Through September, the stock market was on a nearly 10-year bull run, enjoying the benefits of loose financial conditions, strong growth and stimulus provided by tax reform. But soon after, a new round of volatility took hold, driven largely by concerns over global economic slowing, trade conflict and Federal Reserve policy. The S&P 500 finished the year down 4.4% on a total return basis (inclusive of dividends) and suffered its worst December since 1931. Early in 2019, equities have gained ground, but more turbulence may be coming.
In the wake of such a turn of events, does it make sense to pull back on equity exposure? The short answer is, it depends. At times, valuations or risk/reward in stocks may appear less compelling and justify trimming holdings, or it could be that equities are too large a weighting in portfolios for individual needs. However, there’s a big difference between making measured tactical adjustments, rebalancing to strategic long-term targets or making other informed asset allocation decisions, and drastically drawing down exposures in reaction to market events. The latter is market timing, and might be better described as “mis-timing” because investors often pick poor times to withdraw and reenter markets, ultimately undermining their long-term return potential.
Moreover, it’s important to remember that market shifts can happen suddenly. So, just as it may be hard to avoid the sharpest declines, it may be easy to miss a strong upward surge. The display below shows the impact of missing the best days of equity market performance.
Missing Best Days Has Hurt Performance
S&P 500: Past 25 Years Ending December 31, 2018
| Annualized Return | Hypothetical Growth of $100 | |
|---|---|---|
| Total | 9.1% | $876 |
| Excluding top 10 days | 6.1% | $437 |
| Excluding top 20 days | 4.1% | $271 |
| Excluding top 30 days | 2.3% | $178 |
| Excluding top 50 days | -0.7% | $84 |
Source: Bloomberg. As of December 31, 2018. Figures are total return. Hypothetical growth results illustrate the growth of a hypothetical investment in the index as of the date indicated and assume reinvestment of any dividends and distributions. Results shown are hypothetical and do not represent the returns of any particular investment. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
Another problem with market timing is that it is often difficult to distinguish between a temporary downturn and something more lasting. Although ultra-easy monetary policy contributed to relative market calm in 2012 – 2017, conditions have normally been far more volatile, with the stock market suffering steep drawdowns even in positive years.1 Fortunately, time is typically an ally of equity investors. The S&P 500 has risen in 70% of all years since 1929. And over its long history, it has moved past many challenges—wars, economic downturns, political crises—to eventually reach new highs. Past is not prologue, as they say, but the difficulties of 2018 will likely seem less severe in the rearview mirror.
Sharp Drawdowns Have Been Common, Even in Up Years
Source: FactSet. Data through December 31, 2018. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Unless otherwise indicated, returns shown reflect reinvestment of dividends and distributions. Past performance is no guarantee of future results.
Stocks Have Weathered Many Challenges
S&P 500 Index (Log Scale)
Source: Bloomberg (for S&P data). Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Unless otherwise indicated, returns shown reflect reinvestment of dividends and distributions. Past performance is no guarantee of future results.
The long-term resilience of the market suggests a key practical point: that staying invested has been rewarding in equity investing, reducing the chance of realized losses. The longer the holding period, the less potential for decline. This is reflected in the display below, showing the range of total returns for rolling one-, five-, 10- and 20-year periods, measured monthly over the last 30 years. Performance in shorter timeframes has been quite varied and often affected by immediate investor sentiment. As periods are extended, volatility has been reduced, narrowing the range of returns around positive averages.
Long-Term Timeframes Have Reduced the Potential for Market Loss
Range of Market Returns, 1988 – 2018
Source: Bloomberg. As of December 31, 2018. 60/40 portfolio consists of 60% stocks (S&P 500) and 40% bonds (Bloomberg Barclays U.S. Aggregate Bond Index). Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Unless otherwise indicated, returns shown reflect reinvestment of dividends and distributions. Past performance is no guarantee of future results.
Managing Risk Through Diversification
Even with the risk mitigation provided by time, maintaining portfolio diversification has been essential to managing volatility. That is illustrated in the same display with the addition of bonds (i.e., 40%) into the portfolio. This change has markedly reduced the severity of downside outcomes, particularly over the shorter periods, in exchange for lower upside. And as common wisdom would suggest, adding an array of investment types further mitigates risk. Keep in mind that performance leadership has shifted over time (see display below), and that particular asset classes may have quite varied returns, volatility and correlations with one another. Nevertheless, combining some of these assets and their divergent characteristics has tended to improve a portfolio’s overall risk/return relationship, and smooth returns over time.
