Especially in times of market stress, you will hear a lot of self-proclaimed experts and talking heads prognosticating about what is likely to happen with world events and how that might impact the markets. If you are tuned in to a financial-oriented source, you’ll also hear people tell you how to maneuver your portfolio. They issue general predictions and recommendations that are not intended to be prescriptive to any one person’s situation and portfolio. Since they are not intended to apply to any person’s individual situation, the recommendations do not take into account your personal risk tolerance, your tax situation nor your goals or use of your money. Bottom line, these recommendations are intended for traders and not investors. So, what does that mean for investors? There are two high-level ways to manage a portfolio through a downturn. We can Guess or we can Manage.
I intentionally use the term “Guess” not to create a bias but to remind myself that nobody knows what will happen next. The market has a long history of moving in counter-intuitive ways that only make sense when you look in the rear-view mirror. Some portfolio managers decide to prove their worth by making predictions (guesses) about what will happen with the world/economy/markets and then move portfolios in anticipation to either hit or avoid what they see coming. I am not egotistical enough to believe that my crystal ball generates better guesses than the next person's.
The core problem with this approach is that it is fundamentally grounded in a guess, regardless of how many charts they can produce as proof their guess would have been right the last time. The act of shifting a portfolio results in real world costs such as transaction charges, taxes, etc. that can/will count against the ultimate performance of the portfolio. Further, it forces you into constant motion – the portfolio manager’s value is linked to their guesses so there always has to be another guess and more motion. Want proof that this method of portfolio management doesn’t work? Consider if it did. What if there was a person whose guesses were right consistently enough to be obvious. Wouldn’t we all be following that person’s Twitter feed and moving right along with them? We aren’t, so there isn’t such a person.
That brings us to the way that most of us should handle our money, Manage it through market events. Instead of trying to predict what is going to happen next, we accept two fundamental facts. One, markets go up AND down. Two, given enough time, markets have always recovered after a downturn. Knowing these truths, we can use techniques to enhance a portfolio’s performance in times of stress.
- We can Rebalance to bring portfolio risk back to our target after the market moves it. When stocks go down enough, we shift a portion of the portfolio from bonds to stocks to bring the risk level back to our intended target. Simple and effective because it forces us to move money in the opposite direction of our emotions. Instead of selling when stocks are down, we buy when prices are lower.
- We can Harvest Tax Losses by making simple changes that push temporary losses out onto your tax return where they can offset future gains produced by the portfolio. This creates real tax savings that are quantifiable and add to overall returns.
- We can Invest into the downturn if there is excess cash and a will to do so. Buying stocks while they are down is hard, but has always been profitable in the long run. You don’t have to catch the exact bottom to be effective, just feel good that you captured a lower price than existed last week or last month.
Investing is based on a fundamental belief that markets will always move higher eventually even though we cannot predict when. Notice that none of these portfolio management techniques rely on any guessing about the near-term direction or precise timing, only on paying attention to the portfolio and taking action to be opportunistic during the downturn. You can probably tell from the tone of this note that I have a strict rule: “Never guess with client money”.
NOTE: Asset allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Photo credit: Crystal Ball by Mark Bonica, CC BY 2.0