Worldwide, stocks have fallen significantly and volatility has increased in the early weeks of 2016.The hardest part about being a disciplined investor is maintaining a patient, thoughtful approach in the face of market headwinds. It’s tempting to sell your portfolio and wait out the storm, at least until things seem to have settled down.Some investors hit the panic button, liquidate everything, and wait. When people make investment decisions based on fear, however, they abandon the smart, calm approach that should guide their rational long-term planning.This is a good chance to consider the opportunities available to long-term investors. Modern portfolio theory suggests that the smart, long-term approach is to stay the course.Though the S&P 500 has had a correction of approximately 10% in the last month and international markets are off 10% to 20%, diversified portfolios with stocks and bonds have been less impacted than concentrated portfolios. This presents excellent opportunities to invest (and reinvest) in a globally diversified portfolio.Though it’s natural to want to pull out when the market gets volatile, it is impossible to know where the bottom is. Frequently, market timers withdraw at the bottom, already absorbing all of the losses. Other times, they attempt to buy back in at what they think is the bottom, only to see the market fall further — what is known as “catching a falling knife.” Then, once the fear factor has been initiated, it is hard to anticipate the market’s upswing, building the courage to reinvest while getting the re-entry timing correct. In fact, research shows that market timing generally underperforms a buy-and-hold, disciplined approach. Simply riding the swings, even the volatile ones, outperforms active investing and market timing.As an example, the chart below shows the S&P 500 over the one-month period from July to August 2011. The S&P 500 fell almost 15% in the month. The market had been on a tear through mid July, up 50% from its 2009 lows.If you jumped out of the boat in August 2011, nervous that stocks were overvalued, you’d have missed a big chunk of a great market rally. Over the next three years, the market was up 66%.The research says stay the course. Don’t try to time the market. Invest in a diversified portfolio, reconfirm your risk tolerance, and harvest available tax losses.
- Don’t try to time the market. Attempts to time the market, by jumping out at initial signs of market tops, or jumping in at signs of market bottoms, underperform a disciplined, buy-and-hold, stay-the-course approach. Most finance research indicates it is nearly impossible to figure out where the market is going (minutes, days, weeks, months, or years from now). It is impossible to know if the markets will move higher in the coming days or continue with volatility. Even the so-called experts do not beat the market reliably. Still, markets historically reward smart, disciplined risk-taking over the long-term: investors take on risk by investing in companies and are rewarded with capital gains and dividends.
- Invest. We strongly advocate setting up regular, recurring deposits. These serve several purposes. First, they build your account value, getting more of your assets to work for you. Second, deposits enable a simple rebalancing of your portfolio to pick up small relative under-valuations between asset classes. Finally, they enable you to invest when the market has experienced a larger decline. These factors combine to lower your portfolio volatility and your overall risk.
- Confirm your risk tolerance. If you’re watching the market downturn nervously, it’s a signal to rethink your risk exposure. Visit our Managed Accounts page to retake your questionnaire and see if your portfolio’s risk level matches your current comfort with market volatility. Your portfolio should be aggressive enough to achieve the long-term returns you want, while still enabling you to be comfortable living through short-term market pullbacks.
- Harvest tax losses. Our investment team carefully reviews market conditions for opportunities to reduce your taxes. We automatically look for conditions to lock in a lower cost-basis and capture tax losses for our clients, who can use that loss to offset other gains (and even income) to reduce their taxes. We purchase a similar asset class ETFs so our clients remain fully invested for a market rebound. If you haven’t turned on Tax Loss Harvesting, you can do it now by clicking here. If you want to learn more about Tax Loss Harvesting, visit our FAQ.
At SigFig we work to deliver the optimal investing tools and asset management services for our clients and their portfolios in any market conditions. Volatile markets can frighten even the most seasoned investors, but with the right tools and investment partners, even a market downturn can be an opportunity to invest better.
