What's Past is Prologue
Originally used in The Tempest, Act 2, Scene I, Shakespeare was invoking the concept of destiny or fate. Today, we use the phrase as it is commonly used by historians when discussing the similarities between events throughout history. Is this an opportunity to find comfort in the past?
Concerns about Russia’s invasion of Ukraine have weighed heavily on Wall Street in recent days, including this week’s broad declines that saw the S&P 500 close in correction territory, which is defined as more than 10% below its most recent high.
This has left many investors asking: “what’s different now?” While we know current events are not easy to watch, it is important to recognize that the market’s response is normal and it’s part of any normal “market cycle.” In this environment, it can be helpful to put today’s market volatility into perspective.
Market pullbacks and corrections are common and to be expected
What’s happening currently is nothing new in terms of volatility and pullbacks throughout history. According to data from Morningstar, pullbacks occur with some regularity. As you’ll see below, about 45% of trading days result in negative returns and more than 42% of the weeks during the year have finished in the red:
Frequency of Negative Returns
The volatility we’ve seen so far in 2022 is well inside these parameters, while we appreciate that current geopolitical instability has added to recent spikes.
Also, while market corrections are common, they are not nearly as common as predictions of market corrections. According to Forbes, since 1928, a correction of at least 10% has happened in the S&P 500 about once every 19 months. Of the 27 corrections since World War II, the index has experienced an average decline of 13.7%.
Below is a list of the peaks and troughs (the lowest point) of the six corrections in the S&P 500 since the end of the Great Recession in 2009. This includes the Covid-19 crack-up in February and March 2020, which would be more accurately described as a market crash, given the 33.9% peak-to-trough decline in the S&P 500.
Days Peak to Trough
April 23, 2010
July 2, 2010
April 29, 2011
Oct. 3, 2011
Nov. 3, 2015
Feb. 11, 2016
Jan. 26, 2018
Feb. 8, 2018
Sept. 20, 2018
Dec. 24, 2018
Feb. 19, 2020
March 23, 2020
It is important to limit your downside risk
Regardless of an investor’s appetite for risk, it is important to limit your downside risk to help ensure that you are not taking on more risk than you are comfortable assuming, or more than your financial plan allows for. Employing strategies to help limit your downside risk should be a fundamental component of your investment strategy.
A key tactic to mitigate downside risk is diversification. This extends beyond simply having an appropriate mix of stock and bond investments. Such an approach is incredibly important and serves as a core building block for virtually all portfolios.
True diversification includes adding asset classes like real estate and other alternatives that don’t correlate as strongly to traditional stocks and bonds. In addition, diversification includes investing internationally to take advantage of opportunities in both foreign developed markets and emerging markets.
The point of investment diversification is to not have all your investment eggs in one basket, as the saying goes. Different asset classes and geographic regions behave differently under different market and economic conditions. A properly diversified portfolio can help investors capture market upsides while limiting the impact of disruptions and down markets in accordance with their risk tolerance.
Take advantage of market swings to maximize investment opportunities
If you invest, you need to come to terms with the fact that the market will move both up and down somewhat regularly, and perhaps even more during periods of geopolitical instability. Instead of fearing these downward swings, use them to your advantage. Here, it’s also important to have predetermined price levels in mind for stocks. Then, if they fall to a certain point, you can be ready to buy them at a more attractive level.
Another key tactic to employ is portfolio rebalancing. Set a target asset allocation for each asset class in your portfolio. This includes sub-asset classes of stocks and bonds. It includes domestic and international stocks and bonds as well. Beyond this, the allocation includes alternative asset classes such as real estate and others.
When developing an asset allocation strategy, you should set ranges for allowable variances in the allocation to a given asset class. This might be + or – 5% of the target allocation, for example. If the allocation to that asset class varies outside of that range for any amount of time we rebalance. This may involve selling part of this asset class if the variation is to the high side, or directing assets from another part of the portfolio to an asset class whose allocation has moved past the lower end of the target range.
A downturn in the market often results in equity-based asset classes dipping below the rebalancing threshold of their target allocation. Redirecting money to these asset classes when the markets are lower, and prices are often lower as well, can result in the classic buy-low situation.
Active portfolio monitoring is critical
Knowing when to take actions, such as rebalancing, is the result of active portfolio monitoring, and you should monitor allocations on a regular basis and rebalance at regular intervals.
Beyond this, stay on top of where you've invested. The characteristics of both individual securities and managed investments can change over time. You should further realize that change is a constant in the current investment environment. So, don’t hesitate to “pull the trigger” on an investment when the situation warrants.
Proper diversification along with active portfolio monitoring are, perhaps, some of the most important tactics you can employ. You can take this a step further by tailoring these functions to your unique needs.
A financial advisor can help make your journey easier. Our goal is to understand your needs and create plans to address them. While we cannot control financial markets, geopolitical instability, inflation, or interest rates, we can make sure to focus our efforts on the things we can control.
We can discuss your specific situation during a complimentary financial consultation, please schedule an appointment at your convenience.