Strategies for navigating stock market volatility
What to do when stocks are volatile
Hello everyone and welcome to the Planning for Retirement Podcast. My name is Kevin Lao and I am your host. Just a quick background on me, I’m a CFP been in the business for almost 14 years and I have my own firm serving clients all over the US. We’re based here in St. Augustine, Florida. My firm is Imagine Financial Security. But this Podcast is to educate you on the strategies we put in place every day to help our clients plan for retirement and achieve financial independence.
If you have any questions about working with me one-on-one or, even had feedback on our Podcast, I always love to hear from you. And you can visit my website at imaginefinancialsecurity.com and contact me that way. Also, be sure to subscribe and leave us a review on iTunes, if you’d like what you hear.
This episode on January 24th 2022 is episode number eight. It is called what to do when markets are volatile? Before we jump in just a quick disclaimer, this should not be construed as investment, legal or, tax advice. And you should consider your own unique circumstances and consult your advisers before making any changes. So, let’s dive in.
All right, as I mentioned it is Monday, January 24th, it’s the evening. My three boys are now sleeping. So, I have some quiet time to record this episode, which I’ve been looking forward too. We’ve been in some ballot of volatility over the last four to five months really starting with the Delta variant in the third quarter.
The markets got a little bit spooked. Of course, with the recent variant Omicron in the fourth quarter of 2021 and we’re officially in correction territory with the NASDAQ intraday today was down 17% from its previous high. The S&P 500 was minus 10% and some change from its previous high.
Correction vs bear market
We’re definitely in correction territory with both of those and the small caps in the US, are actually in bear market territory. So bear market, just to define this, is a drop of 20% or, more from previous market highs. So, many times I’ve clients or, prospects, they come to me and ask what should they do? What should their strategy be?
So, really to simplify things, there are three things you can do. You can sell something. You can buy something or, you can do nothing.
And I hear many talking heads in our industry, even advisors, co-workers, friends, family, I hear a lot of people talk about number three, which is do nothing. Bury your head in the sand, just let the dust settle and just don’t look at your statements, and then wait a year.
This is great for people who don’t know what to do because making a mistake is, you certainly want to avoid selling something at the wrong time and making that big mistake.
So, doing nothing is certainly better than making a big mistake.
But the real answer, the one the pros practice, and the one my firm employs is, to do a little bit of both. You sell some things and you buy others.
Now, what to sell and what to buy is, much more of a complex question. I’ll go into what our process looks like, in just a moment. But first of all, I just want to talk about what’s going on in the markets now? We’ve had record high inflation. We’ve had for many months, really since June, we have had interest rates spike at the beginning of the year, so far in 2021. So, the concern, there is large purchases like, homes and cars are becoming less affordable.
It also impacts the ability for businesses to borrow money, which has been a very easy thing to do for businesses, for many years, really since 2010. So, that’s going to become a little bit more difficult. A little bit more expensive, which will impact the growth and then ultimately, number three, which is really related to the first two is, this concern of slowing growth in 2022 and 2023.
Really, with the reopening from the global shutdown in 2020 towards the end of 2020 and 2021, we’ve been experiencing a rapid expansion because we were experiencing the reopening from the lock downs. Naturally, the pace of growth is going to slow and so, investors are certainly concerned with that, and ultimately concerned with stock prices not being aligned with their valuations.
So, those three things are really contributing to the stock markets being volatile and what I will say is, volatile markets are normal. They’re healthy. If stocks had no volatility, they would not provide the upside potential, they have provided for decades. We’ve all heard the notion of risk and reward.
Well, if there’s no risk involved, there’s no reward involved. I tell my clients and friends, and family and people I talk to is, embrace the volatility. This is an opportunistic period of time in the markets, and we’ll talk about here in just a second. So what do I mean by opportunistic?
Let me throw out a quick statistic that really jumped out to me. This was done by Hartford Funds I believe, and I’ve been looking at this study year after year, and I think they update this almost every year. We talked about bear markets being minus 20% drop a bull market, conversely, as a 20%, increase in prices from previous lows.
So, listen to this, more than half or, 56%, of the S&P 500, its best performing days in the last 20 years have occurred, while we are in a bear market.
Again, we’re not in a bear market for the S&P or, NASDAQ yet, but I’m just talking about volatile markets in general. When things are bad, we tend to have some of the best performing days in the market. Actually, here’s another one. I’ll follow up on that.
Another 32% of the best days in the market took place, in the first two months of a bull market.
So, if you really add those two up which probably, isn’t fair to do, but let’s say 88% or, north of 80%, of the best days in the S&P 500, over the last 20 years have occurred, while we were in a bear market. Ok. Now, you could argue. You know, a large part of that was 2008-2009, with the worst recession since the Great Depression. We were in a really deep recession, a deep bear markets.
