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Facts of Life

Jonathan Clements

THE PLOT, THE SCRIPT and the characters may have changed. But we’ve seen this movie before.

The current stock market swoon strikes many folks as unprecedented: It’s the frantic financial sideshow to a devastating global tragedy—one that’s seen 1.1 million people fall ill and 60,000 die, with every expectation that the numbers will be many multiples worse before the COVID-19 pandemic is over.

Yet, on closer inspection, 2020’s bear market doesn’t seem so different from earlier market declines. Once again, we’re being reminded of some crucial facts of financial life. Here are seven of them:

1. Our risk tolerance isn’t stable.

Rising share prices turn us into fearless stock jockeys, while tumbling prices reduce us to cash-loving cowards. What about “buy low, sell high”? At times like this, investors toss such basic commandments out the window.

Indeed, I’ve been fielding panicked emails from readers for the past month. I tell folks to think about what sort of portfolio they would feel comfortable holding today and then, once the stock market recovers, they should build that portfolio. But guess what? It’s advice I’m 100% confident will be ignored. Many of these folks will sell stocks now, only to renew their embrace of risk when the market is hitting new highs.

2. Losses wreak havoc with compounding.

If you had invested $100 on Feb. 19, when the S&P 500 notched its all-time high, you’d have been down 34% to $66.08 by March 23. That’s when the S&P 500 hit its recent low. What will it take to recoup that 34% loss? To go from $66.08 to $100, you need a 51% gain. As of yesterday’s market close, we’ve clawed back 11%. I’m confident we’ll eventually recoup the rest.

Still, this highlights the brutal impact of losses on investment compounding. Don’t want it to be so brutal? You can avoid far steeper losses by diversifying broadly and keeping at least some money in bonds and cash investments. You can also speed your portfolio’s recovery by rebalancing during the market decline and by adding fresh savings to your stock portfolio.

3. In Treasurys, we should trust.

During 2008’s financial crisis, Treasury bonds posted gains, while almost everything else lost ground. It was yet another lesson many folks failed to learn. Indeed, in the hunt for something that’ll post gains when stocks are suffering, many investors stubbornly ignore Treasurys, while embracing all manner of costly, complicated and unreliable alternatives.

Among them: hedge funds, “liquid alt” mutual funds, real estate funds and bitcoin. I’ve largely soured on alternative investments, with the exception of gold stock funds. And even gold stocks require a remarkably strong stomach for volatility. Still, they have once again proven their mettle (pun intended) at a time of market mayhem.

4. Bonds are less risky than stocks—except when we go to trade.

Many investors are scratching their head over the recent bond market weakness, which saw steep short-term losses among municipal and corporate bonds. What went wrong? A key problem: The bond market is far more fragmented than the stock market.

For instance, Vanguard’s Total Stock Market Index Fund tracks the CRSP U.S. Total Market Index, which contains 3,500 stocks. By contrast, Vanguard’s Total Bond Market Index Fund tracks the Bloomberg Barclays U.S. Aggregate Float-Adjusted Index, which includes more than 11,000 bond issues.

And that’s just the tip of the iceberg: There are an estimated 30,000 U.S. corporate bond issues outstanding and a million different municipal bonds. With so many issues on offer, it’s hardly surprising that—when investors and market makers get spooked and become reluctant to buy or sell—the bond market doesn’t function so well.

5. If we wait for stocks to get cheap before buying, we’ll likely wait an awfully long time.

After 2020’s brutal first quarter, you might imagine that U.S. stocks would appear cheap based on yardsticks like dividend yield, price-to-earnings (P/E) multiples and cyclically adjusted P/E multiples. And shares are indeed cheaper, but they’re hardly bargain priced by historical standards.

Of course, we may get there yet, but I wouldn’t count on it. Even if share prices fall further, we’re likely to see disappointing corporate earnings and cuts in dividends, which may conspire to make stocks look more expensive, not less. On top of that, stock market valuations have been trending higher over the past four decades. That trend, I suspect, won’t ever reverse.