One of the interesting challenges in studying investor behavior is accounting for the notion of cognitive dissonance, which describes the difficulty of weighing two contradictory ideas at the same time.Consider how you would describe yourself. Are you a nice person? As you reflect on the affirmative, you might also remember a time when you acted with indifference or even cruelty, bringing about an uncomfortable feeling as you ponder this seeming contradiction; I think I’m nice, but I’ve also done some not-so-nice things.As a behavioral “problem,” people often manage this uncomfortable feeling by ignoring or disregarding information that conflicts with their preferred view. Put differently, we usually dismiss the memories of our being unkind in favor of our positive self-image. The problem is obvious; by filtering the information to align with our preferred perception, we have an incomplete picture of a complex reality.This filtering affects our worldviews, too. Consider your view of the U.S. economic recovery. Has there even been one? For many, the recovery has not improved net wealth, job prospects, income, or confidence in the future. Recent presidential debates have focused economic discussions on the economy’s weakness.Yet by nearly every statistical measure, the U.S. economy is strong and growing; the stock market has enjoyed a bull run for more than five years, unemployment is down to 5% (with college graduate unemployment down to 2.5%!), inflation remains under 2%, the dollar is at decade highs against the euro and the yen, and companies report record earnings. Nevertheless, many believe that the economy continues to struggle, perhaps inspired by weak wage growth.The truth is somewhere between. One feature of this economic recovery continues to be a general shift towards higher-skilled jobs. Without marketable skills, education, and flexibility, many people have been left behind. Meanwhile, the recovery has delivered significant gains to investors, the highly educated, and flexible-work employees. The U.S. economy is expanding, but consumers are suspicious of the recovery’s underlying strength. Even though the stock market remains near all-time highs, our perceptions of the economy reflect this cognitive dissonance.In spite of anecdotal evidence suggesting a weak recovery, most statistical analysis indicates the U.S. economy is strong: job creation has increased while inflation remains low. Following the late August stock market hiccup, the benchmark U.S. S&P 500 Index is up nearly 10%.(S&P 500 Index performance 8/26/15 – 11/17/15. Chart from Google Finance.)Meanwhile, U.S. bonds remained stable through October, as the Fed continues to defer a rate hike. With a great jobs report and continued evidence that inflation remains low, expectations have grown that the Federal Reserve will nudge the benchmark overnight rate by a quarter point, though we prefer they resist the temptation. Why? The risks facing the economy are asymmetric: there’s less chance that the economy overheats in the next quarter than falters.A deferred hike provides the Fed with more opportunity to gauge macroeconomic impacts. Though the US’s economy is strong, many of the country’s international trading partners face concerning weakness, potentially slowing domestic growth. Further, where the Fed might typically raise rates to combat increasing Inflation, the evidence indicates inflation remains remarkably low. Finally, a quarter-point signal move does little to provide “ammunition” for the Fed if it faces sudden weakness; better to keep the rates low a little longer and maintain a watchful eye than risk slowing an economy that doesn’t show signs of overheating.Developed international markets have been volatile, up about 3% after tumbling by 9% during the worldwide correction at the end of August.(3-month performance chart, ending November 17, 2015 of IEFA, an ETF tracking the MSCI Developed Markets Index. Chart from Google Finance.)The European Central Bank began a version of quantitative easing to offset austere fiscal programs, which weakened eurozone economies. The British economy has also slowed. The Japanese economy reentered a recession in spite of more aggressive government spending, as a shrinking workforce struggles to sustain output. More broadly, the outlook for Europe remains unclear — the success of the a single economic zone has been repeatedly tested over the last few years, with debt issues across the southern half of the continent, suggestions that Greece drop out of the currency union, and questions about how to handle the influx of Syrian refugees.The lack of synchronicity between the Fed and other central banks have interesting consequences for global markets. The minutes of Fed meetings and speeches given by various policymakers suggest that the US will be first to raise rates among the major central banks. This action has already led to a strengthening dollar as international investors transition to dollars. Meanwhile, emerging markets are at risk of getting trampled as the dollar strengthens against other currencies.Emerging markets have stabilized somewhat after being hit hard by three factors: a) an economic slowdown in China has led to lower demand for construction supplies, including commodities; b) global decrease in commodity demand has softened prices; and c) weakness in many developed nations reduced trade. Oil prices have collapsed from 2014, down nearly 60% this year.The chart below shows the relative performance of IEFA and GSG, ETFs tracking an emerging markets index and a commodities index, respectively.(6-month performance chart, ending November 17, 2015 of IEMG and GSG, ETFs tracking the MSCI Emerging Markets Index and the S&P GSCI Commodities Index. Chart from Google Finance.)Returning to the notion of cognitive dissonance, we have lots of conflicting information about the state of global markets, but we should avoid filtering to fit our preferred worldview. Markets around the world remain in a state of flux; smaller U.S. companies have done well, while large-cap U.S. stocks and developed markets tread water in 2015, and emerging markets declined significantly. This state of uncertainty is exactly the reason it is valuable to be globally diversified in many asset classes. Diversified portfolios help us manage conflicting information; we remain exposed to multiple opportunities while reducing the risks associated with the ups and downs of market moves. This is especially important when markets yield conflicting information and do not always move in the same direction.