Performance Leadership Varies, Reinforcing the Value of Diversification
Annual Total Returns
| 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 |
|---|---|---|---|---|---|---|---|---|---|---|---|
| Emerging Market Equity 39.8% |
Investment Grade Fixed 5.2% |
Emerging Market Equity 79% | U.S. Small-Cap Equity 26.9% |
Investment Grade Fixed 7.8% |
Emerging Market Equity 18.6% |
U.S. Small-Cap Equity 38.8% |
U.S. Large Cap Equity 13.2% |
U.S. Large-Cap Equity 0.9% |
U.S. Small-Cap Equity 21.3% |
Emerging Market Equity 37.8% |
Investment Grade Fixed 0.0% |
| Commodities 16.2% |
High Yield Fixed -26.2% |
High Yield Fixed 58.2% |
Emerging Market Equity 19.2% |
High Yield Fixed 5.0% |
Developed Non-U.S. Equity 17.9% |
U.S. Large-Cap Equity 33.1% |
Investment Grade Fixed 6.0% |
Investment Grade Fixed 0.5% |
High Yield Fixed 17.1% |
Developed Non-U.S. Equity 25.6% |
High Yield Fixed -2.1% |
| Developed Non-U.S. Equity 11.6% |
Commodities -35.6% |
Developed Non-U.S. Equity 32.5% |
Commodities 16.8% |
U.S. Large-Cap Equity 1.5% |
U.S. Large-Cap Equity 16.4% |
Developed Non-U.S. Equity 23.3% |
U.S. Small Cap Equity 4.9% |
Developed Non-U.S. Equity -0.4% |
U.S. Large-Cap Equity 12.1% |
U.S. Large-Cap Equity 21.7% |
U.S. Large-Cap Equity -4.8% |
| Investment Grade Fixed 7.0% |
U.S. Small-Cap Equity -33.8% |
U.S. Large-Cap Equity 28.4% |
U.S. Large-Cap Equity 16.1% |
U.S. Small-Cap Equity -3.6% |
U.S. Small-Cap Equity 16.4% |
High Yield Fixed 2.9% |
High Yield Fixed 2.5% |
U.S. Small-Cap Equity -4.4% |
Commodities 11.8% |
U.S. Small-Cap Equity 14.7% |
U.S. Small-Cap Equity -11.0% |
| U.S. Large-Cap Equity 5.8% |
U.S. Large-Cap Equity -37.6% |
U.S. Small-Cap Equity 27.2% |
High Yield Fixed 15.1% |
Developed Non-U.S. Equity -11.7% |
High Yield Fixed 15.8% |
Investment Grade Fixed -2.0% |
Emerging Market Equity -1.8% |
High Yield Fixed -4.5% |
Emerging Market Equity 11.6% |
High Yield Fixed 7.5% |
Commodities -11.3% |
| High Yield Fixed 1.9% |
Developed Non-U.S. Equity -43.1% |
Commodities 18.9% |
Developed Non-U.S. Equity 8.2% |
Commodities -13.3% |
Investment Grade Fixed 0.4% |
Emerging Market Equity -2.3% |
Developed Non-U.S. Equity -4.5% |
Emerging Market Equity -14.6% |
Investment Grade Fixed 2.6% |
Investment Grade Fixed 3.5% |
Developed Non-U.S. Equity -13.4% |
| U.S. Small -Cap Equity -1.6% |
Emerging Market Equity -53.2% |
Investment Grade Fixed 5.9% |
Investment Grade Fixed 6.5% |
Emerging Market Equity -18.2% |
Commodities -1.1% |
Commodities -9.5% |
Commodities -17.0% |
Commodities -24.7% |
Developed Non-U.S. Equity 1.5% |
Commodities 1.7% |
Emerging Market Equity -14.3% |
Source: FactSet, Bloomberg. Asset classes represented as follows: High yield – Bloomberg Barclays U.S. Aggregate Credit Corporate High Yield; developed international equity – MSCI EAFE Index; emerging market equity – MSCI EM Index; U.S. large-cap equity – Russell 1000 Index; U.S. small-cap equity – Russell 2000 Index; commodities – Bloomberg Commodity Index; investment-grade fixed income – Bloomberg Barclays U.S. Aggregate Index. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Unless otherwise indicated, returns shown reflect reinvestment of dividends and distributions. Past performance is no guarantee of future results.
Considering Tactical Tilts
Although somewhat similar on the surface, market timing and tactical tilts of asset allocation are actually quite different. Both involve portfolio shifts based on current market conditions. However, market timing is about wholesale changes of exposure designed to capitalize on (or avoid the consequences of) a major market turn. In contrast, tactical tilts are generally more moderate, and a supplement to an overall strategic (or long-term) asset allocation. When properly administered, tactical tilts can be a way to capitalize on a portfolio manager’s knowledge and research on the economy, inflation, markets, fund flows, company/issuer fundamentals and many other elements, which potentially can help to enhance returns and mitigate risk.
For example, a tactical asset allocation could emphasize U.S. small- over large-cap stocks due to the strength of the domestic versus global economies, favor emerging markets stocks or debt in light of a reversal in U.S. dollar strength, or underweight long-dated bonds given an upward trend in inflation. In contrast to a pure buy-and-hold approach, tactical tilts allow for educated choices in the face of market changes without succumbing to extreme or ill-advised actions.
Note that frequent portfolio turnover can be tax-inefficient, so it’s important to weigh potential sales in light of any embedded capital gains, the availability of offsetting losses, the risk/reward tradeoff of holding onto positions and, importantly, the return potential of other available opportunities. This balance can be a key consideration in effectively managing your overall portfolio, and something to be discussed with your advisors.
Keeping on Track
It’s easy to preach the virtues of staying invested, but sometimes it is harder to take that advice. Mark-to-market losses are painful and, with each decline, the fear of continued loss can weigh on emotions. No one suggests passivity in the face of market volatility, but we would argue that a thoughtful, well-informed asset allocation (with both strategic and possibly tactical elements), suiting your individual situation and implemented through skilled portfolio managers, can increase the potential for investment success over time.