All stock market crashes provide valuable investment lessons, and the latest one is no exception. Joe Wiggins identified no fewer than 17 takeaways from the coronavirus crisis. In this, his latest article for TEBI, LARRY SWEDROE narrows it down to four. Some of his observations specifically apply to a US audience, but there’s useful insight here for investors everywhere.
Remember, most lessons the markets teach us are nothing new. As Larry explains, we’ve been taught them many times before. The important thing is to learn the lessons now, so that when markets crash again in the future — as they certainly will — you’ll be better prepared than you were this time.
For a decade now I’ve been writing an annual column on lessons the market taught in the prior year. Most lessons are remedial ones, in other words, lessons the market taught in previous years. Unfortunately, many investors ignored them. The coronavirus and the financial crisis it brought provided investors with many reminders (assuming you were paying attention) of lessons the market has taught us in the past. With that in mind, I thought it important to cover a few of them now rather than wait until the end of the year, hoping they help you avoid future mistakes.
1. The highly unlikely is not impossible
Perhaps the most important lesson is to never treat the highly unlikely as impossible. The corollary is to never treat the highly likely as certain. For example, many people ignore the far-left-tail outcomes of Monte Carlo simulations, treating them as so unlikely they can be ignored. The coronavirus provided us with another example of why those left tail risks must be considered, along with having that all-important “plan B” (actions you will take, such as lowering expenses) ready to implement if risks do show up.
2. Financial plans are not set in stone
The second remedial lesson is that a financial plan must be treated as a living document. The development of a plan, including your asset allocation, is not a “set it and forget it” endeavour. Whenever any of your plan’s underlying assumptions change, the investment policy statement (IPS), and asset allocation table, should be altered to adapt to that change. Life-altering events (a death in the family, divorce, a large inheritance or loss of a job) can impact the asset allocation decision in dramatic ways.
Thus, it should be reviewed whenever a major life event occurs. However, even market movements can lead to a change in the assumptions behind the plan’s asset allocation. For example, a major bull market like the one we experienced in the 1990s lowered the need to take risk for those investors who began the decade with a significant accumulation of capital.
At the same time, the rise in prices lowered future expected returns. It had the opposite effect on those with minimal amounts of capital (perhaps just beginning their investment careers). The lowering of expected returns to equities meant that to achieve the same expected return, investors would have to allocate more capital to equities. The reverse is true of bear markets. A bear market raises the need to take risk for those with significant capital accumulation, and lowers it for those with little. A good policy is to review the IPS and its assumptions at least annually, or whenever we have major moves in equity valuations and/or bond yields, such as occurred when the COVID-19 crisis hit the market in February 2020.
As we entered 2020, the Shiller CAPE 10 stood at 30.3. The best predictor we have of the real future returns to equities is the inverse of that ratio, or the earnings yield (E/P), producing a forecasted real return of just 3.3 percent. While the COVID-19 crisis led to a sharp drop in equity prices, it also raised future expected returns as valuations fell. The earnings yield on the Shiller CAPE 10 rose from 3.3 percent to 4 percent by the end of March, raising the expected real U.S. equity return by 0.7 percentage point. However, the sharp fall in Treasury bond yields that occurred lowered the yields on the five- and 20-year Treasury bonds to 0.4 percent and 1.0 percent, respectively. While lower valuations on stocks helped, lower yields on bonds hurt.
This last point about changing assumptions is a critical one. Bull and bear markets in stocks and bonds can lead to dramatic changes in return assumptions and thus the odds of a plan’s success. Plans should be reviewed whenever we experience major market moves—such as 20 percent or more for equities.
There’s yet another reason why financial plans need to be living documents that are reviewed on a regular basis.
Monte Carlo simulations
In “traditional” retirement planning, annual investment returns are assumed to be a constant number, such as six percent per year. Retirement planners arrive at this number based on a portfolio’s asset allocation and on assumptions about the returns of various investments. Outcomes using this computation typically are presented as expected wealth values over the anticipated period of retirement. The problem with this approach is that investment returns are not deterministic. While investing is about risk, retirement calculators that present single scenarios treat outcomes either as a certainty or, at best, a 50/50 proposition (for instance, the odds are 50/50 that you will do better or worse than the expected result).
Investing is not a science in the same way physics is. No one knows with precision beforehand what the return of different investments will be over any given number of years. Investment returns are random variables, characterised by expected values (averages), standard deviations and, more generally, probability distributions. For this reason, projections of an investment program’s possible results should also be expressed in terms of probabilities. For example, an expected outcome should be presented in terms such as:
— There is a 95 percent chance you will not run out of money in retirement.
— There is a 50 percent probability you will have at least $3.1 million remaining at the end of the plan period.
