Transcript:

I’m Ryan Swartz, partner and managing director with Creative Planning, thank you for joining us today. Today’s presentation is on five tips for investor success in a volatile market. This is a very timely topic, given a lot of the volatility we’ve seen pick up early in the year in 2022, a lot of talk about higher interest rates, higher inflation, geopolitical tensions, just to name a few. A lot of that has investors wondering, “How do I navigate this environment?” So we’re going to walk through that today. If you have any questions, feel free to submit those, and a team member will get back to you. Let’s dive right in.

So today, we’re going to start really with our approach to building portfolios, we’ll spend a lot of time on basics of how do we actually develop portfolios and move those forward to get the portfolio in a place where you’re going to reach your goals longer-term? We’ll talk about the efficient market theory and how that puts odds in your favor by understanding how markets work over the long run. We’ll get specific on some tactical portfolio management trading strategies that you can utilize during up and down markets to help improve the overall expected return of the portfolio. Finally, we’ll talk about how to annually manage and monitor that portfolio management, and then we’ll talk about today’s status in the market and review those tips.

So from an approach to building portfolios, first things first, we need to understand and get to know you. Where are you now? In order to do that, we have to take an inventory of assets and build a statement of financial position. This is the building block for how we’re going to actually build a portfolio and structure that. It’s an inventory of assets, how things are titled, what are some of the overall pieces we’re working around?

From there, we want to understand, what are you trying to do? What are the specific goals, and what are the projections and rate of return requirements that you’re going to need to meet those goals? A lot of people think of those goals as just retirement, but they can be a lot of things. Aspirational goals, such as a second home, helping a child, paying off debt, whatever that may be, there’s some challenges that may come up, we want to understand those in the goal-setting process. It could be everything from unexpected expenses, helping a family member. There’s a lot of different pieces that go into what specific preferences and goals people have when they’re considering building the portfolio.

Finally, all the financial ability to assume risk is going to be there, and that’s what’s on paper to build the portfolio, but none of it matters if you’re not comfortable with it, if you can’t sleep at night. We want to understand, what is your risk tolerance? How have you responded during past periods of volatility? Is your perceived risk tolerance in line with how you actually react when things are happening? The best time to review this is after we’ve gone through a pullback. So if you think about the pandemic in 2020, or even most recently, we had a market correction in the early part of 2022. As you start to get anxiety, or you think about that, really assess, did you tell us you were a 10 on a risk scale, but you’re starting to get nervous when the market pulls back 5% or 10%? Maybe it’s a good time check in with your risk tolerance when the markets do recover to look at that again and approach that a different way. The biggest goal is to stick with building a portfolio that suits you.

Once you have your goals, we know the projections, in other words, the required rate of return for your portfolio, coupled with your emotional tolerance for risk, we can start to build that asset allocation. Asset allocation accounts for a large portion of the portfolio’s overall variance over time. In fact, asset allocation selection may be among the most predictable part of investing. If you look at studies across the board on security selection or market timing, or just simply what assets are you putting money in in the world, one of the largest decisions in place that can impact the overall long-term expected returns is how your asset allocation is structured, and it really is important to consider your current situation and future goals and how those come into play.

So let’s talk about the strategic asset allocation, finding that right mix of assets in both public and private markets to meet the investor’s need. So let’s talk through what some of those are. So, one of those areas is cash. Cash has traditionally very low returns, it has barely, if not, kept up with inflation, but cash is a safe place where people can hold some of their emergency funds or their money. Stocks are a part of the portfolio that are oftentimes referred to also as equities. In stocks, you’re an owner of a company or an entity. In that investment, you’re expecting long-term appreciation, in other words, value to increase. You’re also expecting an income component, a return of capital in the form of dividends being paid back to you over time.