Of course, there were a lot of good trading days during that period of time, but you really look at 2020 as another example, that was the other bear market we’ve had over the last 15 or, so years. There was some great opportunity in March, April, May, June, July of 2020, where if you didn’t take advantage of it, it hurt your recovery.
If you sat it out, there’s no way you would have made back what you’d lost at the beginning of 2020. But the important note is, that when things are bad people tend to run. People tend to get scared and that’s when opportunity arises. Ok, valuations become more attractive, stock prices are lower than they were previously and so investors that have been sitting on the sidelines, opportunistic investors, are now buying in, now getting into the market.
It’s like the quote I love from Warren Buffett is, be fearful when others are greedy and greedy when others are fearful.
I love that quote and I think it really applies to the process I employ for my clients.
Another interesting statistic I want to throw out there is that, bear markets last 10 months on average, but bull markets last three years. So, this really goes hand in hand with a lot of the advice people give around, just wait it out, don’t make any moves. You just buy and hold.
Don’t make any rash decisions because on average, bull markets tend to last longer than bear markets. If you did nothing, you probably did just fine over the course of a long period of time. Ok. But how do we become opportunistic? How do we really take action during periods of volatility?
This is really what the answer that people are looking for when they come to me during these periods. Ok. What my clients are looking for in an advisor during volatile markets?
So, the answer is simple. We manage to each investment policy statement. Ok, let me repeat that, we manage to each individual investment policy statement.
So, what’s an investment policy statement?
A simple way, a simple definition is, it’s a written document that designates a certain percentage to be allocated for each asset class. Ok. How do you create an investment policy statement?
So, the equation in my mind is very simple. It’s your financial goals, combined with your risk tolerance or, risk capacity. Minus your financial resources equals your investment policy statement.
Some examples of asset classes would be, let’s say, large cap US growth stocks or, International stocks or, US bonds or, Real Estate, just to name a few. A well-designed investment policy statement will have asset classes that move in different directions during different periods of each economic cycle. Meaning they’re well diversified from one another.
So, as the market shifts, the percentage you own and each designated asset classes, you then have the opportunity to sell at a premium or, buy at a discount relative to your IPS or, your investment policy statement. Ok. If you have no starting point, it’s never going to make sense mathematically of, when to buy and when to sell?
Whereas, if you have an investment policy statement, and you have a certain percentage that’s supposed to be allocated towards international stocks, and a certain percentage that’s supposed to be allocated to US growth stocks, ok, and that percentage has shifted, based on fundamentals of the economy and stock prices. That’s going to give you the answer of what do you buy and what do you sell?
Let me give you a quick example. Let’s look at the recent bear market we had. Ok. Again, I’m not predicting we’re going to enter a bear market right now. I’m just talking about bear markets, because typically people start to pay attention when their accounts dropping by 20%. Even now, people are starting to look its headlines, are being made because the NASDAQ was down intraday today at over 4%.
So, if you’re like, oh, should I be doing something? The last bear market we had was February, March of 2020. Ok, this was the beginning of the Pandemic sell-off. It was short-lived in early, in August. We had recovered all of the losses from the bear market and stocks have been on a rally ever since. But stocks dropped 35% in a six-week period.
Bonds, on the other hand, were up close to 7% during that same time horizon. Ok, so why is this? I mean, interest rates were low, relatively speaking. Ok. So, how could they return 7% in a two month period? Well, it’s because when people are selling out of stocks, because they’re fearful or, they’re concerned about what’s going on in the economy?
They have to buy something. I mean, yes, you could go to cash. But a lot of these individuals, a lot of these investors are going to flight to safety. So, US Treasuries, Municipal bonds, Corporate bonds, they’re flighting to safety. So, bonds spiked because of prices going up. People wanted safe investments paying a coupon rate of, one and a half or, two and a half percent, just because they were concerned with stock prices dropping 35% over a six-week period.
Ok, let’s say for simplicity purposes, we had an investment policy statement, based on your financial goals, based on your risk tolerance, based on your time horizon, based on your financial resources. We said, hey, you know what? Let’s use half of your portfolio to be in the stock market. Obviously, diversified within stocks, US stocks, International stocks, large stocks, small stocks, mid-sized stocks, and the other 50% would be in fixed income also, diversified US bonds, International bonds, high quality investment grade versus Junk bonds, high yield.
So, in the first few months of 2020, stocks were down 35% and bonds were up 7%. So, as it relates to your investment policy statement, ok, we are now, under exposed and stocks, and over exposed to bonds simply by the drastic difference in performance during that time. Instead of reacting to headlines, which is very tough to do, I promise you, ok, you wouldn’t believe the phone calls, I was receiving from clients during 2020, at the height of COVID when stocks in a single day, were going down 11 to 12 and 13%.