— There is a 25 percent chance you will have at least $5.2 million at the end of the plan period, but there is also a 10 percent chance you will accumulate only $400,000 or less.
To arrive at this type of conclusion, it is necessary to use a Monte Carlo (MC) simulation. MC simulations require a set of assumptions regarding time horizon, initial investment, asset allocation, withdrawals, savings, retirement income, rate of inflation, correlation among different asset classes and, importantly, the return distributions of the portfolio.
One important benefit of MC simulations is that they allow us to consider a wide dispersion of potential outcomes. However, as time passes, potential outcomes become realised. In other words, some of the uncertainties become certainties. For example, if you retired in December 2019, by the end of March 2020 you knew global equity markets had crashed and bond yields had fallen sharply. What was once perhaps in the five percent left tail of the potential distribution was now a certainty. At that point a new MC simulation should be run, with new assumptions, and plans may need to be adapted to meet the new reality.
The care and maintenance of the portfolio
There’s yet other reason why investment plans should not be “set it and forget it”. Portfolios require regular care and maintenance, and bull and bear markets provide investors with opportunities to add value, increasing the odds of achieving their goals.
Think of your portfolio like a garden. To keep it producing the desired results, it needs disciplined care, weeding and nourishing. Your investment portfolio also requires regular maintenance to control the most important determinant of its risk — the portfolio’s asset allocation. The way to maintain control is through rebalancing, the ongoing process of restoring a portfolio to its original asset allocation and risk profile. The reason that rebalancing is an ongoing process is that each investment within the portfolio is likely to change in value by a different percentage over time, altering the risk of the portfolio.
When the coronavirus caused the equity market to crash about 35 percent in just three weeks, it was the largest such fall in history in such a short period. Assuming an investor’s tolerance for risk and corresponding asset allocation were properly calibrated heading into the market draw-down, the crash And it provided investors an opportunity to rebalance, buying equities at much lower levels. Also, For investors need not who wait until year’s end to rebalance, but instead should evaluate an opportunity to rebalance rather than whenever markets cause their allocations to drift by a material amount. more than a certain percent (such as five percent), there is nothing to be done. This is why we believe rebalancing should be a year-long endeavour, not tied to the calendar.
Bear markets also provide investors with the opportunity to share the pain of losses with Uncle Sam.
Tax management is a year-round job. A loss should be harvested whenever the value of the tax deduction significantly exceeds the transactions cost of the trades required to harvest the loss, immediately reinvesting the proceeds in a manner to avoid the wash-sale rule. Waiting until the end of the year is a mistake. Losses that might exist early in the year may no longer exist. In addition, it can be important to realise any short-term losses before they become long term. Short-term losses are first deducted against short-term gains that would otherwise be taxed at the higher ordinary income tax rates. Long-term losses are first deducted against long-term gains that would otherwise be taxed at the lower capital gains rate.
For example, before any loss harvesting, imagine a taxpayer has realised short- and long-term gains and unrealised short-term losses. Those losses can be harvested, reducing the short-term gain that would otherwise be taxed at higher ordinary tax rates. If not harvested until they become long-term losses, they reduce long-term gains that would be taxed at the lower long-term capital gains rate.
3. Overconfidence: an all-too-human trait
There’s another lesson the COVID-19 crisis might have provided. It might have taught you that you were overconfident in your ability to deal with the stresses of such a bear market.
If you learned that you overestimated your ability to deal with the stresses of a sharp bear market, you should do what smart people do — admit they made a mistake and change their behaviour. You should run a new MC simulation to see if you can achieve your goals with less risk. If that is the case, the prudent strategy would be to lower your equity allocation to a level better suited to your willingness to take risk. Life is simply too short not to enjoy it. And if you were losing sleep during the crisis, you should consider taking advantage of the rally that began on March 24 and lower your equity allocation, permanently.
4. There’s no alternative to safe bonds
The final lesson, one the market teaches each and every time the bear comes out of hibernation, is that high-yield bonds, preferred stocks, dividend paying stocks, real estate investment trusts (REITs), master limited partnerships (MLPs), emerging market debt and other risky fixed-income alternatives are not alternatives to safe bonds. While their correlations to stocks may on average be low, those correlations rise rapidly toward 1 at exactly the wrong time.
Thus, your bond portfolio should be limited to the safest bonds, Treasuries, FDIC-insured CDs and municipal bonds that are also only AAA/AA rated and either general obligation or essential service revenue bonds. These have performed much better during the crisis, dampening the portfolio’s loss to an acceptable level, not exacerbating the loss.
Keep paying attention
I’m confident the market will continue to provide us with many more lessons over the course of the year assuming you pay attention. I hope the above has provided you with some helpful thoughts that can improve your odds of achieving a secure retirement.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
Want to read more of his work? Here are his most recent articles published on TEBI: