Whether you believe a recession is imminent or far off, calibrating your portfolio to the market environment is essential to successful investing, notes Landon Whaley.
I have a sneaking suspicion my best friend is now purposefully seeking out articles that will cause me to Hulk out like Lou Ferrigno. After sending me a Fidelity article about baby boomers and their 401ks (which I dissected on Nov. 23); he followed with an article written by Nick Strain, a “senior wealth advisor and wealth advisory committee chair at Halbert Hargrove.”
Strain offers up sage advice to 401k investors in light of the fact that “seven out of 10 economists expect a recession by the end of 2021.” For starters, I’d rather throw darts at a board to make investment decisions than rely on economists’ forecasts. Second, these cats are not exactly going out on a ledge to say that sometime in the next two years, the United States will enter a recession.
U.S. growth has been slowing for 15 months, and there are a plethora of data sets registering levels only seen during recessions. So, it’s a fair bet that without extraordinary monetary and fiscal policy stimulus, the United States will soon see a recession.
I’m not a financial planner, and I don’t play one on television, so I won’t take issue with Nick’s advice to pad your emergency fund and cutback on splurges.
Where I begin turning green is when Nick says, “Cashing out or making significant reductions to retirement savings contributions is the worst mistake you can make during a recession.”
My jeans turn into shredded Daisy Dukes when he goes on to explain, “Even for experienced investors, it is almost impossible to buy back into the equity markets at the right time. When you stop contributing to your retirement savings in a recession, you are missing the chance to buy stocks at the lowest prices.”
Folks, I can’t even begin to tell you how statements like this make my blood boil.
But ol’ Nick doesn’t stop there, “Believe it or not, there are some upsides to a recession. Think of declining stock prices as an opportunity, like a limited-time sale. The more you contribute toward your 401(k) during a recession, the better discounts you receive on your stocks.”
Nick acknowledges, “It is nerve-racking to watch your retirement savings decline with the stock market during a recession.” Despite being nerve-racking, he still believes you should “keep your investment strategy in place and maintain a long-term outlook, and your portfolio will rebound from a recession with your retirement savings intact. This will give your portfolio the best chance to bounce back when the bull market returns and will keep you on track for your retirement goals.”
I could do a semester-long course on all that is wrong with Nick’s “advice,” but I know you have a weekend to enjoy, so I’m going keep this as concise as my DNA will allow.
Let’s assume you’re not all bulled up with a 100% allocation to stocks, and instead, Nick has talked you into the standard Wall Street portfolio of a 60/40 mix of stocks and bonds. During post-World War II bear markets, the average drawdown for this portfolio is 20%, while the worst drawdown experienced was 30%.
Who in their right mind, wants to lose a fifth to a third of their capital?
What Nick and those of his ilk, never acknowledge, is that if you sustain this magnitude of woodshed treatment in your portfolio, you’ve got to gain a 25% to 43% return to get back to breakeven.
Another vital, and often overlooked, aspect of any drawdown is the recovery period following the decline. The average bear market drawdown in the 60/40 portfolio erases an average of 47 months’ worth of gains and then takes anywhere from 30 to 50 months to regain the previous high-water mark.
I don’t care if you’re a 26-year old millennial who thinks you’re going to live forever. Or if you’re a 45-year old going through a midlife crisis driving your new Founder’s Series Roadster and figuring out how to change the world with the seemingly limited time you have left on this planet. I don’t even care if you’re a 90-year old hoping the next trip to the mailbox won’t be your last, getting zero return on your money for 77 to 97 months is a non-starter.
Nick’s advice for preparing for a recession is to do precisely what you were doing before the recession began, business as usual. He thinks you should allocate your retirement assets just as you do when the U.S. economy is awesome, and he also says to continue plowing money into a retirement account that is getting steamrolled because of “the better discounts you receive on your stocks.”
Is it just me, or does this type of “logic” make you feel like you’re taking crazy pills? Rather than following Nick’s “sure to get your portfolio whacked advice, might I suggest you follow the Fundamental Gravity playbook.
As we’ve discussed before, should a recession materialize, it's not necessary to call it in advance. All U.S. recessions occur when the U.S. economy is experiencing a Winter Fundamental Gravity. This FG-driven reality means you’ll already be positioned in markets like U.S. dollars and Treasuries beforethe recession gets underway. This FG approach to asset allocation will not only minimize your drawdown should a recession materialize, but it most likely means you’ll come out the other side with more money than you had when the whole thing began. As an example, during 2008, long-dated Treasuries gained 32% (with just a -7.4% drawdown), and the U.S. dollar rallied 5.8%.
This outcome is much more favorable than staring at a -25% hole in the bottom of your account.
That said, buying stocks during a recession is much better than buying them at brand new all-time highs while U.S. growth slows at an accelerating pace, like what’s occurring today.
However, I disagree with Nick that you can’t time the market. We have a seven-year track record of profitable market timing in all types of economic and market environments. And when you’re dealing with a recessionary financial market environment, timing is paramount. (And, of course, whether by accident or on purpose, we all time the market simply base on when we begin investing, so what does it hurt to put some thought into it).
For instance, if you thought the 42% decline in the S&P 500 from May 23, 2008 to Oct. 10, 2008 was the worst of it and bought in because there was a “limited-time sale” on stocks; you got the opportunity to experience yet another crash when stocks fell an additional 26% before bottoming on March 6, 2009.
The headline risk bottom line is that to be a consistently successful investor, you must minimize losses on individual investment decisions, and you must minimize losing years. Managing losses is critical for two reasons: 1. It’s the only aspect of investing you can control, and 2. large drawdowns eliminate the most potent force in all of finance, the power of compounding.
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