It would be an understatement to say that financial markets have experienced a bit of volatility this week. In fact, the VIX surged to its highest level since the height of the Global Financial Crisis more than a decade ago. To be sure, we believe that a host of issues ranging from the unmitigated spread of the coronavirus in the U.S. and around the world, a seeming concerted effort by the Saudis and Russians to flood the oil markets and recession concerns have given market participants reason for pause.
Figure 1: Market volatility is the highest it’s been since the Great Recession
Nevertheless, with stocks in bear market territory and bond yields plumbing all-time lows, some investors may be wondering whether the time is right to get into the markets. It’s true that risk asset prices have had a sharp pullback this month, yet a number of factors suggest that this period of heightened market volatility is likely to persist for a while. Indeed, news that the coronavirus’s spread in the U.S. is going to get worse before it gets better and the lack of support for broad-based fiscal stimulus indicate that economic and earnings recessions are more than likely in the cards.
And from this perspective, the prospect of continued downside moves in risk assets suggests that timing market entry points may be challenging for even the most seasoned investors. Therefore, in the current environment we believe that the question investors should be most concerned about is not that of timing but rather of investment process.
Figure 2: Trying to time the market might mean missing the best days
Missing the best days in the markets
Even so, some investors may be enticed to use timing techniques or other short-term entry strategies in a bid to boost overall returns. Such approaches involve exiting risk assets in anticipation of market moves lower and ratcheting risk back up as market sentiment improves. While such an approach sounds reasonable, getting the timing wrong could cost investors more than it benefits them. How so?
Well, one analysis shows that over a 15-year period, missing even the 10-best days in the market would have led to returns of about half the rate of those made by investors who stayed committed to the markets during up and down periods. How is this possible?
History shows that some of the best days in the markets typically follow the worst selloffs. What this means is that investors who had taken money out of the market in fear of a move lower could miss the beginning of a long-term rally. What’s the point? Unless you have the time, inclination and experience, getting the timing right on a trade may cost you more than it is ultimately worth over the long run.
Figure 3: A diversified portfolio tends might lead to steadier returns over time
Finding the winning trade
This timing discussion also brings up the question about trying to spot winning and losing trades. This is particularly tempting when yesterday’s winners are beaten down and appear to be deep value or a “great deal”. Another temptation during the market selloff is to chase what appear to be winning asset classes and to avoid those that appear to be losing trades. The problem with trying to separate winners from losers, notably during a time of heightened market volatility, is that investor sentiment can shift on a dime, leaving many a portfolio in disarray.
Indeed, data show that the best performing asset class today could be tomorrow’s laggard and vice versa. What’s more, the variability between stocks and bonds and even domicile like the U.S. versus international, tend to vary in performance from year to year. This point is illustrated in figure 3.
What is important to note about this figure is that the value of a diversified investment portfolio is rather steady over time. That is, an investment portfolio utilizing an asset allocation framework and rebalanced at regular intervals tends to perform more consistently and avoids the wide swings associated with staking a claim in any one asset class. This leads us to our final point: a systematic investment process can add more value over time compared to market timing.
Systematic process to investing
To be sure, even some of the best asset managers have had a hard time beating the markets over the past decade which underscores the importance of a solid investment process. What do we mean by investment process? Simply put, we mean 1) choosing the right mix of assets for a portfolio that align with an investor’s risk tolerances and objectives, 2) putting money to work in the markets in a disciplined manner and 3) rebalancing portfolios at regular intervals.
Figure 4: Align your portfolio with your risk tolerance and overall investment goals
Diversify your portfolio
A systematic investment process begins with understanding your own tolerance for risk and adding a set of assets to an investment portfolio that that vary with your overall goals and objectives. What does this look like? Well, for investors with a low tolerance for market swings and a near-term need for access to their assets, a conservative allocation would likely reflect a bias toward more bonds and less stocks.
On the other hand, a more aggressive asset allocation framework could be appropriate for investors who can tolerate wide swings in the markets and have a longer investment horizon. Either way, a solid investment process begins with understanding your preference for risk and your overall investment horizon.
Dollar cost averaging
The next part of the systematic investment process involves being disciplined with committing capital to an investment portfolio at regular intervals. As we pointed out earlier, trying to time the best and worst days of the markets can have an adverse effect on overall investment performance. To avoid such issues, we recommend dollar cost averaging, or more simply, committing a set sum of money to your investment portfolio on a regular basis. What does this look like?
If you have an employer sponsored retirement savings account, this could involve setting automatic payroll deductions and having capital committed to the market every pay period. A similar approach can be taken for after tax contributions made by electing to have a portion of your direct deposit contributions applied towards your brokerage savings account. Alternatively, many brokerage firms allow for scheduled withdrawals from a checking account. Either way, putting capital to work at set intervals can help reduce cognitive load, simplify decision making during market stresses and keep your savings goals on track.
Rebalance your portfolio
A final step in the systematic investment process is portfolio rebalancing. This is important because the values of various assets within a portfolio will drift away from their initial allocations as markets move up and down over time. The purpose, then, of rebalancing is to align portfolio holdings with their target allocations. When should you rebalance?
Rebalancing can take place 1) on a set schedule, 2) when asset values drift by a certain thresholds or 3) in a combination of the two. For example, rebalancing on a set schedule could involve evaluating portfolio holdings quarterly, partially selling positions that have appreciated and adding to allocations that have underperformed during the period.
Alternatively, using a threshold to rebalance could involve using a decision rule that prompts a rebalance only when the value of a certain asset class is a set percentage above or below its target allocation. This could lead to less frequent rebalancing during flat markets, but more rebalancing during periods of heightened market volatility.
Asking whether now is the time to get into the markets often misses the point of what it means to be an investor. To be sure, trying to time the markets and hoping to find the next “fat pitch” or winning trade are behaviors often associated with speculative behavior. And, as we have pointed out, such behavior can lead to unfavorable investment outcomes.
Rather, during times like today we challenge investors to ask themselves whether the decisions that they are making are aligned with a systematic investment process. This is, committing to a target asset allocation framework, deploying capital to the markets in a disciplined manner and rebalancing as appropriate.
There’s never a right time to get into the markets. Nevertheless, we believe that staying committed to a disciplined process and using techniques to manage uncertainty during periods of heightened market volatility can help investors increase the odds of achieving their savings goals regardless of market conditions.