A diversified strategy is not without its ups, downs, and sideways, and the current market environment exhibits all of these. Such markets require maintaining discipline and focusing on the long run, even if it feels like you are running in place.The reasons for holding a diversified portfolio are clear; we know with some certainty that each year, some asset classes will shine, while others decline. Of course, we would love to invest only in the winning asset classes, but no one knows which will win, lose, or run sideways. In an effort to maximize our returns while managing risk, we spread our investments across the available assets.Even when we understand the logic and the mathematics of long-run performance, it is still difficult to stay disciplined when a familiar asset class outpaces the disciplined, diversified approach. Why shouldn’t we change course and invest in the single asset class that is currently outperforming our diversified, long-run strategy? In spite of our experience and rational investment philosophy, the lure of recently better performance is strong.One thing modern portfolio theory doesn’t take into account is the risk that our human, emotional self overrides the logical, rational self — to the detriment of our portfolio. It is up to investors to remain focused and committed to maximizing long-term performance, while keeping risk manageable.
For U.S. stocks, mixed signals continue
Over the last six months, U.S. equities outperformed international developed and emerging markets, but that’s not to say that U.S. stocks were great investments. After several years of relentless upward momentum, the S&P 500 flatlined for the last few months; nearly all the positive year-to-date returns came during the month of February alone. Even as its trajectory stalled, the S&P 500’s increased volatility is noteworthy, but not immediately alarming, as it is now closer to historical norms (the previous few years had relatively low volatility).Our view is that the general pattern speaks more to multiple divergent views among market players on where the U.S. economy is going. As the United States enters a new phase of a global economy with many dimensions in flux, there is value in the absence of a single dominant view about the future. For example, historically, the United States has been a net importer of oil and generally benefited when gas prices were low, but as U.S. production increased over the last decade, declines in oil prices now bring some negative consequences to oil producers and energy employment in the Midwest.
(S&P 500 Index performance for the six months ending August 20, 2015)
Continued anticipation of a rate hike
For the better part of five years, markets have been waiting for the Federal Reserve to start lifting interest rates off the ground floor. As anticipation mounts, U.S. bonds pulled back from their early 2015 highs, suggesting bond markets are already pricing in a rate increase.
(Six-month performance chart, ending August 20, 2015, of AGG, an ETF tracking the Barclays Aggregate Bond Index)
The recent minutes of the Federal Reserve Open Market Committee note that labor markets are improving (unemployment is down to 5.3%) and inflation remains below their 2% target. Polled economists are leaning towards a September interest rate liftoff date over December, though we remain skeptical of a September hike. The economy continues to improve on the back of 2.3% GDP growth in the second quarter of 2015, but there is little evidence of overheating or inflation pressure. China’s recent currency devaluation will continue pressure on our trade deficit. Moreover, Fed Chairwoman Janet Yellen’s dovish stance on rates – she prefers to keep interest rates low to spur economic growth while risking a higher chance of inflation – makes her likely to push to extend the current low-rate environment until the end of the year. If the Fed acts in September, we can interpret that action as signaling the Fed’s belief that the economy is sufficiently strong to weather any negative consequences of tightening monetary policy.
What is going on overseas?
The last several months have not been kind to developed international markets. It is easy to point at the Greek crisis for a reason why European markets struggled, but that is only part of a bigger story. Questions remain about the viability of a single currency union, with Germany and other major economies’ outsized role in driving economic policy, and this continues to hamper European growth. Across the continent, European government austerity policies have had terrible consequences for growth: eurozone expansion fell to 0.3% last quarter, following two quarters of just 0.4% growth. The one bright spot in developed markets, Japan, has enjoyed substantial gains–up almost 16% in the last six months–even as its economy contracted 1.6% in the second quarter.
(Six-month performance chart, ending August 20, 2015, of EFA, an index fund tracking the MSCI Developed Markets Index.)
China’s performance depends on the timeframe
Most frustrating for globally diversified investors has been the abysmal performance in emerging markets. Led by China and declines in commodity prices, these markets slid nearly 15% over the last six months. China’s main Shanghai Index is off 25% since its June heights, but consider the entire run-up in values over the last year. Even though it just lost a quarter of its value, the Shanghai Index is still up 72% over twelve months.
(One-year performance chart, ending August 20, 2015, of the Dow Jones Shanghai Index.)
Where should globally diversified investors go?
Even as it seems like all markets are flat or falling, a globally diversified investor should be asking this question: What, if anything, about the current environment and future prospects for growth changes our view about the long run? Our view is that there is little in the recent past and little on the immediate horizon to shift our opinions about the long run. International markets are risky, emerging markets especially, but they comprise the vast majority of the world’s resources, consumers, and long-run growth opportunities.
Locally, the U.S. economy is building on its recent growth and a Fed rate increase should reinforce positive inference about the state of the economy–solid growth in prospects, earnings, and labor market tightening. Inflation continues to appear low in the short and long term. Divergence in market views reflects a better, more balanced outlook about the long-run future. On the whole, our stance continues to be that a broad, globally diversified, risk-appropriate portfolio will serve the needs of the long-run investor.
Last week according to schedule, the Federal Reserve Bank’s Open Market Committee met and agreed to leave interest rates untouched at 0% – 0.25%, with a hint that they would raise rates by the end of the year. What should investors do about this, especially those with significant fixed income holdings?I argue that the answer is, “not much.” While it’s true that bond prices move in the opposite direction as rates, different factors affect how much those prices adjust, and the impact on a portfolio can range from “some” to “almost negligible.”First, why do rates and prices move in the opposite direction? The intuition here is straightforward: if rates rise, bond buyers would rather own new bonds that pay at higher interest rates than old bonds that are paying at lower interest rates. Thus, as interest rates rise, the price of bonds already in the market start to fall.Conversely, when interest rates fall, bond buyers would rather hold old bonds that are paying higher interest than new bonds that pay lower interest rates. Thus, as interest rates fall, bond prices rise, all else being equal.Though it is clear which direction bond prices will move as interest rates move, the rate change alone doesn’t speak to how much the prices will move. For this, we look to the “duration” of the bond holdings. Duration, simply, is a measure of the time a bond will pay interest and principal back to its holder.*Consider how investors might view holding a short versus a long duration bond as rates rise: they’re much less likely to want a low interest paying bond for a long period of time than one where they’ll get their principal back fairly soon. Thus, the longer the duration of the bond, the more the bond’s price will be affected by the rate change. Again, this logic makes sense, all else being equal. As an approximation, a quarter-point increase in rates would produce a decline in the price of a five-year duration bond of about 1.25% (0.25% * 5 = 1.25%).
SigFig Asset Management expectations: Short Duration Fixed Income asset classes prices fall a little, but won’t collapse
For SigFig’s Asset Management clients, the duration of the fixed income ETFs is an important consideration. Our current allocations use Short-Term US Treasuries, with duration of approximately 1.8 years, while our broader US bond holdings have an average duration of approximately five years.The Federal Reserve’s statement indicates that they expect to increase rates slowly, starting sometime before the end of the year, as the US economy continues to improve and settle on firmer footing. The Fed’s meeting notes suggest an expectation of 0.5% – 0.625% by the end of the year. Furthermore, they expect to raise rates very slowly over the next couple years.Putting this in more concrete terms, if rates increase by one-half percent this year (with all else being equal), we may expect our Short-Term US Treasury and broader US Bond holdings to fall by approximately 1% and 2.5%, respectively.