You can invest in bonds. When we invest in bonds, you’re actually a lender, you’re not an equity owner, so you’re actually lending money to someone. That could be an entity like the government, an entity like a municipality, or it could be a corporation. When you’re a lender, you’re actually setting up a timeframe where you’re receiving the income, and at the end of that timeframe, you’re receiving your principal back. There’s different risks involved with that, but the behavior of those investments is very different than stocks.

Furthermore, you can also invest in real estate. Real estate is a different asset class, because it does not correlate with bonds, it does not correlate with stocks. The power in real estate comes from three different opportunities, and leverage. Number one is distributions. So when you buy real estate, it’s bringing income to you. You want to have, whether it’s a lease or it’s a rent, or some kind of income component to the real estate. You’re getting that income stream that’s helping to come in and pay for the ongoing maintenance of the property or the real estate investment. You’re also getting appreciation, so much like equities in this manner, real estate will behave in terms of getting a long-term return over time. And finally, if you have any type of financing on the real estate, the leveraging power of that capital appreciation over time is accelerated, so paying down that mortgage of that real estate can actually help you as well to create additional return in that property over time.

Finally, you can invest in other asset classes that make money only if you hold them. In other words, they don’t bring income to you, they don’t really actively work for you. So think of things like commodities, such as oil or gold or silver, any type of wheat, soybeans, et cetera, those are commodities that you’re investing in that you’re looking for a higher return in the future, but they’re not creating an income stream over time.

So once we have that high-level asset allocation, we understand the dynamics of how those work, we want to make sure that you’re also diversified within those areas, so there’s a very high importance of sub-asset classes. It’s not enough to simply choose multiple asset classes, you need to make sure you’re diversified within those classes. As an example, if you determine that 60% of your portfolio should be invested in stocks, it would be risky to put it all in the financial stocks, or technology as a sector. A better approach would be diversify across multiple industries, regions, markets, and different market caps or sizes of companies. Picking and choosing individual stocks, or betting on a sector or industry, that increases the risk of the portfolio, while owning multiple sub-asset classes helps dampen the risk, and because those areas move at different rates over time, it actually can smooth out the return of the portfolio.

If you look at the chart, you’ll notice that there is… If you look at your eyes left to right, you’ll never see a pattern that you can clearly define. If you follow one of those colors left to right, very hard to discern that pattern, and oftentimes what led a prior year doesn’t lead the next year, or vice versa. Asset classes move at very different rates, getting to a long-term goal of sometimes a similar place, but because they move at different rates at different times, it’s very important to diversify among those asset classes. The more diversification, of course, you have in a portfolio, the less likely that portfolio is to swing wildly up, but also it’s less likely to swing wildly down. Diversification can help reduce company risk and volatility. It can help you reduce industry risk and volatility. Diversification, though, does not eliminate market risk.

Another component to diversification is determining what risk you’re putting into the portfolio. For instance, investing in individual stocks and sectors creates more volatility to the downside, and you could miss out on market opportunities. Instead of owning one stock or index, owning the market provides diversification, and can help against volatility. For instance, during the lost decade of 2001 to 2010, the S&P 500 index didn’t make any money, yet all other classes were positive. In fact, if you look across these classes, you would receive double or triple-digit returns over that timeframe, not because you’re a genius, just because you weren’t putting all of your eggs in that one basket of large company U.S. stocks.

It becomes extremely important to match the asset allocation and the sub-asset allocation of those classes to your overall goals. For instance, if you look at this chart, you’ll notice that there are asset classes like emerging markets or small company stocks, and even real estate, that have had average long-term annual returns that have been very great. They’ve also had very wide ranges in risk. In other words, they’ll have higher returns on the upside, but also a larger potential for downside risk. If you’re looking at longer-term goals and you want to make sure there’s part of that money that you’re not going to need for a longer period of time, perhaps those asset classes could be a better fit to allocate funds toward that money. Conversely, if you need money in the near term, or you’re looking to pull money down, and there is risk in the short run of an unknown timeframe, you might be better off looking down toward asset classes that have a narrower range of overall risk and return.

