As coronavirus fears have irked markets globally, it gives us an opportunity to redefine how we respond to uncertainty and its impact on portfolios.
Ben Carlson has done a nice job providing some thoughts on our headline risk du jour, but we want to give you some additional insight.
First, the nature of risk is that it’s unpredictable. And whether the cause of the turmoil is political, economic, health related, or some other nuisance, we know that the future, by definition, is unknowable.
Not long ago, the markets were deeply disturbed by the interactions between President Donald Trump and North Korean leader Kim Jong-un, and the potential for war between the United States and North Korea. Imagine having fallen into a coma in 2010 and awoken to see that as a headline.
There are plenty of other crises (real or media manufactured) which catch the attention of the market, only to be forgotten as quickly as they were generated. It’s impossible to know which “crisis” will actually move the market in a sustainable way. And while capital markets are resilient, they sure hate uncertainty.
Historically, investors who have shown an ability to embrace uncertainty are those who have proven to be most successful at building and maintaining wealth, and those who make the wrong mistake at the worst time have fallen behind. This dynamic is well-defined by Carl Richards, who calls it The Behavior Gap. That is, the gap between the return on an investment, and the return that investors actually receive thanks to their bad behavior.
In practice, it looks something like this:
So, how does Greenway handle this sort of uncertainty?
First, we design portfolios that take it into account before it actually happens.
We had no idea that the potential for a global pandemic would be the thing that drove markets crazy, but we do know which types of assets are riskier, and which tend to be safe havens during market madness.
For clients with longer time horizons, it means acknowledging that the money you have invested might not be needed for decades into the future. As long as the market recovers by then, we have little to be worried about. In fact, we’re confident that our younger clients will experience multiple maddening market events during their lifetime, and for them, a sustained downturn is actually a pretty good thing.
For everyone, we have two main tools in our toolkit to take advantage of market downturns: Rebalancing and tax loss harvesting.
- Rebalancing is the process of buying low and selling high, and resetting a portfolio back to its proper state. In the past few years, we’ve had some opportunities to take advantage of stock market downturns and buy additional shares at a discount, but for the most part, the past decade has been good to stocks.
We set our threshold at about 5%, meaning if the portfolio swings 5% one way or another away from our target, we’ll look to rebalance it. We may be more aggressive than the 5% threshold if we can trade inexpensively during volatile times like these.
- Tax loss harvesting is the process of replacing an asset that has a capital loss, and replacing it with a similar asset. The portfolio remains relatively unchanged, but you get to reduce your tax bill. Schwab does a decent job of describing the process here.
Ultimately, our job as advisors is to help clients minimize mistakes. Investing is like amateur tennis: the player who makes the fewest mistakes is probably going to win the game. Our portfolio process is well-defined and is based on decades of academic research, and our implementation means we’re aiming to get the ball back over the net on every point.