The first quarter of 2022 has been anything but calm. After robust returns across markets during 2021, volatility returned meaningfully.
This year began with growth stocks continuing a steep decline that started late last year, followed by indications the Fed would reduce its balance sheet and raise rates in response to high inflation readings and an invasion by Russia against Ukraine. Although it's the first time in two years that COVID hasn't been the primary concern, there has been plenty for the market to contend with over the past several months.
The S&P 500 Index declined as much as 13% before recovering to a decline of 4.6% by quarter-end. Meanwhile, the NASDAQ Composite Index declined as much as 22% from its October 2021 peak before finishing the quarter down 8.9%. In addition, with fears that above-average inflation will be sustainable and with, interest rate expectations rising, the bond market suffered a 5% decline during the quarter. It felt like there was nowhere for an investor to hide this quarter.
Where the stock market will go next week or next month is anybody's guess.
We operate under the belief that short-term movements between euphoria and despair will always be unpredictable. During tumultuous times, we consistently advise clients to remain long-term focused. Their diversified portfolio and the balance were explicitly built with their circumstances in mind. It isn't easy to see through the short-term fog when your portfolio value has declined, but this is the third time markets have declined more than 10% since the fourth quarter of 2018. We frequently remind clients that the average drawdown for stocks is between 10 and 15% in any calendar year.
Individual client circumstances serve as a primary driver for asset allocation. A client's net worth (assets less debt) and withdrawal rate are used to determine their "ability" to take risk. The ability to assume risk represents the amount of risk that the client's financial state can easily absorb. The higher the rate of expenses relative to portfolio value, the lower the ability to take risk. It represents a greater need for the portfolio to hold its value, even short term. The reverse is true as well. The lower the rate of expenditures relative to the portfolio, the higher the ability to assume risk. A strategic portfolio in this resilient state can absorb a higher rate of short-term downturns while still easily meeting withdrawal demands.
In addition to a client's ability to take risk is an assessment of their willingness to assume risk. There are all kinds of questionnaires available to make this assessment. Still, we have found that simply sitting down and having a conversation with a client, learning their history, and trying to understand their emotional habits when it comes to investing and finance in general leads to a more thoroughly derived conclusion. Willingness to take on risk is a constant learning process as our asset picture changes, as we age, as our psychology changes, and as a client gains more experience with a living portfolio.
In constructing a portfolio, we need to properly balance a client's ability and willingness to tolerate market turbulence with their desire for investment performance. This is where determining the allocation to equities and fixed income -- the offsetting ballasts between risk-seeking and risk-averse assets -- becomes essential. It’s important to note that risk-seeking and risk-averse assets have a low correlation by design. Fixed income investments tend to rise and fall much less dramatically than equities, making them a strategic offset to the higher volatility inherent in equities. In exchange for that volatility dampening, fixed income has historically provided a lower total return than equities over the long term. Additional layers of diversification strategy beyond equities and fixed income go into a client's asset allocation strategy as well. The goal is to construct an asset allocation that allows clients to maintain conviction and stay invested through the market cycle.
We revisit our portfolio targets regularly, incorporating any new information or circumstances about the client and any changes in markets that we want to reflect into portfolios. On the client-side, what events have changed to a point where we may need to adjust our asset allocation for that client?
Some common examples include:
• Employment change resulting in a material income change
• Portfolio value grows faster than withdrawal rate
• Change in life goals (i.e., deciding to retire earlier)
• Increased medical expenses
• Unexpectedly having to provide care for a loved one
• An inheritance or other windfall benefit
Planning around these life events and life changes is a strong reason to consider altering a portfolio's asset allocation. However, contrast these unique and infrequent events with day-to-day market movements, and there's just no comparison. Short-term market movements should not drive long-term portfolio asset allocation.
It is critical to display patience, think long-term, and use periods of volatility to rebalance and seek opportunities. We stay focused on client goals as we set and revisit asset allocation targets to balance growth and conservation to be consistent with a client's unique needs and circumstances.
If you have any questions about your asset allocation strategy, please reach out to us for assistance.