So it’s very important to have the asset allocation in place, high-level strategic allocation, sub-asset allocation that matches up with your goals, and then from there, we also want to make sure that tax efficiency is looked at through the asset allocation strategy. This is called asset location. So asset location actually minimizes taxes on the overall portfolio by driving tax-efficient investments to taxable accounts, and it moves tax-inefficient investments to tax-advantaged accounts. So investments like passive index mutual funds, index ETFs, tax-exempt or tax-free bonds, and even stocks, are a lot of times better held inside of a taxable account, and they don’t necessarily need to be shielded in a tax-advantaged account. But other areas, such as taxable bonds, actively-traded mutual funds, or even some real estate investments, are better held in tax-deferred accounts or tax-sheltered type of accounts.

When you look at building a portfolio, you want to understand, where’s the income coming from, what asset classes in my net worth statement am I working with to drive that income, and then what asset location of where should I hold and invest in that asset allocation to build the most tax-efficient strategy you can over time?

So once we have the portfolio built, we know the strategic asset allocation, we’ve been very intentional about our sub-asset classes, and we’ve asset-located our portfolio, we want to look at ways where we can continue to put ourselves in a better position over time that aren’t impacted by the market day-to-day. One of the areas that’s important to understand is the efficient market theory. Efficient market theory states that markets are typically fairly priced and efficient, there’s little opportunity to make excess profits by, quote, “Beating the market.” Because information flows so freely and decisions are being made in real time, the theory suggests that valuations are also made instantly. In fact, no known studies since 1980 have shown any evidence that it’s possible to time the market. There’s just simply too much information available to too many people.

As an example, to show how detrimental market timing can be to long-term returns, here’s an example of investing $10,000 in the S&P 500 from 1980 to March 31st of 2021. If you were staying invested for all those days, you had excess of a million dollars saved with that $10,000 investment, but if you missed just the best five days, you actually reduced your return by 38%. Missing just 10 days reduced that return by 55%, and if you held out the best 30 days, you were off by 84%. Obviously, missing 50 days, it’s even worse, at 93%. Just missing a few days can be very detrimental to the long-term return of your overall portfolio.

So now that we understand more about how we construct the portfolio, the asset classes, the sub-asset classes, and how the overall market works on an efficient basis, let’s get into some of the tactical strategies that we want to employ during markets when volatility arises. There’s typically three triggering events that we look at for tactical trading. The first event is something we call regression to the mean. Regression to the mean is when emotions get the best of people. So any time an asset class is trending well above its historical averages or well below its historical averages, there’s a potential for that asset class to get overheated. Regression analysis suggests that over 35% above that historical average, or 35% below, it’s very, very low probability that that asset class stays there over the long run.

As an example, if we look intuitively, most people can understand mortgage rates. So if you had a 30-year mortgage at 4%, are you going to refinance when the interest rates rise to 10%? No, you know that 10% is above the higher than normal historical average for mortgage rates, and they’ll eventually come down. However, if mortgage rates drop to 2%, yes, you’re going to refinance that rate, historical averages are above that, and we know rates will eventually rise, we want to take advantage of that, so you’re constantly putting yourself in a better position to make that happen.

This is very evident with markets and behavioral finance, as people make decisions in real time when market pullbacks and volatility occur. For recent examples of regression to the mean, we don’t have to look that far to understand that. If we look at 2020 as the most recent example, real estate was among the worst performers, but if you fast-forward to the very next year, real estate led asset classes over its performance during that time. In 2017 and 2018, we see more examples. Bonds and real estate were among the worst performers in 2017, and they finished the year in 2018 among the best performers.

Once we understand regression to the mean, it’s an easy transition to look into how we can take advantage of that for our second tactical trade trigger, which is called opportunistic rebalancing. Rebalancing is the concept of not always staying static in your asset allocation as the markets move. So for instance, if you started the year with 30% in bonds and 70% in stocks, but the stocks had run up, by the end of the year, the bond proportion of your portfolio only accounted for 20%, it would be time to take some gains out of the stock side and strategically rebalance back to the bond side. Over that period of time, you actually can end the year on the strategic asset allocation track, but take advantage of those gains as they come up.

