The first quarter of 2020 was certainly one we would prefer to have missed. It is difficult to believe now that major stock indices made all-time highs in the middle of February, only six weeks ago. Since then both equity and fixed income markets experienced declines of unprecedented speed. However, despite the cause of this decline being unprecedented, the decline itself was not. In fact, since the turn of the century, 20 years ago, this is the third decline of this magnitude. While we are still in the middle of this decline, and the near-term ramifications are uncertain, we can be confident saying that the economy will recover. We can also be very confident this will not be the last substantial decline in market prices over our investing time horizon. With eleven years having passed since the last major correction, some investors had become complacent, others were taking too much risk for too little reward or made decisions with uncertain outcomes with excessive certainty. With that in mind, we want to revisit some timeless investing and financial management lessons while the current pain is front of mind.
How Much Risk Can I Handle? One of the most important roles we play in the financial planning process is to try to ensure that our client’s portfolio is aligned with their risk tolerance. All our planning tools, which project long term returns to make decisions about retirement and other financial goals, are predicated on the client’s ability to stay invested over the long haul. While we always endeavor to match investments with the client’s risk appetite, the client’s true appetite for risk may only become apparent in periods of market stress. When discussing his opponent’s strategy, Mike Tyson said, “everybody has a plan, until they get punched in the face.” As investors, we just got punched and we now have a pretty good idea of how we will react in the future. If you felt only moderate stress and didn’t feel anxious to sell or make major portfolio changes you are likely allocated correctly. Conversely, if you found yourself losing sleep or felt as though you needed to move to cash, we should revisit your allocation to make sure you are positioned to maintain your investments in a future crisis.
Our alternative style investments are mostly uncorrelated and largely behaved as we would have expected. In the last crisis, in 2008, there were investors who were surprised that investments they believed were highly secure were significantly exposed to the events that drove the recession. One Wall St. adage says, “the only thing that goes up in a down market is correlation.” This means, in periods of stress, investments that seem to have little connection to the crisis, decline as much or more than those directly impacted. This happens for any number of reasons and is a common feature of major market declines. Over several years we have been diligent in selecting “alternatives” with return streams truly unconnected to the economic cycle. Despite a great deal of work to make this determination we couldn’t be sure until we got into a period of stress. While it is too early to declare total victory, so far, the results have been as anticipated. Our alternative investments have performed very well on both an absolute and relative basis.
Finally, we have seen that leverage in investments should always be used very carefully. Many, very sophisticated, investors were forced to make sales at deep discounts to satisfy margin calls and to increase capital in recent weeks. Leverage removes the best defense against a real economic loss, time. Few investments are going to be true money losers, particularly in public equity and debt markets, given the benefit of time. However, paper losses can be turned into permanent losses if an investor is forced out of a position because of excessive leverage.
The weeks ahead are likely to be volatile and the worst could still be ahead, but we can be confident that prices for financial assets will eventually be higher. We can also be just as confident that there will be future market disruptions in the coming decades. Let’s use these fresh scars to make sure the next cut isn’t as deep and doesn’t hurt as much.
As always, we appreciate your business and trust and encourage you to contact us with questions and concerns. We also encourage you to follow us on Twitter, LinkedIn and Facebook or our recently expanded website (www.sterneckcapital.com) for real time comments and updates.