For well-diversified portfolios, holding bonds still makes sense
Within the context of a well-diversified portfolio, it is reasonable to continue holding bonds in the face of a rate increase.First, the impact to the total portfolio could be relatively small: though a 60/40 stock-bond portfolio might see the individual bond positions lose 1% – 2.5%, the total portfolio’s value could fall by less than 0.75%, even if the equity positions are unchanged.Second, fixed income assets continue to provide diversification benefits to the equity positions in the portfolio.Third, a rate increase would be good news, because it signals that the Federal Reserve believes the economy is growing stronger, with increasing evidence that the recovery is sustainable. Moreover, increasing economic stability suggests that borrowers (bond issuers) are more likely to repay their holdings (i.e., they are more creditworthy) and that could actually decrease their borrowing costs.Finally, potential losses in fixed income are offset by the possibility that US bond values increase because of global macroeconomic instability (e.g., Greece-Eurozone concerns, Russian-Ukrainian war) as investors seek higher quality investments.SigFig’s Investment team continues to watch the Federal Reserve’s actions with interest. We view that future rate increases signal the Fed’s belief in the growing strength of the US economy, which bodes well for company profits, equity prices, and consumers. In sum, pending rate adjustments do not mean an impending collapse in bond prices; the reality of bond price movements is complex and multi-faceted, and so bonds remain an important piece of a balanced portfolio even in the face of potential interest rate increases.
*The duration is typically shorter than the bond’s maturity, because the bond will usually pay interest back to the holder periodically before repaying the principal back at maturity, but since the principal repayment is usually the largest cash flow back to the investor, that last payment is weighted the most heavily.
Numerous studies have shown that, over time, active investing underperforms a passive approach. There are several contributing factors, including:
So why doesn’t everyone invest passively? Taking the long-run view requires patience, and marketing is a powerful lure. Investors don’t want to match or slightly trail the returns of the market (when you factor in expenses); they want to beat the market, and that is something a passive index fund by definition cannot do. Instead, they fall for a good story: a team of smart investment professionals who have a secret strategy or the latest technology can deliver better than the market’s returns.The reality is, there are three basic ways to make money investing in markets:
- Find undervalued opportunities before everyone else.
- Invest in the broad market over the long run, as through long-run economic gains, companies across a market deliver increasing value to their owners.
- Minimize costs.
Searching for undervalued assets has a strong, but illusory lure; the wealth manager just has to be smarter and faster than everyone else. The problem is that there are literally thousands of money managers, all looking for undervalued opportunities. The New York Times reported that over the six year bull market (2009 – 2015), not a single manager (out of 2,862 stock market funds) could sustain performance ranking in the top quartile of managers for all six years.Even if a fund manager successfully tops the market for a few years, it’s very difficult to sustain that outperformance over a long period of time. Put simply: it’s extremely difficult to outsmart everyone consistently enough to beat long-run passive index performance. If it’s impossible to find a consistently excellent fund manager, why should investors pay high fees to the fund?Index funds, on the other hand, don’t try to outsmart the market. By purchasing everything in the market index in the proportions the securities comprise the index, the fund manager aims to match the market’s performance. Some assets will increase in value, some will fall, but in sum, the index fund performance matches that of the market.Moreover, with index funds or ETFs, investors capture value through long-run broad market gains while minimizing costs. Index funds pass on lower costs to their investors, because management costs are lower, transactions costs are less frequent, and taxes tend to be smaller.Using an active fund manager puts higher costs on the investor: the fund manager receives a large salary, paid through the expense ratio (often 1% or more of the investor’s managed assets); fund trading costs, which may be high as the manager trades frequently in search of opportunities; and higher taxes. Even if the active manager is successful at beating the benchmark, these extra costs can often outstrip any gains for the investor.Essentially, because they manage investor money at lower costs, index funds can increase the investor’s after-tax, net returns.