Most rebalancing can occur on a scheduled basis, weekly, monthly, every six months or a year. The problem with scheduled rebalancing every six months, one year, or on the calendar, is from a tax perspective it can be detrimental, but more importantly, markets don’t move according to a set schedule. Russia didn’t decide to invade Ukraine on cleanly on the last day of the quarter, Brexit didn’t happen right on the last day of the quarter or the week. We believe opportunistic or tolerance band rebalancing is a better approach. Tolerance band rebalancing is simply setting a threshold where certain asset classes meet those thresholds, and they get traded at that time, versus on a particular date or a schedule of the calendar.

If you look at this over one year, you can see the impact of a tolerance band investing opportunity in the middle of the year that got met and traded at that time, versus waiting until the end of the year. Over three years, it can be even more impactful. It may be better off to not necessarily rebalance in years one and two, but take that advantage of that opportunity when the tolerance band is met in year three.

After understanding regression to the mean and opportunistic rebalancing, the next tactical trade trigger is aggressive tax-loss harvesting. Tax-loss harvesting is the process of looking for opportunities to realize losses in order to offset gains. Selling an investment that’s declined in value in the short run and replacing it with a highly correlated alternative can allow you to stay invested in line with your overall asset allocation and your goal, but extract losses on your tax return. Up to $3,000 of losses per year can offset ordinary income taxes on your tax return, or the loss can be carried forward to use against future income or capital gains on other property. The risk profile and the expected return of your portfolio remains unchanged, but the temporary tax losses are extracted in the transaction. The realized investment loss generates a tax deduction, and those tax savings can be reinvested to further grow the value of the portfolio over time.

As a recent example for how impactful tax-loss harvesting can be, we can look back to the pandemic. For instance, if you were able to invest $100,000 and you had that invested in U.S. large company stocks, represented by the blue, and the market then pulled back, you could swap that position in the blue and reconstitute it to the orange, and actually have that position continue to recover over time. You’re extracting those losses on the tax return that you can then carry forward for future tax deductions.

So how do I continue receiving monthly retirement income during periods of volatility, while I’m also tax harvesting and rebalancing? One of the ways that we do that in the portfolio construction is to, beyond the emergency fund of three to six months, maintain three to six years of living expenses in shorter-term bonds and income products in the stable part of the portfolio to cover those monthly income requirements. That allows us, during times of volatility, to pull from those areas that are less volatile, and actually buy into markets in the weakness at that time. Conversely, if markets are moving up, we can pull from areas that are returning well, and create that income in coordination with dividends, while also tax harvesting along the way.

So if we maintain a separate diversified growth portfolio alongside the assets we know we’re going to need in the next three to six years, we can continue to have a good opportunity to keep up with inflation, to grow those assets, leave the financial legacy, and provide tax efficiencies along the way, gradually transitioning from the growth side of the portfolio when those gains are opportunistic, and moving them back into the shorter-term part of the portfolio.

To quickly recap, we covered three tactical trade triggers that are impactful during volatile markets. The first was regression to the mean, which really outlined how asset classes can move year-to-year very extreme, and taking advantage of that. We use opportunistic rebalancing to keep that portfolio on track to the strategic asset allocation over time, when you need traded, not on a scheduled basis. And over time, we’ll actually extract losses through tax-loss harvesting to add those deductions to your tax return, all while keeping you on track toward those goals.

So how do we monitor this over longer periods of time? One of the ways that we recommend doing that is through an annual portfolio management review. During that review, we want to continue to make sure we’re taking a look at what were you spending year-over-year, how were those income needs that you thought you were setting out to do, in reality, how were those actually in place? We want to review the updated financial plan, update the statement of financial position, look at those financial projections at least annually to determine that rate of return requirement is still going to meet your overall goals, and then reset that asset allocation if needed.

