If you’re watching the markets or your investment portfolio too often, you have unfortunately noticed the sharp drop in stocks over the last week. In five trading days, we’ve seen various stock asset classes drop by over 6%. Very little mention is made of the fact that we are in the midst of a well-above-average year through month-end July.
The cause for this recent decline is heightened trade tensions between the US and China. After the US announced plans to enact $300B in tariffs on Chinese goods starting in September, China “manipulated” its currency, allowing the yuan to fall to its lowest level versus the dollar in a decade.
Of course, any media outlet could have told you what I just summarized above. What the Wall Street Journal or CNBC cannot tell you, however, is what (if anything) you should do about the decline. Why? They don’t know you, your specific goals or your overall financial situation. And those are the only variables that should cause you to manipulate or change your plan, assuming you have one to begin with. If you’re a Servo client and you would like to discuss anything at any time, you know to shoot me an email or give me a call.
If you’ve taken the time to read the blog, however, you’d probably appreciate some general perspective on keeping a level head in troubling times. If so, continue on…
One of my favorite things to point out when markets get rocky is how common it is for stocks to lose ground. Most investors in my experience either don’t know the tendency for stocks to decline or how severe the losses can be. The table below looks at the worst monthly declines for a globally diversified, small cap and value “tilted” stock asset class portfolio, (represented by DFA Equity Balanced Strategy) over the last 23 years beginning in August 1996. We’ve seen 7 months (about once every three years) where the diversified portfolio dropped double digits in just 4 weeks! Another 14 months saw losses of between -5% and -10%, including one already in 2019. Clearly, big losses happen, unpredictably, from time to time.
You might assume, in looking at all those monthly losses, that even long-term returns for the DFA Equity Balanced Strategy would be disappointing. Not so. The chart below shows that $1 invested in August 1996 is worth almost $8 today, after a compound return of +9.4% per year. There were a lot of good months to make up for the bad months we see above. In fact, only 36% of all months were negative, the other 64% were positive. This is why I don’t suggest trying to time the market—you will lose far more often than you win.
Stocks tend to get safer the longer that you hold them (they experience fewer negative returns), but that doesn’t mean they are ever “safe.” Often times, new clients become unnerved when their portfolio’s return doesn’t match its long-term average in the first few years. But that’s to be expected! Short-term returns are random and the range of returns over any one-, three-, or five-year period is all over the place. Consider the table below, it shows that the worst periodic returns for the DFA Equity Balanced Strategy were -50.3%, -18.3%/yr, and -5.3%/yr over the aforementioned 1/3/5 year periods. Those are a long way from the average +10.7%, +9.5%, and +9.1% per year returns we’ve seen over all 1/3/5-year periods! Sometimes bad things happen to good portfolios.
Undoubtedly, you want to know if there is a way to minimize those short-term losses. Many investors try to time the market, but that doesn’t work well, as the dismal performance of active managers consistently reminds us. There is an alternative, however. And that is to hold less in stocks and dedicate a portion of your portfolio to relatively safer bonds. The chart above shows a 70/30 mix of the DFA Equity Balanced Strategy and the DFA Fixed Balanced Strategy (bonds). Its worst 1/3/5-year returns were about 30% less painful than the all-stock allocation.
But this isn’t a free lunch; lower risk means lower expected returns. We can see this in the form of the average 15-year returns for the Equity Balanced Strategy (+9.2% per year) versus the 70/30 Balanced Strategy (+7.7% per year). 1.5% annually might not seem like a lot, but small differences in returns compound considerably over long periods. $1,000,000 invested at +9.2% per year for 15 years grows to almost $3.7M compared to just over $3.0M at +7.7%. $700,000 difference is almost as much as the portfolios began with. Another way to look at this is to realize, at +9.2% over 15 years, you only need about $800,000, or 20% less principal, to reach the same place as $1M that earns +7.7% per year. This is not to say that everyone should be 100% in stocks, but instead, you should carefully balance risk and expected return when deciding on a portfolio. Volatility stings no matter how little you have in stocks, but you can’t spend lower volatility, only greater wealth.
In summary, remember the keys to investing success: start with a philosophy, apply it to your particular goals, focus on your plan, set realistic expectations for good and bad times, consider your choices carefully, and then tune out the noise. As always, if you need help clarifying or pulling all of this together, give me a call.
Source of data: DFA Returns Web
Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.