“WHAT CHANGES have you made to your portfolio during this market decline?” That was the article request I received from HumbleDollar’s editor. Initially, I had reservations about taking on the assignment, afraid that my story would be misinterpreted as giving financial advice. What follows isn’t financial advice, but rather a highly personal account of one investor’s approach.
I’ve been quite cautious for the past few years. Written into my investment policy statement is Benjamin Graham’s advice to have between 25% and 75% of one’s portfolio in stocks. I’ve had close to 25% in stocks for the past few years. Confession: I allowed my stock allocation to drop to 19% in mid-February, an all-time low for my investing career.
Lesson No. 1: Following an investment policy statement is sometimes easier said than done.
Last year, I learned just how powerful a force FOMO—fear of missing out—really is. Having a very conservative asset allocation during 2019, when we saw 30%-plus stock market returns, was less than satisfying, to say the least. While I believed that my conservative positioning was prudent, given the numerous risks that I saw, that hardly made it easier to stay the course when the stock market was hitting new highs almost weekly. Doubts began to creep into my head.
Lesson No. 2: FOMO makes it hard to stay the course in protracted bull markets.
With that backdrop, what am I doing now in the midst of the first bear market in more than a decade? I have a plan in place to buy back into the stock market. That plan involves putting cash to work at designated thresholds below the S&P 500’s Feb. 19 all-time high of 3386. Those thresholds are set at down 20%, 25%, 30% and so forth, until the “doomsday” scenario of down 70%, which would put the S&P 500 at 1016.
Over the years, I’ve learned that buying into the stock market is never easy. For me, it helps to have an automatic system in place, so my emotions don’t get the better of me. And, yes, two triggers have already been reached, down 20% and 25%, and we’re almost at down 30%.
Lesson No. 3: Consider putting a system in place to rebalance or buy into stocks, particularly for times of heightened market volatility.
Why include an extreme scenario of down 70%? The short answer: Because I’m a chicken. I fully realize that such a system almost guarantees that I won’t be fully invested—which, for my portfolio, means 75% in stocks—by the time this bear market ends. For me, it’s about balancing two regrets: putting cash to work too quickly vs. putting it to work too slowly. Behavioral finance teaches us that we feel the pain of losses twice as much as the pleasure of gains. I’m trying to limit my pain—by limiting how much I have to invest in stocks.
Lesson No. 4: Asset allocation is all about balancing two potential regrets—being too aggressive in bear markets and being too conservative in bull markets.
What am I buying? Despite the bear market, U.S. stocks still aren’t cheap. Prospective 10-year returns remain close to zero in inflation-adjusted terms. By contrast, international stocks—and especially emerging markets—are far more attractive. That’s where I have been putting money to work.
Value stocks have been underperforming growth stocks for about a decade. Should the selloff continue, I plan to add to my holdings of U.S. value funds. Finally, the one sector bet that I am making—a small one—is in the oil patch. Dividends are attractive and crude oil prices are at decade lows. As usual, diversification is paramount, so I’m investing in oil producers using a low-cost, broadly diversified exchange-traded index fund.
Lesson No. 5: While it’s impossible to predict short-term market moves, it’s possible to estimate long-term expected returns in asset classes with a fair degree of certainty—which is far more valuable information for the long-term investor.
My last article was all about risk. I am fully aware that raising my stock allocation during a bear market is not without danger. But it’s consistent with my countercyclical rebalancing approach. I would rather embrace risk when it’s richly rewarded—that is, when prospective returns are high. As stock markets fall, prospective returns increase. It’s as simple as that.
Still, I also like to model how much damage could be done to my portfolio in a worst-case scenario. A 70% decline in the S&P 500 from its all-time high fits the bill. Using a fairly simple spreadsheet, I estimated my total returns should the market fall 70%, assuming I buy into stocks in increments, as described above. The doomsday scenario would be an overall decline in my portfolio of about 33%. That would certainly be unpleasant, but it’s something that I believe I could live with based on my age and risk tolerance.
Lesson No. 6: Always consider the worst-case scenario when investing. In other words, hope for the best, but plan for the worst.
I’ve talked before about the benefits of bear markets. I have no idea where the financial markets go from here. For all I know, we could have already seen the bottom. It’s also possible that we go far lower. The volatility we’ve witnessed in the past few weeks has been breathtaking and frightening—but with volatility comes opportunity.
John Lim is a physician and author of How to Raise Your Child’s Financial IQ, which is available as both a free PDF and a Kindle edition. His previous articles include Risk Returns, Crash Course, 12 Financial Sins and 12 Investment Sins. Follow John on Twitter @JohnTLim.