So how do we relate this to right now? Well, we’ve just been through a period of time, just recently, where there’s a lot of concerns that are boiling out there, a lot of noise in the marketplace, higher inflation, interest rates rising over time, and then we’ve had conflict and geopolitical tensions in the world. So there’s a lot of talk about will that turn into a recession, will that move into a bear market? One of the things that we need to realize is, what is a bear market?

So the SEC defines a bear market as a time when stock prices are declining and market sentiment is pessimistic. Generally, a bear market occurs when a broad market index falls by 20% or more for at least a two-month period. Typically, bear markets last anywhere from a few months to a few years. They ultimately end when prices reach maximum pessimism, consumer and business confidence begins to recover, and stock prices rebound 20% from their lowest point.

So what causes a bear market? Well, sometimes bear markets happen for cause. Market bubbles burst when they’re overly optimistic on asset prices, and they drop to more realistic levels. Sometimes a geopolitical crisis or a war can create a bear market. That’s one of the things many people are afraid of today, when they saw the geopolitical tensions that are happening with Russia, Ukraine. It can be a sluggish economy, where earnings are not there and we’re just not growing as fast compared to where we were years prior, or there could be a drastic policy change in tax rates or interest rates, or it could be a pandemic, like we saw, the most recent bear market was in 2020.

When we take a closer look at how frequent bear markets are, they’re very frequent. In fact, we’ve lived through a number of bear markets, and we’re going to live through a number of bear markets into the future, so they happen more often than you think, the duration is typically a few months to a few years. They’re short in duration, and any behavioral misstep during that period of time could lead to a missed opportunity when the ultimate market recovers, as we can see on the right side of the chart. So what do all bear markets have in common? They all eventually end.

Now that we’ve gone through how we construct portfolios, some of the tactical trades that we make during volatile markets, and current market conditions, let’s look at some of the tips for investor success in a volatile market. Number one, invest for the long term, take a goals-based approach, avoid making rash, emotionally driven decisions, don’t let news outlets and other investors scare you. Secondly, maintain a diversified portfolio, spread out your risk over multiple asset classes to smooth the volatility over time. Diversification can reduce the risk of being too heavily invested in the worst-performing asset classes. Number three, keeping some cash on hand, save an emergency fund to cover unexpected expenses, maintain three to six months of those living expenses in cash. Having cash on hand can prevent you from selling investments at an inopportune time.

Maintain an appropriate level of risk. Your risk tolerance should be established during periods of calm when you’re not swayed by market fear or euphoria. Take into consideration your comfort with loss, your current financial situation, your future income needs, and your long-term goals. Hold true to your risk profile during periods of volatility to avoid making emotional decisions. Finally, develop a bear market strategy in advance. Bear markets are a normal and healthy part of market cycle. Every investor will experience several bear markets. Having a strategy in place for buying and selling and holding investments can help you weather volatility and come out ahead.

So, what not to do? You know who you are. Do not sell all of your investments and move to cash. The time to get off the roller coaster is not midstream while the ride’s going on. Do not make fear-based decisions, flip that to opportunistic decisions during times of market volatility. Do not lose sight of the prize, the long-term goal and your risk tolerance is why you’re invested the way you are. And finally, resist the urge to try to time the market.

So let’s review the important takeaways. Markets will recover, eventually. Those who fare the best through bear markets are those who remain focused on their long-term strategy and avoid making emotional decisions. Finally, having a strategy in place to manage your investments can help you take advantage of a volatile market. At Creative Planning, we serve as a partner in helping our clients navigate challenges in order to reach their financial goals. We understand that no two clients are alike, which is why we offer custom solutions to help you achieve your version of financial success. With all the uncertainty we face, isn’t it good to know you can have a team of experienced professionals in your corner? Contact us to schedule a confidential, no-obligation meeting. Thank you so much for joining us today, look forward to getting to know you.