Question: The stock market has soared since COVID-19 hit in March 2020, but I’m starting to feel anxious. Is it possible that we are witnessing another collapse? As we start the new year, I wonder if now is the right time to reduce risk in my portfolio?
Responnse: Portfolio risk is a misunderstood concept. Some people think market volatility is a risk and I agree it could be for a trader whose investment horizon is measured in hours or days. However, for the rest of us, the focus on market volatility sometimes confuses questions about risk more than it clarifies them.
A more useful definition of portfolio risk is “the likelihood of something happening that permanently reduces my capital.” Using this definition, here are three risks that every portfolio faces:
1) Bankruptcy or default — if I own a stock that becomes worthless or a bond that stops paying, I suffer a permanent loss of capital.
2) Forced liquidation during a market downturn – if I am forced to sell stocks at temporarily depressed prices, my portfolio cannot recover when the market recovers.
3) Inflation — the erosion of the real value of my portfolio holdings.
There are of course other risks, but these three illustrate what I mean by risk. As you think about mitigating risk to your portfolio, including what could happen in a market downturn, I encourage you to keep a few basic facts in mind:
Fact #1: Market timing (i.e. trying to dodge a market crash) does not work. As numerous academic studies have shown, trying to time the market generally reduces long-term investment performance.
Fact #2: Market downturns are inevitable, but they are not permanent. If western democracies have demonstrated anything, it’s that free economies grow over time and stock markets go up.
Fact #3: It usually takes about four years for the market to recover from a crash of 20% or more.
With these facts in mind, here are some suggestions that will help you manage your portfolio risks effectively.
First and foremost, make a financial plan. A financial plan will help you clarify your goals, put your financial decisions into context, and better understand what you want from your portfolio. Your financial plan will also help you gain greater discipline in your investments. Sometimes people want to skip this step but don’t. I’ve never met anyone who didn’t become a better investor after completing a comprehensive financial plan.
Once you have a financial plan, you can start working on your portfolio. Your goal is to build a resilient portfolio, that is, one that can withstand market shocks and thrive over time.
A resilient portfolio has three characteristics. First of all, it is well diversified. A well-diversified portfolio includes a large number of stocks in many different sectors. In a well-diversified portfolio, no individual stock is large enough to sink the portfolio if that particular stock runs into trouble.
A resilient portfolio also invests in high quality stocks. High quality businesses have the ability to weather the economic storms that would sink more junkier businesses. Many investors learned the difference between quality and junk during the dot-com crash. Between March 2000 and November 2001, technology stocks of all kinds fell precipitously. Some stocks, like Webvan and Pets.com, simply evaporated. Other stocks, like Amazon, also took huge hits (Amazon fell over 90% in the dot-com meltdown), but were strong enough to survive and ultimately thrive. It’s resilience.
Finally, a resilient portfolio can withstand short-term drawdowns without having to sell stocks when the market is down. Remember fact #3? If you know you will need to withdraw funds from your portfolio over the next four years, think carefully about how much of that money you want to invest in the stock market. If the threat of a market drop bothers you, you might want to invest that money in short-term bonds or CDs instead. But be careful. As we discussed last week, being “too conservative” does exist. Short-term investments may seem safe, but they also expose you to the very real danger of inflation.
Steven C. Merrell is a partner at Monterey Private Wealth Inc., an independent wealth management firm in Monterey. He welcomes your questions regarding investments, taxes, retirement or estate planning. Send questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to [email protected]