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What We Know We Know, and Know We Don't

What We Know We Know, and Know We Don't

| September 27, 2022

Here we go again. Fear and loathing, 2022 version. The same things seem to happen again and again when the market drops week after week, month after month.

  1. The news of the day seems unprecedented, feels scary, and is said to be world changing.
  2. Some folks get a little excited about the wild market moves, while others get quite concerned.

Taking a step back, it’s during the good times when investors develop the behavior of checking their account balances for a quick little dopamine hit and reassurance that things are going okay. Stocks have generally marched higher for the past decade-plus, so that’s been an understandable habit to pick up. Unfortunately, checking your balances is a double-edged sword, as the periodic losses you see tend to hurt about twice as much as the pleasure garnered from gains, and portfolio figures change completely on a daily basis. You may be doing more harm than good by checking so frequently.

  1. There will be good news at times. It will appear as if calmer heads are prevailing in the market and that the road to recovery is indeed underway. “The worst is behind us,” you might hear on financial TV. That’s what it felt like during the summer after the mid-June low in stocks.
  2. The bottom then drops out, and even many smart and even-keeled investors begin to panic. The “flight or fight” response takes over – and that’s when huge long-term investing mistakes sometimes happen. When times are riddled with fear, our emotions take over. That evolutionary response can be very counterproductive to maintaining and growing wealth. The innate fear of loss is why it’s so hard and important to be intentionally measured and careful during times like this. We didn’t evolve from owning financial assets like shares of Microsoft – we grew out of instincts to flee from danger just to survive. Thus, investing is, from an anthropological perspective, brand new to us. Simply put, what kept us alive over the eons are the same things that now work against us when it comes to investing in volatile markets.

Tom the Lender Sidebar

In an earlier life, I helped manage the lending department for a large stock brokerage house. Back then, $7 billion was probably a lot of money. It sure seemed like it. Our business was lending that money to investors who wanted to buy stocks with borrowed cash.

For example, if you had $1 million, nice folks that we were, we’d loan you another cool million. That way, you could make (or lose!) money twice as fast.

Even in the good times, investing with so-called leverage can be quite a challenge. However, emotional errors that occur, such as those during times like this, can lead to catastrophic mistakes.

That experience helped me learn much of the stoicism I employ today around investing. To me, investing is just another part of life. There are things we can control, and there are things we know we just can’t. Likewise, some events are predictable with the right tools, while others are almost totally random.

We must be comfortable with a degree of certainty and uncertainty - it’s table stakes to being a successful long-term investor. It’s also a mandatory mindset if you want to be a prosperous entrepreneur or business owner offering a service for income. The risk is that you become overconfident, and you stray from acknowledging what could go wrong. Focusing on your assumptions is critical. Be humble. Nothing has been made clearer than the importance of humility when it comes to investing in 2022.

What's also quite valuable these days? Studying history, but in the right context. The thing about financial markets is that, yes, they do sort of repeat, but new things also happen all the time. Keeping an open mind is mission critical, as well. We don’t need to fly by the seat of our pants – quite the contrary. A plan based on empirical data helps us learn from the past and make educated decisions within a risk-aware framework.

Back to my days as your friendly neighborhood lender, I saw an alarming number of people absolutely decimate their financial futures. The lessons and stories could fill up the yellow pad on which I am writing this blog! They weren’t all crazy, silly, or obvious, either. Many were just about people who worked hard their whole lives to save up an impressive amount of money, but who were also ill-equipped to deal with their investments, the volatility, and the decisions they were faced with upon their retirement. These folks frequently ran into serious, unfixable problems, especially during tumultuous times like we see today. Often, these errors don’t even happen until people retire. Now is one of those times when folks will, once again, make big, life-changing mistakes.

So, What Do We Know?

