monthly draw because of market volatility.
However I HAVE had to lower clients’ draws if they insist on an asset allocation that does not contain the optimal mix of stocks and bonds. The optimal mix is a range of 70% stocks/30% bonds for aggressive clients (supporting an annual draw rate of 5%) to 60/40 for conservative clients (supporting a draw rate of 4%). I have, when absolutely pressed, adjusted a client’s allocation to 50% stocks/50% bonds, but then I had to lower their draw to 3%.
Bottom line: Trump is an idiot determined to blow up the economy. Whether he’s gone in 18 months or 5 years does not change the plan I have laid out for you.
Best regards,
David
Here are the risks Heron Wealth advisors think about in descending order of concern:
Longevity Risk – the chance that you will outlive your money. More broadly, what is the chance that a portfolio will not be able to deliver required cash flows? We address that risk by setting an asset allocation that includes faster growing, more volatile stocks as well as slower growing, less volatile bonds. We would typically have 60-70% stocks and 40-30% bonds. Why these numbers? Because we have 75 years of data on stock, bond, and cash returns and inflation that tells us what are reasonable expectations for portfolio growth and draw rates. Even if we discount future expectations about returns (and we have,) we can project that if you draw conservatively 4%/year of assets, aggressively 5% of assets, you will never run out of money under most scenarios. There are a few dire scenarios where this won’t be true – nuclear war, meteor strike, world wide zombie apocalypse. In those scenarios, we would focus our asset allocation on canned goods!
Equity Risk – Yup, stocks go up and down – a lot! Just in the last 9 months, we’ve seen stocks sell off 20% in three months, then rally back 25% to new highs in 4 months. For financial needs of less than 5 years, we generally DON’T invest in stocks (we stick to bonds and cash.) However, the same volatility ALSO makes stocks the highest returning asset class. If stocks had as little volatility as CD’s, then stocks returns would be closer to 2%, not 7%. We NEED stocks to be volatile to obtain the returns we need, we just don’t put short term money in them.
Foreign Investment Risk – We believe foreign stocks (Europe, Asia, Far East, Emerging Markets) markets have higher growth prospects than the US markets and also diversify our risks away from the US. However, countries outside the US have less protections for investors. The risks are higher, so we invest in two broad based index ETF’s – about 2/3’in developed economies in Europe, Australia, and Japan, 1/3 in emerging markets in South America, Africa and Asia. This takes us to about 75 countries total.
Currency risk - When we invest overseas, we’re exposed to currency risk. If the dollar falls, we gain additionally on these investments, or lose if the dollar gains. Over 5-10 years, the gains and losses net out, just leaving the higher return from those markets. I would not invest overseas for a time frame of less than 5 years.
Political Risk – you never know when a new law will hurt or harm a particular part of the economy. The Tax Act of 2017 pretty much killed the NYC luxury real estate market while exploding the deficit. Trump’s tariff wars have not yet seriously harmed the overall economy, but soybean farmers, lobster fisherman and certain manufacturers are facing bankruptcy.
Concentration Risk - when you put money in a single stock (or a single company,) you have both the possibility of an incredible upside and also the chance of total wipe out. You resolve that risk by diversifying your equity exposure among a minimum of 40 stocks, further diversified by industry and sector. The extreme of diversification is to buy the Russell 3000 index, which includes the first 3000 stocks in the US stock markets by market capitalization. There are another 10,000 stocks that are micro cap, but they are so small that it is hard to invest. For example, right now we’re helping a client sell off a position of about 100,000 shares of a micro-cap company he was president of. We can only sell 3-5000 shares/day without causing the share price to drop.
Another thing we do to enhance equity returns is to break down the Russell 3000 between Growth and Value components, and between Large, Mid and Small Cap components. Amazon is a large cap growth stock – of course you have heard of it. Sealed Air is a mid cap value stock that you haven’t heard of. But you HAVE used their product. When you get a package from Amazon and your purchase is wrapped in those puffy cushions – that’s Sealed Air!Inflation Risk – we have enjoyed nearly 25 years of low inflation, a combination of obtaining great efficiencies by using computers, and by shifting production of the physical products we buy from the US to overseas. That era may be coming to an end. Right now, we project 2% inflation in our models, but 3% is not out of the question. If we think long term balanced portfolio returns will be around 7%, our after inflation return drops from 5% to 4%, which means reduced purchasing power in the future.
Interest Rate Risk – along with low inflation, we have enjoyed nearly 25 years of falling and low interest rates. If inflation rises, then so will interest rates (because investors focus on after-inflation returns,) which will make bonds less valuable. If you issue a 20 year bond with a coupon of 4% today, the face value will be $1000. If rates don’t change over the next year, the face value will still be $1000. However, if rates go to 5% in a year, then the value of that bond will fall to $878. That’s a 12% decline in value for a supposedly "safe" investment.
We control this risk by watching the time to maturity. If we’re concerned about rising rates (which we saw for the three years through December 2018) we only buy bonds with maturities of 5 years or less. A 5 year 4% bond, if rates go to 5% in one year, will decline to $964 (down 3.5%.) That’s down, but a tolerable loss. We further hedge interest rate risk with "inverse" bond funds that invest in floating rate bonds and short futures. As a result, we can deliver a package of bond funds with a 4 or 4.5% yield, but little principal risk.Credit Risk – All bonds are not the same. It is unlikely (though not impossible) that the US Treasury would default on our bills, notes and bonds. Municipal bonds range from high credit worth to high risk; same with corporate bonds. Right now, US corporations have never so much cash as right now, so credit risk is very low because there’s little doubt that companies could cover interest payments. That would change in a recession, so we continue to monitor the situation.
Liquidity Risk – How hard it to get cash out? We won’t invest in anything for our clients that they can’t get out of in 24 hours. That rules out most limited partnerships with lock-ups, which include private equity, venture capital, hedge funds and leveraged loan investments. Bonds and mutual funds can be cashed out within 1 business day, stocks and exchanged traded funds (ETF’s) within 2 days.
Volatility Risk – how much an investment portfolio goes up or down in a given day, is the least important thing I worry about. I rarely look at the market returns more than once a week, and never in the context of what did the market do today. If I do look at market returns, I want to know month to date, quarter to date and year to date cumulative returns. Daily returns are about 90% random noise – a down day today, or even a down week, is usually offset by an up day, or an up week. Only over longer lengths of time do true trends become apparent.
As always, I welcome your comments and questions,
Best regards,
David Edwards, President
Heron Wealth
www.HeronWealth.com
Direct: 347 580-5288
Mobile: 917 705-3893
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