Summary: When facing investment trouble, do portfolio crisis management!
“Everyone has a plan until they get punched in the mouth.”Mike Tyson
If you are anything like me, your investment portfolio spent the last week getting punched in the mouth. Between Tuesday, February 25, 2020, and Friday, February 28, 2020, the Dow Jones Industrial Average (DJIA) dropped by over 11% peak to trough, performance that was echoed by all other major stock market indices. This spells investment trouble.
It’s tempting to make rash decisions after a significant market sell-off, but investing, like most endeavors, should be approached with a calm state of mind.
Here are a few tips to help you behave rationally when the market isn’t:
1. Remember that volatility clusters.
There is a tendency for the biggest up days and down days in the market to occur in close proximity to each other. In the case of recent market volatility, the DJIA followed the worst week of returns since the 2008 financial crisis with the strongest single day rally in over a decade. If you sold off in a panic as the market bottomed, you would have missed this bounce and would be looking to re-enter at a higher price point. If you were holding your investments in non-registered accounts, you will now have the additional burden of capital gains taxes. Trying to avoid down days will lead you to miss out on up days and add to transaction costs.
2. Investment Portfolio construction should be based on risk profile and time horizon.
It amazes me how many people put their hard earned money into the stock market without a plan. This can lead to more investment trouble. You don’t go on vacation without a plan. You probably don’t even go out with friends without a plan. Why would you risk your hard earned capital, upon which your future hinges, without first making a plan?
Investment portfolio planning is primarily a function of your risk profile and your time horizon. When you are at the early stage of building financial capital, a stock market correction can be a blessing in disguise: it will paint a clear picture of your risk tolerance. Everyone is willing to take on more risk when it means higher returns as the stock market rises. Sometimes you have to lose money to find out your true appetite for risk. For most readers, this will likely be the lowest-stakes market correction of your lives. Financial assets are relatively small, time horizon is long, and there is plenty of time to recover from drawdowns. If you are investing a bit of money from each paycheque, be happy to have a lower price point for market entry. Rash decision making will become more punitive as your portfolio grows and retirement age draws closer.
3. Investing in stocks is risky in the short term. Not investing in stocks is risky in the long term.
Converting your portfolio to cash is appealing as stock prices fall. However, holding cash in the long term will erode the value of your savings as inflation chugs steadily forward. Just ask your grandparents how much they could get for a dollar in the 1950’s. Investing is a decision based upon delayed gratification: you are choosing to forego spending today in the hopes of having more money available to spend in the future. But beyond this, holding appreciating assets is crucial to maintaining the spending power of your money. Riskless assets bear no return; comfort with a certain level of risk is necessary for your portfolio to reap the benefits of compound interest over time.
4. Hindsight is 20/20.
I do not consider myself to be a stock market guru. I don’t know if it is truly possible to be a stock market guru (most of the world’s most famous investors have spotty track records with periods of underperformance). But there is something interesting about investing in stocks: given a small enough sample size, luck is indiscernible from skill. An individual with no skill and no concept of the amount of risk they’re taking can make a huge sum of money off of one trade. When the outcome is successful, it is very easy to backfill a reason for the success. In poker, they refer to this as resulting: a good outcome is wrongfully equated with good process.
The same can be said when things do not go according to plan. In hindsight, the causes of current market turmoil appear painfully obvious: a few thousand cases of a virus emerge globally; international trade flows are disrupted in an attempt to maintain a pandemic; the transportation and retail industries suffer as people retreat to their homes for safety; stock market contagion ensues. Predicting the past is easy because we already know what happened. With a week of perfect foresight, I’m confident that just about any market participant would be able to become rich.
The one thing confirmed by history is the inevitable long-term climb in stock market valuations. Too much energy is wasted focusing on short-term fluctuations. Unless you run a hedge fund or have access to a supercomputer that can perform high frequency trades to identify arbitrage opportunities, short-term fluctuations should not be a relevant component of your investment process. Time in the markets is more important than timing the markets.
Making wise decisions results from good process. Develop your process, follow it, and let everyone else worry about the noise. Most importantly, when facing investment trouble, don’t panic!
Opinions are those of the author and may not reflect those of BMO Private Investment Counsel Inc., and are not intended to provide investment, tax, accounting or legal advice. The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness and neither the author nor BMO Private Investment Counsel Inc. shall be liable for any errors, omissions or delays in content, or for any actions taken in reliance. BMO Private Investment Counsel Inc. is a wholly-owned subsidiary of Bank of Montreal.