What to Expect When You’re Expecting a Bear Market
(Bloomberg Businessweek) -- If there’s a silver lining for Main Street investors in the stock market turmoil of the past few months, it’s this: They now have a far more realistic idea of how much risk they’re willing to take—and a new appreciation for what portfolio diversification means.
The plunge in the S&P 500 late last year, 19.8 percent from its September high to its December low, wasn’t quite enough to meet the traditional definition of a bear market (unless you’re rounding up). And stocks have climbed back more than 9 percent since. Still, after a very long bull market, fear of missing out has suddenly morphed into worry about years of fat gains melting away. Some investors are taking a serious look at the risks in their portfolio for the first time in a while. Financial planners see it in their offices. “Our highest client acquisition periods are when the markets are getting murdered,” says Lou Stanasolovich, president of Legend Financial Advisors. “We live for this.”
It’s true that many people don’t do a deep analysis of their portfolio until a hard knock forces them to pay attention. While many are nervous now, few are in crisis mode, which makes this a good time for them to reexamine whether their portfolios are still in sync with their risk tolerance and financial goals. “We should spend more time planning for volatility and potential losses than trying to predict when the next downturn will happen,” says Peter Lazaroff, chief investment officer at investment adviser Plancorp.
Of course, advisers warn against selling emotionally after a drop. Many investors will even want to buy stocks, if only to get the share of their portfolio that’s devoted to equities back up to their intended allocation. “When big market moves happen, there’s a big opportunity to rebalance,” says Greg Davis, CIO for Vanguard Group. “Valuations are back to fair levels when it comes to U.S. equities.” Sam Boyd, a 31-year-old financial planner and senior vice president at Capital Asset Management Group, says that when he sees high volatility, he just hopes it coincides with the end of his pay period so his 401(k) contribution goes into the market as it falls.
The idea of a portfolio review isn’t to try to time the market, but to accept that volatility is normal and make sure you aren’t getting more of it than you can handle. Investors can start by looking at all their accounts next to one another to see where they overlap and if they need to be rebalanced. Many are likely to discover that their supposedly diversified portfolio is surprisingly concentrated in large-cap tech stocks. “I hear people say all the time that they have an S&P 500 index fund, so are diversified across 500 companies,” says David Alison of Alison Wealth Management. What they don’t take into account, he says, is how shares of a handful of massive technology companies have grown in value and now take up a large portion of not only indexes such as the S&P 500 but also the portfolios of actively managed mutual funds.
About a decade ago, at the stock market bottom on March 9, 2009, the largest weighting in the S&P 500 was Exxon Mobil Corp., at 5.6 percent of the index. The oil giant was followed by about 2 percent weightings each in companies as diverse as AT&T, Chevron, Johnson & Johnson, and Procter & Gamble. As of Jan. 8 the highest weighting is Microsoft Corp., at about 3.7 percent of the index. It’s followed by Amazon.com, Apple, Berkshire Hathaway (which has Apple as its largest common-stock holding), and Johnson & Johnson. The S&P’s top 10 also includes Alphabet Inc. and Facebook Inc.
Highflying tech stocks are also dominant in many funds with a big presence in 401(k) retirement savings plans. At the $108 billion Fidelity Contrafund, for example, three of the top five holdings on Nov. 30 were tech stocks: Amazon represented almost 7 percent of assets, Facebook 5.4 percent, and Microsoft 4.2 percent. All told, tech represented more than 34 percent of the fund’s portfolio, according to Morningstar Inc. data.
What’s more, portfolio concentrations tend to grow when clients invest on their own, Alison says, because people often invest in what they know. “My Apple employees are buying Facebook, Netflix, Qualcomm, Amazon,” he says. His Facebook clients aren’t buying more Facebook directly, he adds, but when their restricted shares vest, they hold on to them rather than diversify.
Reassessing tech exposure doesn’t have to mean running from these companies altogether. As of Nov. 30, the Vanguard S&P 500 exchange-traded fund had about 22 percent of its assets in the tech sector. You can use that figure as your rough baseline. If your overall stock portfolio holds much less, you’re making a bet that tech stocks have become overvalued. (This may make some intuitive sense after a long rally, but remember that these kinds of active calls are extremely difficult even for professionals to get right.) If you hold a lot more, you may have unintentionally chased the momentum of the market’s hottest sector, and it could make sense to pare back to a weighting in line with the index.
Investors should also consider if they have enough money in bonds. This may feel like odd advice just now: One reason the stock market is hurting is because the U.S. Federal Reserve has been pushing up interest rates, and bond prices fall when rates rise. Still, a diversified portfolio of high-quality bonds should be less volatile than stocks and can play a key role in preserving capital over time.
A starting point for thinking about how much to hold in bonds is your age, says William Bernstein, a principal at Efficient Frontier Advisors. An old, conservative rule of thumb is “your age in bonds”—so if you’re 45, you’d hold 45 percent in fixed income. But you can adjust that up or down based on how comfortable you are with risk. Many target-date retirement mutual funds, which allocate assets based on an investor’s age, are much more aggressive. That can work if you tend to see stock market drops as buying opportunities.
Which brings us to psychology. Bernstein puts the challenge of staying cool amid constant market noise in blunt terms: “It’s all a head game, and it’s surviving the head game over time that determines how successful you are.” Theoretically, young investors could be 100 percent in stocks because they could have 40 to 50 years of earning power and the ability to ride out market cycles. The problem? “There aren’t very many sentient beings in this quadrant of the universe that can actually tolerate [a portfolio] of all stocks,” Bernstein says.
Even a young person may want some bonds as ballast, to help lessen urges to sell during a market swoon. Perhaps more crucial is keeping money in safe short-term bonds or a money-market fund—outside of a retirement account—to tap in case of an emergency, such as losing a job. Recessions—and jumps in unemployment—sometimes follow bear markets, and you don’t want to find yourself forced to sell stocks for living expenses after prices have plunged.
Experienced, older investors face a tougher dilemma. They’ve lived through market downturns and know the wisdom of staying the course, but they’re also closer to retirement, when they will be living on savings and investments rather than adding to them. They also face this turmoil with more dollars at stake than they had when they were young, which can intensify the pain of a percentage loss they might have once brushed off.
Behavioral tricks that reframe how to think about money can make it easier to deal with such problems. Some planners suggest allocating money into three different “buckets” for goals with different time horizons. A “now” bucket for daily expenses and emergencies might hold three years of income in a bank account or money market. For a 60-year-old, a “soon” bucket would cover expenses further out, like the first 5 to 10 years of retirement expenses. That would be invested conservatively, maybe in bonds. “Generally, in a diversified portfolio, if you have 10 years, you’re not going to be hurt too badly,” Alison says. A “later” bucket focused on goals more than 10 years out holds the rest of the portfolio and can be invested in stocks. Once you’ve tackled those big issues, you can go back to tuning out most of the market indexes’ ups and downs.
To contact the editor responsible for this story: Pat Regnier at pregnier3@bloomberg.net
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