Warren Buffett, one of the world’s most famous investors, is often quoted as saying “be fearful when others are greedy and greedy when others are fearful.” You might say that is easier said than done and we won’t disagree with you. Obviously, there is a great deal of fear right now among investors as a result of recent market volatility and the impact on portfolios. Q4 2018 has been the worst quarter in 10 years, and several indexes are down over 20% since their peak. In fact, December 2018 closed as the worst performing December since the Great Recession.
Since 2008-2009’s Great Recession and recovery that began in 2009, the market has been in a Goldilocks scenario that includes: record low interest rates, muted inflation, an improving global economy, growing corporate earnings, and booming stock market returns. It can be easy to forget the lessons of the past and become complacent. AAFCPAs Wealth Management is not complacent about this market or our clients’ individual financial plans. We understand what clients have invested in, and the associated risks and probability of returns—and with that understanding and conviction comes courage.
What is going on now, and what is driving this volatility?
First, the ongoing battle between the US and China tariffs has spooked the markets. These tariffs are having a chilling effect on corporations as they cloud their profitability outlook. Companies that are uncertain about current or future trade barriers are worried that their outlooks and corporate earnings could be significantly impacted by a prolonged trade battle. Just this year, Apple adjusted revenue guidance due in part to this uncertainty. It is expected that this trade war will be settled eventually, but the question is: when?
At the same time, the Federal Reserve has slowly and methodically raised interest rates. They raised rates only once in 2015, and once again in 2016; but since then they have raised rates on seven separate occasions with more expected in 2019. These rate increases are designed to accomplish two things: 1) the Federal Reserve wants to get ahead of any potential contraction, and be better positioned to cut rates again if they need to stimulate the economy, and 2) to slow down a rapidly heating economy and keep a check on inflation.
In response to rate increases and trade conflicts, the economy started to show signs of slowing both domestically and internationally. Consequently, the fear of a slowing economy briefly caused interest rates to invert. Think about it this way: If you loan a friend money for 1 year they might give you 3% interest. If they say, can I pay you back in 5 years, you will likely not say, sure, pay me back 2%. You will want a higher rate of interest for the longer period of time. Inverted yields work just like this, with short-term rates higher than longer term interest rates. Since rates inverted briefly they have corrected and are no longer inverted.
So what now?
Each time we have a market correction, bear market, or major market event investors often fear that it is a unique, monumental, catastrophic event. The reality is, it’s not. As Wealth Advisors, we expect the bad with the good. Even with the perceived unpredictability of the current market, one thing is very clear: the market is actually very predictable. On average, the stock market is up 3 out of 4 years. Broadly speaking, the stock market on average has returned about 10% since its inception in the 1920s and bonds have returned about 4.5%. The positive outweighs the negative. The stock market will recover as stock prices follow earnings.
Investment results are more dependent on investor behavior than on fund performance.
There are many reasons investors struggle to handle volatile times like these, and in some cases act imprudently. Interestingly, in Dalbar’s annual Quantitative Analysis of Investor Behavior (QAIB), researchers examine the causes of poor decision making and investor psychology. Human factors such as loss aversion, media response, and diversification misconceptions lead to poor market decisions and underperformance. For example, many of us find the joy of making $100 is less than the feeling of pain from losing $50 (loss aversion). Many will also react to the news headlines without full consideration of unique, longer-term goals (media response). And many investors have a misconception that they are diversifying by simply using different sources, such as buying the same investment type with different names.
The Dalbar study revealed that the average equity investor in 2017 during a good stock market period underperformed by 1.19% over the course of that year. Further, the study showed that investors guessed wrong 9 out of 12 months on when they put in or pulled out money. That means that fund flows went in or out at precisely the wrong time. Emotion can often cloud our judgement.
So what is an investor to do?
AAFCPAs Wealth Management takes many factors into consideration when we build our client’s portfolio in order to help ensure they may achieve their goals with the least amount of risks.
In most cases, we do not advise our clients to simply “buy the market” as no one can time the market with a high degree of certainty, and any attempt at timing does not take into account emotions, timeframe, goals, or risk tolerance.
AAFCPAs Wealth Management builds an all-weather portfolio that is customized around each client’s short and long term goals. We build plans using Monte Carlo simulations, which are based on each client’s unique retirement goals, and designed to get the market returns they need, invested in both good and bad markets, over the course of a full market cycle.
We fully leverage diversification as a risk management technique. In reality, proper diversification ensures that your investments do not all go up or down at the same time—and the positive performance of some investments neutralizes the negative performance of others.
We become increasingly conservative as clients approach the time in which they will need to use their funds. Additionally, we may work with clients to build in reserve funds which further protect them should there be a market downturn in the first few years of their retirement.
AAFCPAs Wealth Advisors closely monitor the market and economy and stand ready to adjust portfolios as changes are warranted in accordance with our clients’ individual goals and objectives.