What Should I Do About Risk and Uncertainty?
By: Brian Seay, CFA
You are likely to experience a loss of 30% or more of your investment portfolio in one year over the rest of your life. If you are under 40, you will probably experience that kind of significant loss more than once. If you are older, you have likely already experienced it. In the global financial crisis, the S&P 500 fell more than 55% from October of 2007 through March of 2009. A 60/40 stock bond portfolio fell more than 34%. During the onset of the Covid Pandemic, from mid-February through mid-March of 2020, the S&P 500 fell more than 33% and a balanced portfolio fell more than 21%.
There are a multitude of risks today. Inflation, geopolitics, technology disruption, high valuations, population and immigration changes and the list goes on. So how do we think about risk as investors? I wanted to talk about real risk – what that is, how we measure it and most importantly what we do about it with clients.
You may have heard a lot of terms associated with investment risk. Terms like max drawdown, volatility or standard deviation, perhaps even value at risk or other more complex statistic concepts. I want to put that off to the side for a moment and reframe risk in a way that I think makes it easy to grasp. Real risk in investing is simply the chance, or perhaps probability, that you do not accomplish your objectives. If you are saving for retirement, real risk is that you run low on money and must significantly scale back your lifestyle. That can be very painful. Even if you aren’t at risk of running out of money, you may have other personal goals like building assets for your family or leaving resources to charity. Perhaps you don’t accomplish those. If you are an organization, like an endowment or non-profit, risk is that you aren’t able to meet your annual spending goals out of your investment account or that it loses so much value it ceases to be a long-term asset for your organization. Said simply, risk is the chance that you do not accomplish your goals.
Standard deviations, other measurement tools and even market corrections aren’t really risk. Certainly, they are tools for measuring risk and useful for understanding the real position of your portfolio, but just because the market is up or down over a day, week or even year, shouldn’t change the real chances of accomplishing your goals by much.
If you have a well thought out financial plan, market volatility and downturns, even serious ones, should be accounted for in your plan. We typically run scenarios for clients that include multiple significant recessions and downturns over the course of their investment timeline. So, their plan, from day one, actually includes several deep recessions and market drops. Those bad years are baked into the cake so to speak.
The single worst investment mistake you can make is selling out during market downturns because you can’t take it anymore. The stock market in particular moves today based on expectations for the future, that means it will move back higher from a bottom before the economy really “feels good” and makes you want to reinvest your money. Let’s look at the financial crisis and covid periods again as examples. You can see during the financial crisis, the S&P 500 bottomed in March of 2009 and was then up almost 60% before the end of the year.
In April of 2009, the Fed was expecting U.S. economic growth to be negative, between negative 1.3% and negative 2%. The economy lost more than 600,000 jobs In March of 2009. GM and Chrysler were closing plants. Not exactly a setup for significant stock market gains, but that’s what happened the remainder of the year. If you started investing in the S&P 500 in January of 2007, you certainly had a challenging couple of years, but your $100,000 turned into $299,000 by the end of 2019. However, if you sold out on March 1st of 2009, when the fever pitch was at its worst, and didn’t get back in until January 1st of 2010, You only had $193,000 in December of 2019. That’s a full 1/3 haircut off your wealth.
Lets zoom forward to Covid. The market bottomed in March down almost 30%, but recovered to 5% of its previous high by June of 2020. If you bought the S&P 500 Index with $100,000 in January of 2020 and held on, you have almost $200,000 today, almost double your initial investment. Remember, March of 2020 was the first time most U.S. states saw their first Covid cases. Later that month they closed schools, issued stay at home orders and we started daily briefings from President Trump at the White House. It was the beginning of the Pandemic. It was the bottom of the stock market. If you sold on March 15th of 2020, when the news was at its most dire and waited to re-enter the market until the MRNA vaccine was approved by the FDA on August 22nd of 2020, you only have $158,000 today. You never overcome the lost time.
So the first takeaway is to evaluate your real portfolio and financial plan risk. Investment results are never certain. But are you confident you can accomplish your goals in a variety of market and economic scenarios? If not, now would be a good time to reevaluate your situation.
So how do we increase our odds of being able to stick it out? That comes from building a portfolio with many different kinds of assets that should reduce the total decline in your portfolio during bad times.
I often find investors that think they are “diversified,” but their exposure is really just to U.S. large cap stocks. They are well diversified in many U.S. large cap stocks to prevent one specific company from causing a big issue for their portfolio, but if the whole stock market tanks, they will have a problem. Ensuring that your stock portfolio itself has exposure across geographies and company size, like small and mid-caps, is a good starting point. I understand the proverbial argument that returns over the last decade have come largely from U.S. large cap stocks, especially tech stocks. But to meet your investment goals you can likely afford to shave off a few percentage points of U.S. returns to hedge against the risk that we have a decade like the 2000s, where international stocks significantly outperformed the U.S. So Diversify your stock holdings.
Then we need to go beyond stocks. Fixed Income or bonds pay interest in exchange for your investment. They can be highly effective when the economy turns sour and interest rates decline. Just like there are many kinds of stocks, there are even more kinds of bonds. You’re probably familiar with Treasuries, or U.S. Government debt. Companies like Exxon Mobil and American Airlines also issue debt. Banks issue several different kinds of bonds. You can also buy asset backed bonds that are groups of things like home mortgages, commercial real estate loans, car loans and even credit card debt. Finally, there is private credit or lending to private equity companies that are going to buy a business. Those loans can have interest rates in the low double digits. So the market is broad and different kinds of fixed income can help diversify your portfolio in different kinds of markets. In our quarterly outlooks we talk about different types of bonds and which ones you might consider in the current environment, so I won’t go through all of that here.
Outside of stocks and bonds, you should also consider things like precious metals and commodities. Gold has done well over the past few years because of uncertainity around inflation, the U.S. economy and changes to the buying patterns of global central banks. Commodities like oil and gas, corn and even orange juice can be useful as well during periods where inflation may rise.
Real estate is another great asset class that can diversify equity market exposure. Some parts of the market, like commercial offices, are highly correlated with the stock market. But others, like Timberland or farmland may not be.
You can even buy shares in public infrastructure like toll roads, bridges and airports. Those kinds of assets get used regardless of what’s happening in the stock market.
Outside the core asset classes, you have different types of trading strategies like hedge funds or long/short funds that may take some of the assets I mentioned already and trade in ways where they can make money if prices go up or if prices go down. Different kinds of trading strategies, if owned consistently across time, can also lower the drawdown of your portfolio.
So there are lots of different options for diversifying your investment portfolio to reduce risk and likely reduce the drawdowns that occur during economic turmoil. The right assets to own and exact percentages of each asset are unique to each individual or organization’s portfolio. What are your return objectives and how can assets be combined to achieve both your return goals and to manage risk along the way.
Right now, as I’ve explained in my outlook for 2025, we are in a period of slowing economic growth. Interest rates are high, and the economy is decelerating from a period of very fast growth coming off the re-opening after covid that way enhanced by massive stimulus from the U.S. government. I don’t expect a lengthy, severe recession, or significantly higher inflation. However, both are possible and thus portfolios should be positioned to manage the risk of either scenario. Gold works well in the current environment because it should do well in both the uncertainty of a slowdown or recession and if inflation unexpectedly picks back up. You can see how understanding the economic environment and the available assets, then allows you make smart choices about assets to include in a well balanced, truly diversified portfolio that will help manage risk long-term.