  • The good news is we know that investing with a whole bunch of leverage on margin is usually reckless, so we’re not doing that!
  • We also know that the stock market tends to drop huge every five or 10 years.
  • There are, of course, no guarantees, and it’s certainly not a sure-fire bet, but the broad stock market tends to rise in about 70% of all years. It’s wrong and dangerous to think it goes straight up without periodic pullbacks (known as bear markets). Still, I see people surprised every time the market drops.
  • We know through history that a diversified stock portfolio tends to get back to even after a recession, hitting new highs before too long. Even after the 2008 Great Financial Crisis, the S&P 500 was making new all-time highs by 2013.
  • We know that we don’t want to be too optimistic with our assumptions. If we are wrong, we might encounter serious financial difficulties if things don’t go as well as we hoped. Being pragmatic and even conservative in our assumptions for growth is wise.
  • We also know that some investments are much safer than others, and the safer ones usually pay less. Riskier strategies often feature greater upside potential. Now, that does not mean you should have all of your portfolio in one or the other. A solid investment plan includes owning risky stocks, safer stocks, risky bonds, safer bonds, alternatives, and so on. That’s how we construct portfolios for our clients and ourselves.
  • We know that people who need money from their investment accounts to fund daily expenses should probably have five to 20 years’ worth of cash flow in “safer” investments to help them ride through the inevitable turbulence in the market. We then use those safer assets to fund cash flow needs rather than having to sell stocks in poor market conditions.
  • We know that the market tends to go down about one out of every three years. So the drops shouldn’t come as a surprise, yet they seem to every time. Consider that the average annual top-to-bottom drop in the stock market is 14%. Checking in on 2022, and we are at about 24%, not too far from the long-term average. After the massive rally off the COVID lows in March 2020, it seems rational to have an old-fashioned pullback. Here’s a good way to put that in perspective: The S&P 500 is still higher by roughly 10% compared to the pre-COVID high as I write this.
  • Regarding the pandemic, to be up about 10% two years afterward is definitely not an ‘end-of-the-world' type of outcome. While markets could get a lot worse from here, where we’re at today is not all that bad in the scheme of things. It’s still painful, though.
  • We know that zooming out is smart. Yes, stocks are down more than 20%, but over the last three years, from the COVID lows, the U.S. market was averaging about 20% per year.
  • Many people’s portfolios were up in simple terms, say $600,000, over the past three years at the peak of their investments. Now they might only be up $200,000. That’s still progress. It’s another way that I say “three steps forward, two steps back” as a common way to describe how investing works. It’s never a straight line up to the sky.
  • The reality is we don’t get to keep the new highs as the new lows. Markets wouldn’t feature positive returns if they didn’t carry risk and fluctuate.
  • Furthermore, when we invest your money, we determine your cash flow needs, then construct an asset allocation designed to endure the ups and downs of the market. You’ll see us continually make changes to portfolios over time, but the big picture and long-term trajectory don’t change just because the market declines.

Part of the assumptions we use when building investment plans is the full anticipation, expectation, and GUARANTEE that stocks (and even bonds) will drop from time to time and not bounce back to new highs instantly. That’s how our portfolios are designed before these crashes and bear markets.

Now do a quick experiment with me.

Answer this: How many big pullbacks will you experience if years like 2022 happen every five years for the rest of your life?

I’m hoping to be lucky enough to see another 10! Nobody knows, but recognizing that the market goes up two out of every three years, on average, how do you plan to act the next time the market falls big?

  • Are you going to panic and sell and want to give up?
  • How are you going to act this time?
  • Are you going to fire-sell your Microsoft and all your other stocks and just throw in the towel on investing because it got scary and hard? Most folks with whom I work would say, “of course not!”

If your situation hasn’t changed significantly, and by that, I mean your life expectancy, your health, and your family, then your portfolio strategy shouldn’t be altered based on the news of the day. Despite the manic Wall Street marketing machine trying to control what you do and influence your behavior; you do not need to sell all your stocks when times get tough. Being stoic about the things you know you cannot control is the wisest path for a serious investor.

Generally, maintaining your pre-crisis investment plan, rebalancing (which in periods like right now means buying more stock), and adjusting our allocation between stocks and bonds continues to be needed during the good times, too.

Still, we’re not overreacting. For those who are more aggressive or optimistic people looking to capitalize during bear markets, there might be some other things to do. Actions like investing more cash into risky assets or decreasing distributions while spending a little bit less can be levers to pull. But, if your circumstances have not changed much, the most important thing is to not give up on the investment plan you put in place before the downturn began. Making wholesale changes to your allocation just because volatility is high is no way to invest prudently.

Now, I say all this with a very intimate understanding of how stressful times like today can be for everyone.

If you find yourself uncomfortably nervous to the point where you’re losing sleep, having severe anxiety, and so on, not only should we talk about it, but we should get together to ensure that we’re still on the right path.

You saw our notes on how to ensure you weren’t taking too much risk during the good times. Those good times are when we like you to reduce risk. De-risking in the middle of a crisis guarantees that you’ll participate in the downside and not in the inevitable recovery.

I get it that it’s hard to de-risk when times are good. But that’s indeed when we want to sell a little bit. After all, selling high and buying low is the preferred approach, right? It sounds trite, but in times of great stress, we sometimes need to be reminded of the fundamental truths of what we know.

Investing isn’t a game. It’s not for fun. It’s a serious business with important goals. Reckless or panicked actions do not belong anywhere near your family’s finances.

Every situation is different, so please call, email, or book an appointment if you want to brainstorm around your circumstances. We’ve been having more conversations lately; those are important, and we want to have them with you if you want to discuss your situation.

Thanks for taking a look!

Your ISC Team