We’re currently in the midst of a period of heightened uncertainty, volatility, and panic due to the COVID-19 (coronavirus) pandemic. Clients are justifiably worried.
The stock market has been volatile. Our daily lives have come to a screeching halt. Vacations, sporting events, and concerts have been cancelled. There are plenty of reasons to be concerned about the near future. And, naturally, that includes one’s investment accounts. Everywhere people look, risk abounds – and the abruptness of the recent market decline, combined with outsized volatility, has made it even more unsettling.
In this environment, clients understandably question our desire to keep owning equities. Why would you hold stocks when you have strong reason to believe that pain lies ahead? We think it could be useful to help our clients appreciate how we think and operate during stressful periods (in their investment accounts as well as our own) by asking a different question: what is risk?
In the eyes of a short-term trader (or a long-term investor who employs leverage), who may have an investment time horizon of months, weeks, or even days, risk is any market movement that works against your trade (down on a long position or up on a short position). When put in that position, you are completely dependent upon the short-term whims of other market participants.
A long-term investor, on the other hand, can choose to be indifferent to short-term volatility (we suggest a long-term horizon is five-plus years). We want to be in that camp, partly because we believe that predicting short-term market moves or changes in sentiment with any degree of certainty and consistency is a fool’s errand (or, at the very least, a more competitive endeavor).
Instead, from the perspective of a long-term investor, we think there are two primary risks in investing. The first is the inability to stick to an asset allocation throughout market cycles. This manifests itself in portfolios through a reduction in risk assets (equities) during periods of despair and an increase in equities during periods of optimism. This behavior, which is an emotion driven form of market timing, ultimately results in a “buy high, sell low” strategy. Unsurprisingly, it can prove destructive to one’s financial health. While there’s no cure for one’s emotions, we think that a reminder of a few truths is worthwhile. First, the world is always uncertain. Second, short-term market movements are unknowable. And third, over the long run, equity ownership has proven to be a fruitful endeavor. It’s the ability to remind oneself of all three of those truths that can be helpful in times of stress (like what we’re experiencing today).
Said differently, an unforeseen correction in the stock market of 20%, 30%, or more, is possible at any time (that said, it is historically rare). And if you’re going to be a long-term investor, they are unavoidable. Stocks are always risky. Anybody who owns equities that does not accept this reality is putting themselves in a fragile position – a position that is likely to end in suboptimal decision-making (most notably, heading for the exits in the midst of a world blanketed in fear).
There’s another (related) risk to an inability to stay committed to a sensible long-term asset allocation: the inability to meet one’s long-term financial needs.
Here’s one way to think of it. If you’re 60 years old and have a 20-year investment horizon (even retirees need to maintain purchasing power), you can invest in a treasury bond with a current yield around 1%. If you had $1 million saved and put all of it into long-term treasuries, you would receive a check for $10,000 a year. When the bond matures in two decades, your initial investment would be returned (which, after two decades of inflation, would likely have much less buying power than your $1 million today). Over that same 20-year period, an investment in an S&P 500 index fund would compound to $3.9 million (assuming an annualized return of 7%). That’s a long way of saying that there’s also a (costly) risk associated with hunkering down in a hole and refusing to accept any volatility.
The “solution” is to determine a suitable balance between stocks and bonds that accounts for one’s ability and willingness to bear risk. The ability to weather short-term volatility depends on one’s financial position and time horizon, while willingness considers how one deals with the ups and downs from a behavioral perspective.
But the other part of the “solution” is to remember what equities are. Those shares of Microsoft or Apple in your brokerage account are not just numbers on a screen. You are a minority owner of those businesses. And regardless of how crazy things become in the short-term, both of these companies have the financial wherewithal to survive (as an example, they each hold more than $100 billion of cash & equivalents on their balance sheet). They sell products and services that are in high-demand by consumers and businesses around the world. And while the world may shut down for weeks or months to address virus concerns, which could lead to lower demand for some time, billions of people – someday – will continue to do business with these companies.
And while this is harder to appreciate from where we stand today, peering through a lens with a longer perspective reminds us that the world continues to make steady progress, as it has for decades and centuries. Owning high-quality companies at reasonable valuations has been a good way to participate in this progress.
Opportunity lies in wait for those who are willing to stomach short-term uncertainty. We hold broadly diversified portfolios of high-quality businesses with strong balance sheets for times like these. When all is said and done, we believe that the world will ultimately find a way forward. Our companies will make continued progress as well. As investment advisors, our hope is that we can convince our clients to stay focused on the long-term so that they will be properly rewarded for tolerating periods of stress and anxiety.
As always, please CONTACT US if you have any questions or concerns.