6. To earn handsome long-run returns, we must run the risk of severe short-term losses—and those losses occur with brutal regularity.

Over the past 50 years, we’ve had the 1973-74 stock market crash that accompanied the OPEC oil embargo, 1977’s market decline, the early 1980s stock market swoon born of skyrocketing inflation and a double dip U.S. recession, 1987’s harrowing market crash, the 1990 slide triggered by Iraq’s invasion of Kuwait, 1997’s Asian Contagion, the 2000-02 slump unleashed by the dot-com bust and the 9/11 terrorist attacks, the 2007-09 crash driven by the Great Recession, 2018’s losing year and 2020’s coronavirus crash.

The bottom line: Big market declines happen at least once a decade, and yet we’re shocked—shocked!—every time. To grasp the stock market’s turbulence, check out the annual returns for the S&P 500. The frequent losses may strike some as unnerving, but I’m comforted by looking at the year-by-year results. I remember so many of these declines, including the anguished declarations of doom, and yet every one of them proved fleeting.

7. If an investment offers high expected returns, there must be high risk—even if we can’t figure out what that risk is.

When the S&P 500 was at its all-time high just over six weeks ago, I suspect the vast majority of investors knew that owning stocks was risky, even if they didn’t fully appreciate the magnitude of that risk. After all, even when stocks are rising, it’s hard not to notice the day-to-day turmoil.

Instead, I suspect today’s most surprised investors were those who loaded up on rental real estate. In particular, I think about the folks who took out large mortgages to buy apartments and houses, and then aimed to cover their borrowing costs with short-term rental income from customers of Airbnb, Vrbo and similar services.

It might have looked like easy money (or somewhat easy, given the work involved in cleaning up after short-term tenants) and less risky than being the landlord of a single tenant, who might fail to pay the rent and prove difficult to evict. But as we’ve discovered, there was a serious risk—the risk that the entire world would hunker down at home and stop traveling.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Money and Me27 Things to Do Now and Fear Not.

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james mcglynn
james mcglynn
1 year ago

Sometimes there is no substitute for cash. During working years 3- 6 months cash is recommended and in retirement 2-3 years of cash is recommended. As we saw short term bond funds were sold and declined as investors needed actual cash. Asset allocation has to start with sufficient liquidity before investing.

Richard Gore
Richard Gore
1 year ago

Outstanding observations and advice. Thank you for helping us see the big picture!

Roboticus Aquarius
Roboticus Aquarius
1 year ago

Your comment about risk tied into some projections I made recently.

I partially rebalanced two weeks ago. If I assume that prices are the same as then when I finish my rebalance next month, and should the S&P500 return to it’s February high, that should net me an extra 2% return (unless I rebalance again along the way, which would reduce it to around 1%.)

Now, If I had chosen to go 100% stocks at that point (the market was at it’s recent low), then the benefit would be about 10% whenever the S&P happens to fully recover (or perhaps 5% if I rebalance along the way). That’s a really nice bounce, but it requires taking a very big risk that I won’t need that money anytime soon.

The reality of markets is they can always go lower, and it can take a decade or more to recover to previous highs. Buying “low” can still be a very risky proposition.

Langston Holland
Langston Holland
1 year ago

One thing this crisis has done is turn our focus to what really matters. Not a word around here of late about variable annuities or boats other than getting out of them. 🙂

My summary of the financial universe is this: asset allocation.

The Guide on this site will help you figure out what it should be for your circumstance.

What about cash? You use cash to insulate your asset allocation from forced changes.

How much cash? Enough to weather the storms that threaten your asset allocation.

For a 100% stock allocation, the worst storms have lasted about 7 years.

For a 60/40 stock/bond allocation, the worst storms have lasted about 3 years.

Split the difference and find other things to do.

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