Navigating the Rapids

August 20, 20197 Min Read
Articles

I was out kayaking the other day and came upon a fork in the river – one path was a direct, rapid-filled passage and the other was calm but required more water to cover, costing me extra time. Should I take the risky, expedient route or the safe, roundabout way? The decision reminded me of how markets behave and the decisions we have to make as investors.

Volatility, like choppy waters, is around us all the time but certain moments feel more uneasy than others. As an example, markets have absorbed a lot in recent weeks as trade threats, recession fears, and a global economic slowdown continue to surface. As of August 21st, the S&P 500 return for August is hovering around -2%, which is a recovery from the nearly 5% drop faced during the first few days of the month, but still unpleasant (S&P Dow Jones Indices LLC, S&P 500 [SP500], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/SP500, Aug 22, 2019).

Many pundits will pontificate whether this is a turning point in the market, but they are rarely correct and never held to account. Predicting when recessions may start is a fool's errand and recent research finds no evidence that one common-recession predictor, the yield curve, actually forecasts that stocks will underperform bills (Eugene Fama and Kenneth French, "Inverted Yield Curves and Expected Stock Returns", Jul 28, 2019; https://famafrench.dimensional.com/media/467645/inverted-yield-curves-and-expected-stock-returns-july-28-2019.pdf). Instead of relying on opinion, I'd like to review how markets have behaved during similar time periods.

Beware of “It’s About Time”

Current headlines feel reminiscent of 1997 when warnings of the longest bull market in history were commonplace (David Barbosa, "Analysts Say 1990's Bull Market Faces Its Toughest Test", New York Times, Mar 31, 1997; https://www.nytimes.com/1997/03/31/business/analysts-say-1990-s-bull-market-faces-its-toughest-test.html). The expansion was in its 87th month, the longest on record at that point, and every market wobble unnerved investors (Matt Egan, Annalyn Kurtz, Allie Schmitz and Jen Tse, "Stocks are at an all-time high. Here's what stopped the last 12 bull runs", CNN Business, Apr 23, 2019; https://www.cnn.com/2019/04/23/investing/bull-market-history/index.html). But, the market continued its upward ascent for another 33 months, returning 59.4% between October 1997 and June 2000 (As measured by the S&P 500). Further, over $100,000 of additional wealth would have been added by staying invested from October 1997 through the end of 2001 recession (Based on a $100,000 investment starting in October 1990 and additional wealth measured between October 1997 when the S&P 500 became the longest bull market and December 2001 after the 2001 recession).

The moral of the story is that it’s impossible to predict when the tide may change and you can lose out by trying to time markets.

Growth of $100,000 invested during 90's bull market
Shading for NBER based Recession Indicators for the United States from the period following the peak through the trough, Federal Reserve Bank of St. Louis

Reacting Can Be Costly

Today, investors are as jittery as they were in the 90's, but reacting to falling share prices hasn't been a winning strategy. Examining the data, the S&P 500 return has been positive 75% of the time in the 12 months following a 2% or more drop in the index (Based on monthly S&P 500 returns, since 1979). In addition, the average return of the S&P 500 over the 12 months following those drops has been 15%.

Past performance is NOT an indicator of future actual results. This information is provided for illustrative purposes only to indicate the historical performance of the investing approach. Backtested performance is developed with the benefit of hindsight and has inherent limitations. Results do not reflect actual trading in accounts or the effect of material economic and market factors on the decision-making process. Further, backtesting allows the security selection methodology to be adjusted until past returns are maximized. Actual performance may differ significantly from backtested performance. Results are adjusted to reflect the reinvestment of dividends and other income and, except where otherwise indicated, are presented gross of fees and do not include the effect of transaction costs, advisory fees, or expenses. Investment strategies, such as asset allocation or diversification, do not assure or guarantee better performance and cannot eliminate the risk of investment losses. There are no guarantees that a portfolio employing these or any other strategy will outperform a portfolio that does not engage in such strategies. Mutual funds, exchange-traded funds, and other securities are subject to risk, including loss of principal. All investments have inherent risks. There can be no assurance that an investment strategy proposed by United Income will achieve its goal.

