Protecting Your Investment Portfolio Appropriately
In my first article Can We Protect Investment Portfolios From Armageddon?, I shared some historical examples and lessons that we can take away from those events. So what are the practical implications and conclusions that can be drawn?
Practical Applications
So the first bottom line conclusion appears to be this: It makes no sense to spend time planning for Armageddon, and it is unlikely one could time the market around an Armageddon event, in any case. This is why we believe it is important to set a client’s Investment Policy target parameters based on an expectation of their likely cash demands on the portfolio. This policy conclusion can be stress-tested against historical bad markets to determine the likelihood that a given Investment Policy has a high probability of working even if bear markets are encountered at unexpected times. Based upon such a well-reasoned conclusion, it is important not to abandon the plan and run for the exit just because things are getting stressful.
Does it follow, however, that there is nothing to do in the way of anticipating adverse developments? We do not think that is necessarily the case. Here are some things we believe do make reasonable sense in portfolio planning with respect to bear markets.
In addition to the pitfalls associated with dodging torpedoes, history also teaches that when we have experienced major bear markets (e.g., 1929 Great Depression; 1973-74 Bear Market; 2008-9 Great Recession) there is generally an economic explanation that might provide some clues, in advance, to suggest risk mitigation, not risk elimination, strategies. These economic signals are worth paying attention to, not for the purpose of outright market timing attempts, but as a means to influence marginal decisions that affect your portfolio such as the following:
- Whether to modestly overweight equities or modestly overweight bonds as compared to one’s investment policy target parameters;
- Whether to immediately employ newly available cash in equity positions or to take a more measured dollar-cost-averaging approach; or,
- Whether to provide for near term anticipated cash needs on a pay-as-you-go basis, or to pre-reserve some portion of anticipated needs.
In managing client portfolios, we believe that paying attention to various economic metrics is, indeed, a sensible way to provide guidance for decisions. Which economic metrics to use? The particular metrics to watch cover a variety of data points but can be summarized.
- First, remember the famous political advice given to Bill Clinton in his first successful presidential campaign, “It’s the economy, stupid!” What is the economic backdrop for the markets? Does the data suggest we are entering recession, in recession, emerging from recession, or is recession some distance into the future? Though the record is not without exception, it is a fact that almost all bear markets in history have been associated with an economic recession.
- Second, ask the market version of the Goldilocks question, Are stocks too hot, too cold, or just right? When the market is pricing stocks at historically high multiples of earnings, stocks are more vulnerable for repricing if bad news should hit. On March 24, 2000, at the end of the Dot-Com run-up, the S&P 500 Index of blue-chip stocks was selling for 25.6 times the next year’s earnings. This is much higher than the long-term average of 15.5. There was plenty of euphoria after the turn of the Millennium, but at these levels, stocks were too hot. We had a recession in 2001 and the index ultimately retreated 49.0 percent to bring the P/E ratio back to a much more “just right” multiple of 14.1, by October of 2002. Another example, when we reached the end of the Great Recession bear market in March of 2009, the S&P 500 companies were selling for a very low 10.3 times forward earnings. Blood was in the streets and the financial headlines were screaming, “Disaster!” at that point. However, this was not a time to give in to fear. Stocks were too cold and a powerful rebound commenced beginning on March 9, 2009. The Price/Earnings ratio is one market valuation metric, but there are a number worth reviewing to get a comprehensive view.
- Third, in the valuation debate, we must always ask, “compared to what?” In considering valuation metrics, you cannot simply conclude that a Forward P/E multiple of 17 because it is higher than the long-term average of 15.5 means that stocks are headed for a bear market. If competing investments, such as bonds, are offering very low interest rates compared to their historical average at the same time, this would justify the P/E multiple of stocks being higher.
For our managed portfolios, we evaluate these factors in our Investment Committee discussions when judging marginal portfolio decisions. We suggest that investors should follow a similar practice for monies they are managing on their own. There are two other things we suggest clients consider if they still find they are losing sleep over worrying about a torpedo to the portfolio.
- First, consider your likely withdrawal needs and compare this to the portion of your investment portfolio allocation that is invested in conservative investments like bonds. If you withdraw 4.0 percent of the portfolio’s current value per year and you hold 40.0 percent of your assets in conservative bonds, you can cover your needs for 10 years without having to sell stocks. Ask yourself, “Is 10 years long enough to be comfortable that my stock investments can repair themselves from a torpedo hit?” If your answer is no, then consider moving the conservative portion of your asset allocation incrementally from 40.0 percent to 50.0 percent. That expands the recovery window by 25.0 percent to 12.5 years from 10. That might be enough to give you a peaceful night’s sleep, while preserving most of your investment return potential in the long-run.
- Second, consider adding a little insurance to the portfolio in terms of some ownership of gold or a security tied to gold. Gold will serve to provide a “panic hedge,” in the event of unsettling global events as investors always flock to gold at times of global stress. We don’t suggest overdoing this, but consider a position of something like 5.0 percent.
Conclusion
Our experience from more than 40 years of helping investors look at these questions is that people generally spend far too much time focusing on this question of avoiding Armageddon. Becoming too occupied with these fears will likely to lead to poorly conceived decisions to protect one’s portfolio. In most all the cases we have observed, the result is to protect the portfolio for earning appropriate and satisfactory long-term returns.
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Linscomb & Williams does not provide legal, tax or accounting advice. The information, analysis, and opinions expressed herein are for general and educational purposes only. This presentation may contain forward looking statements that may or may not occur. Nothing contained in this presentation is intended to constitute legal, tax, accounting, financial, or investment advice. Always consult with your independent attorney, tax advisor, and other professional advisors before changing or implementing any financial, tax or estate planning strategy.
Information expressed herein is based upon opinions and views of Linscomb & Williams and information obtained from third-party sources that Linscomb & Williams believes to be reliable, but Linscomb & Williams makes no representation or warranty with respect to the accuracy or completeness of such information. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.
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