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The Bad, the Ugly - and the Good

This has been a painful quarter for the stock market. Historically, it’s the fourteenth worst quarter for stocks since 1926 for what it’s worth, with the S&P 500 down 17% since the end of September.

With the overabundance of financial news that any of us can access 24 hours a day, seven days a week online, on our smart phones, on tv, etc. the current stock market drop and scary headlines add insult to injury – unless you are selling business news such that this is likely your favorite time because you can sell more headlines to shell-shocked investors searching for meaning as to why the market is falling when unfortunately none really exists – at least that is reliably actionable. Academic science on the markets tells us that even in difficult market times like these we should not react emotionally to market ups and downs. But we recognize that the uncertainty of the future is more difficult to grasp than the certainty of what happened in the rear view mirror.

Markets always are experiencing change – good or bad, and today’s challenges perhaps related to interest rates, tariffs, the government shutdown, etc. are part of the ebb and flow of the investment cycle – albeit more extreme to the downside this quarter. Nobody with certainty can predict when issues will resolve to drive markets higher – or lower. Financial media pundits are paid by many financial services companies who are incentivized to scare individual investors to react to market swings because these large brokers and banks earn more money when trading activity is higher. (I worked at Goldman Sachs in NYC for trading desks, and there was no better time than during market swings for the firm to make commission revenue off of clients trading!) We can’t predict if we are in the short run staring at another Great Recession – or worse, a Depression, or if this is a pause that refreshes and the markets will rally to new gains.

Despite the bad results for the stock market this quarter (and we can’t blame anyone for feeling cause or concern about it), we aren’t receiving many emails or phone calls from alarmed clients. We know many of our clients are not completely surprised by these kinds of dips, as mutually we’ve discussed expectations on how markets work – they don’t always go up, and that establishing the right financial plan customized to meet your financial goals, coupled with an asset allocation and a written investment policy, and using diversification and ongoing rebalancing to manage risk are the hallmarks to long term success through up and down markets.

The opportunity to review planning regularly with clients allows for adjustments to be made to the long term plan and better designed investment strategies so they are best suited to meet your life goals and help you sleep at night. Portfolios for our clients are also constructed according to their customized risk tolerance and financial goals, with a mix of stocks and bonds in most cases, such that a market downturn in stocks isn’t going to dramatically hit their total portfolio as much as the CNBC commentators might suggest or want you to believe. We combine smarter asset allocation designs for clients with TruNorth’s ultra-low advisory planning fee (our fee at 0.33% is about one third the industry average of 1%) and by using low cost market index oriented investments, we help our clients keep more of their money working for them.

For markets to remain vibrant and for us to earn higher expected returns in stocks, it’s crucial (albeit unsettling and unpleasant) that markets experience all kinds of scenarios including the recent downturns. As a reminder, stocks average at least one 14% decline every year, and daily dips in the markets occur about five times a year (Anthony Isola – Ritholz). It’s how investors achieve higher expected returns in stocks over time. We get paid more to take the risk. If stock prices never fell, we would earn on stocks far lower investment returns over time akin to the lower rates of returns we see in Treasury bills, bank CDs, etc. Earning lower rates of returns by just owning lower risk investments over time for most of us would not achieve our long term financial goals. Inflation would eat up our returns and our purchasing power for all manner of goods and services. For example, a 55 year old person today may very well have another 35 years or more of their life expectancy to remain an investor, and to keep up with inflation, this investor likely needs to be an owner of stocks in their portfolio. Down markets are opportunities to rebalance as well by purchasing equities that have fallen in price (which we are doing today for clients - buying stocks to re-adjust back to long term asset allocation targets for the long run). Now at year end, we also are tax loss harvest selling in taxable accounts to offset capital gains and lower tax liability.

None of us have a crystal ball in the markets and the academic data tells us that actions trying to predict market ups and downs by trading stocks to be in or out of markets is a difficult and statistically lousy game to play – akin to gambling in the markets. Past market downturns historically, when you have stock investment time horizons longer than three and five years (which is almost all of us), have resulted in increased probability of seeing gains in stocks following such a big down quarter in stocks as we are seeing today. Since 1940, after the 14 worst stock market quarters, stocks (S&P 500) were on average 26% higher after one year (11 out of 14 times the one year return was positive), 38% higher after three years (12 out of 14 times the 3 year returns were positive) and 91% higher on average after five years (12 out of 14 times the five year returns were positive) (Ben Carlson – While one can’t guarantee that these historical relationships will hold this time, and stocks will see outsized gains from this bad quarter, the probability of higher expected stock returns has likely increased – perhaps substantially.

One final topic we want to discuss is a very common question: why not market time and sell when markets are down? First, it’s impossible for anyone to predict when and how long market downturns occur (hindsight is 20/20). Let’s look at real world data and not intuition or guesswork when it comes to the effects of market timing and selling to try to avoid losses in stocks. When we sell, we have to be right twice: we have to know when to sell, and then we have to know when to buy back in to theoretically take advantage of both sides of the trade. Sounds great in theory, but the practice of it results in more negative outcomes.

When we react to market swings, overreactions by selling increases the probability dramatically that we are going to miss out on the market’s best days of returns which is most important to our investment success, since stocks are up on average almost 70-75% of the time. From 1990 to 2017 in stocks, there were periods of multiple boom and bust cycles, yet if we stayed invested during the entire period, we would have earned average annual returns of 9.81%. If we missed the 1 best day in the market due to selling out, our annual return drops to 9.38%. If we missed the five best single days, our annual return falls to 8.21%, and if we miss the 15 best days, our return falls further to 6.18%. If we are really trading to time markets, and we miss the 25 best days, we earn less than half of what we would gain if we just stayed invested, with an annual return of 4.53%. We get paid more by staying invested despite the pitfalls and range of emotions that it takes to stay the course when times are tough like now. (Data from David R. Jones, Dimensional Fund Advisors)

Do you know your annual return if you were invested in a “low “risk asset class – 30 day Treasury bills, for example during that same 1990 – 2017 period? 2.77% annually is all we would have earned. We won’t likely be able to meet our long term goals without some stock risk owning equities for the long run. (Data from David R. Jones, Dimensional Fund Advisors)

By all means we stand ready to help in any way to help you work thru what these kinds of markets mean to your portfolio and your financial plan now and into the New Year. Please call, email and/or schedule a time to meet - we are available anytime.

We wish you all the best of holidays with your family and we’re working hard to help the New Year and 2019 to be a great year for our clients. Thank you for working with us.

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