For some investors, even the remote possibility of returns less than -15% is undesirable. Diversifying with bonds is a good approach to avoid such a scenario while still aiming to build wealth. This more cautious portfolio, a 30% stock/70% bond portfolio for instance, can still build wealth but with less ups and downs. Looking at the same time period above, a 30% stock/70% bond portfolio delivered positive returns 92% of the time in the 12 months following a drop of 2% or more in the S&P 500, and the average return was 11% (Based on a monthly rebalanced portfolio comprised of 30% S&P 500 index and 70% Bloomberg Barclays U.S. Aggregate Index returns, since 1979). Most importantly, the average return when markets did decline was -6%, almost a third of the magnitude of declines compared to the all-stock portfolio.

Past performance is NOT an indicator of future actual results. This information is provided for illustrative purposes only to indicate the historical performance of the investing approach. Backtested performance is developed with the benefit of hindsight and has inherent limitations. Results do not reflect actual trading in accounts or the effect of material economic and market factors on the decision-making process. Further, backtesting allows the security selection methodology to be adjusted until past returns are maximized. Actual performance may differ significantly from backtested performance. Results are adjusted to reflect the reinvestment of dividends and other income and, except where otherwise indicated, are presented gross of fees and do not include the effect of transaction costs, advisory fees, or expenses. Investment strategies, such as asset allocation or diversification, do not assure or guarantee better performance and cannot eliminate the risk of investment losses. There are no guarantees that a portfolio employing these or any other strategy will outperform a portfolio that does not engage in such strategies. Mutual funds, exchange-traded funds, and other securities are subject to risk, including loss of principal. All investments have inherent risks. There can be no assurance that an investment strategy proposed by United Income will achieve its goal.

Tradeoffs with Guarantees

Our team is regularly presented with investment strategies promising upside participation with no downside risk during periods of volatility. We reviewed a number of these so-called downside protection strategies in our First Quarter of 2019 Market Review, but another product we have been seeing a lot of recently are annuities. Annuities are often sold as a means to protect against market drops, but they can be expensive, inflexible, and complex. After all, annuities are insurance contracts, not investment vehicles. For this reason, annuity sales tend to spike following market volatility ("Sales of Bonds and Fixed Annuities Soar", Retirement Income Journal, May 23, 2019; https://retirementincomejournal.com/article/investors-are-climbing-the-walls-of-worry) as salespeople generate interest in the guarantee of annuities, but they may not be for everyone (Marc Lichtenfeld, "Why Annuities are a Bad Idea for Almost Everyone", Market Watch, Aug 18, 2018; https://www.marketwatch.com/story/why-annuities-are-a-bad-idea-for-almost-everyone-2018-03-05).

It's best to work with your wealth manager to determine whether an annuity is right for you (here is a good checklist, too). As always, it's important to focus on what you can control as an investor. How markets behave is out of our control, but we can control things like diversification, taxes, and fees. Annuities oftentimes have higher ongoing fees than a balanced investment portfolio because of their guarantee. According to the SEC, mortality and expense risk charges are around 1.25% per year, administrative fees are around 0.15% per year, and surrender charges can be as high as 7%. Alternatively, the total annual expense ratio of 30% stock/70% bond portfolio at United Income would cost 0.22%, which is 84% cheaper than the average cost of a variable annuity (The annual expense ratio of the United Income 30% stock/70% bond portfolio is based upon the underlying ETFs a member would be invested in if they selected this portfolio).

Cost Comparison of a Varible Annuity vs. ETF Investment Portfolio
This information is provided for illustrative purposes only. Fees presented do not include the effect of transaction costs, advisory fees, or expenses. Mutual funds, exchange-traded funds, and other securities are subject to risk, including loss of principal. All investments have inherent risks. There can be no assurance that an investment strategy proposed by United Income will achieve its goal.

Staying the Course

In the end, I decided on a third route. As I was deliberating, a more experienced kayaker coasted by and headed towards the rapids. I followed her and hugged the shoreline, smoothing the ride and keeping my time-cost low. A sound financial plan and investment strategy can achieve a similar outcome – follow directions from a trusted advisor, maintain growth while keeping costs low, and minimize risks when necessary. That's reasonable advice whether you are on the water, approaching retirement, or investing for the long-term.