By Nirav Batavia, CFA
Market volatility, especially the rapid price drops that we have seen in the first quarter of 2020, can be unsettling. The natural emotion that often follows is some form of panic as investors look at their account statements. Some investors will want to get out of the market to make the pain stop. Others may feel the urge to make a change in their asset allocation or invest additional cash in an attempt to recoup losses without considering the short-term downsides if unforeseen changes happen in their life. Having a long-term financial plan and an advisor to act as a coach through these times can help balance emotions and ensure investors take the right steps for their long-term well-being.
Step 1: Try Not to Do Anything Rash
Buying and staying disciplined is not just for normal markets. Markets drop 30%+ about every 13 years, so these events are bound to happen in everyone’s investment experience. They always happen for different reasons, but they almost always feel like “this time is different” with no light at the end of the tunnel. Jeremy Grantham, co-founder of the investment company GMO, said, “Finally, be aware that the market does not turn when it sees light at the end of the tunnel. It turns when all looks black, but just a subtle shade less black than the day before.”1
In 2008, there were commentators who thought a large percentage of companies were going bankrupt as the market dropped 56.8% from peak to trough. During 2000–2002, the NASDAQ dropped by 78% from peak to trough. These selloffs have to feel endless and remove hope of a return to normalcy. If market participants believe there is a light at the end of the tunnel, the selloff would not sustain. Fear must reach levels where some investors ask the question, “Is this time different?” Another way of saying that is investors need these periods of volatility to provide the equity risk premium (return greater than the return of a risk-free asset like the three-month U.S. T-bill) and long-term positive returns. In the past, markets have eventually recovered, and investors have always been better off for remaining disciplined and taking advantage of opportunities presented during volatile markets.
For most investors, the reality is that down markets are unequivocally better for them than if these drops never happened. It allows dividends to be reinvested at cheaper levels, savers to buy at lower prices than they could have otherwise and portfolios to be rebalanced from bonds to stocks to take advantage of lower prices. When markets eventually recover, those purchases at lower prices end up driving higher long-term wealth than if the market had never dropped in the first place. This piece is one of our absolute favorites in illustrating this concept: “Why a 66% Crash Would Be Better Than a 200% Melt-Up.”2
Down markets being better from a long-term wealth perspective means the opposite is also true — up markets are generally bad for investors’ long-term financial net worth. However, the problem is human nature lends us to keep score by portfolio value. In fact, we are hard wired to do so and, therefore, we end up focusing on the short term to the detriment of our long-term well-being.
If we as investors believe that we should be compensated in the form of positive expected returns in excess of the risk-free rate for holding assets with risk, we must also accept that excess returns cannot be realized long term without periods of volatility and even sizable declines. So, the first and most important thing you can do is realize these down markets are part of the plan and avoid deviating from the plan.
Step 2: Evaluate Your Cash Situation
Most clients who engage with an advisor are told to set up an emergency fund before doing anything else. While it is relative to each client’s situation, a rule of thumb often used is somewhere between three months and six months of expenses. That tends to be a valuable rule of thumb in normal times, but during a crisis like the one today, this should definitely be re-evaluated. Job losses, furloughs and even different living arrangements could require larger emergency funds than previously anticipated.
Find a New Emergency Fund Level: Assess whether life changes require additional months of savings and agree upon a new emergency fund level if needed. This should include an honest look at your household situation and what could happen to cash flow in a worst-case scenario. (What if the economy is still not normalized in 12 months? Does that change your answer toward your job and income security versus today?) We have seen situations ranging from no changes to needing to add 18 months of expenses to maintain a reasonable emergency fund because of circumstances.
Build Toward the New Emergency Fund Level: Next, create a plan to get to that increased emergency fund level in a reasonable amount of time. While most clients may need to access brokerage funds to free up enough cash to expand the emergency fund, other clients, who continue to have stable incomes, can expand their emergency fund through savings alone, which is preferred.
Access Accounts to Raise Emergency Funds: If accounts need to be accessed to raise emergency funds, an after-tax brokerage is the preferred option because there are no penalties associated with withdrawal. If a brokerage account is not available or not possible, there are a number of options to access retirement assets, especially in 2020. Accessing retirement accounts should be a last resort but it can become necessary in some cases and your advisor can talk you through those options.
Step 3: Deploy Excess Cash (for Pre-Retirees)
Some clients have enough of an emergency fund for their current situation and may have additional cash as well. These clients need a plan to invest into the market. As we mentioned in Step 1, the fact that prices are lower than they have been in the recent past drives greater long-term wealth if clients are in a position to take advantage. However, given the volatility of the markets, individuals may be apprehensive about deploying all their assets at once. There are two approaches that make sense in the deployment of capital.
1. One-Time Deposit: Theoretically, this is the correct approach. Since expected returns are always positive (otherwise, nobody would lend or undertake any financial risk if they did not think they were going to make money), the earlier you invest, the better the theoretical long-term outcome for the portfolio should be. We recommend this if we know the client will remain disciplined through the ups and downs of the portfolio, or if the intended deposit is small in relation to the overall portfolio.
2. Dollar-Cost Average: By dividing the deposit into equal monthly increments, the portfolio reduces the point-in-time risk — the chance that the market drops significantly right after the money goes in — since the point of entry is spread over time. However, this reduces the expected return since the average dollar is getting into the market later than it would in a one-time deposit. This is why we try to keep dollar-cost averaging to short periods like three months or six months.
If the introduction of dollar-cost averaging reduces the chance of an investor losing discipline to the process, it can make more sense than a one-time deposit from the perspective of a long-term plan. Dollar-cost averaging tends to be the preferred method for large deposits and clients who are very concerned about current volatility.
Step 3: Evaluate Spending (for Retirees)
If you are already retired and living off your investments, now is a good time to make sure you are spending within your means to ensure your money will last your lifetime. While we do anticipate these periods and build them into your sustainable spending projections when creating your financial plan, down markets can have a significant impact on your long-term plan, either positively if you can reduce withdrawals or negatively if you are overspending. Here are a couple factors to think about:
1. If you were spending more than your sustainable spending amount, your withdrawal rate as a percentage of the portfolio is now even higher and it will be harder for your portfolio to recover if the down market is sustained for a long period. This is a good time to speak with your advisor and evaluate your sustainable spending relative to your expenses.
2. Even if you are in a good spending position long term but spending less due to the current environment (maybe traveling or dining out less), your portfolio could benefit by reducing withdrawals for a period of time to allow more of your money to stay invested. Again, your advisor can help you think through this process.
Going through these three steps is an important exercise for many individuals during market downturns. Clients and their advisors get a chance to take a step back from the recent situation and focus on the long-term plan. It also allows investors to address any changes in their circumstances and evaluate if they are in a position to take advantage of the current lower prices in the market. By systematically addressing these steps, we can all have greater confidence in long-term plans and outcomes.
1 Jeremy Grantham, “Reinvesting When Terrified.” GMO, March 2009.
2 “Why a 66% Crash Would Be Better Than a 200% Melt-Up.” PhilosophicalEconomics.com, May 17, 2014.
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