Ok, the calls that we were feeling were concerning, ok, but we had to stay disciplined, ok, and if we’re now, underweight and stocks, ok, and overweight and bonds, mathematically speaking, as a relates to your investment policy statement, and that 50-50 designation, we had the asset class. By simple way of math, we have to then trim off some of the gains from bonds so, sell at a premium, and purchase stocks at hopefully, discounted prices.
Now, hindsight is 2020 we know how that worked out. But in practice, this is literally the discipline that goes into this, ok. So, we’re not reacting to headlines. We’re not trying to time the market, ok. We’re simply looking at a financial goal, a time horizon, and an investment policy statement related to a certain account, and we’re going to buy some things and we’re going to sell others.
Now, within stocks, we’re going to have different percentages allocated to different segments of the market. Ok, within bonds, same thing. Okay, so I’m just using a very high level simple example of half in stocks and half in bonds. Once we made that move, I know Hindsight is 2020, but stocks went on a tear for the next four months because we had repositioned and loaded up in stocks during the bottom March, April of 2020, and we had that recovery over the next four months, we recovered much faster than, if we had did nothing.
Ok, the same thing held true in 2021. So, fast forward, ok, we’re looking at it and said, hey, we had a massive run in 2020, and even into 2021. So, that same 50-50 portfolio, we’re now overweight in stocks, and we’re underweight in bonds. As painful as this might be, especially, when we’re going through a significant bull market, we need to buy discipline.
Trim off some of the gains from stocks, not bail out of stocks, but trim off some of the gains, to get it back to that targeted 50% that we want to have in the portfolio and purchase fixed income albeit, it’s not going to generate a ton of interest. Given interest rates are super low, but it’s there for that stability. We’re not overweight, when stocks take the next tumble, which we talked about happens every four years on average for a bear market.
Now, that we’re going into this ballot of volatility, third quarter of 2021, fourth quarter of 2021, first quarter of 2022, if we had followed this discipline, follow this process, we’re not going to be experiencing as much of a dip, as we had, if we had done nothing.
Ok, this also is beautiful because it works well when you’re retired, and you’re actually, drawing income from the portfolio.
So, my clients that are— let’s say, a client needs $5,000 a month from the portfolio. We need to raise cash somewhere by liquidating a certain asset class. Every single month, when we go into the portfolio, we look at the Investment Policy Statement and figure out what we’re under? What we’re over weighted?
And that drives our decisions on what we’re liquidating to generate income from the portfolio.
Again, it works in the accumulation phase. It works in the income distribution phase, and for those of you that are younger listening to this, and let’s say, you don’t even have fixed income in the portfolio, where you might have cash. You might have cash that you’ve been waiting to invest, that you haven’t put to work yet. This is dry powder. It’s an opportunistic time to deploy that cash strategically, to buy equities at potentially discounted prices and especially,
If your time horizon is 10 or, 15-20 years, you don’t need to even time it perfectly, and you shouldn’t even try to time it perfectly because conceivably, if capital markets continue at the trajectory, they’ve been going over the net, over the last 100 years plus, you’re going to be much better off than just leaving that money in cash. I promise you that especially with inflation.
So, those of you that are long ways away from retirement, there are strategies you can deploy, instead of selling off fixed income. If you’re closer to retirement, it’s a perfect time to look at what are you overweight in? What are you underweight in? What is your investment policy statement look like? What should it look like? Should it be updated, based on your time horizon, based on your financial goals and circumstances changing? For those of you in retirement don’t panic.
Hopefully, you have a process in place where a certain dollar amount for income each year is, going to be generated from asset classes that are immune to stocks. Ok, in summary, if you don’t know what to do don’t make a knee jerk reaction but at the same time, don’t just sit idle and do nothing. Ok, create an Investment Policy Statement for each account. Ok, that you have follow the Investment Policy Statement, implement it with a discipline process. Don’t act on emotion.
Ok, if you want to consult with an advisor, consult with a fiduciary, go to NAPFA.org. Go to Fee Only network. Go to XY Planning. If you want to consult with me one-on-one, I’m happy to talk. You can get on my website at Imaginefinancialsecurity.com but I hope you find this helpful and can apply during periods of volatility moving forward. Be smart, review your situation, make sure you’re taking the appropriate steps for your own strategy and your own unique circumstances.
Ok, again, hope you enjoy today’s episode. Be sure to subscribe. Leave a review on iTunes like, I mentioned if you liked what you heard, and I really appreciate all of you, and appreciate you tuning into today’s episode. Until next time, have a great one.