When Investing, Prepare to Be Surprised
It’s a difficult time to be an investor. In 2015, global equity markets were up and down on a regular basis, with the S&P 500 up just 1.4%, its worst performance since 2008. Every investor should expect surprises, since we will experience a crisis at some point in the future. A globally diversified approach in bonds and equities works in all environments.
The world has gone through numerous panics, crashes, and depressions. Wikipedia provides an extensive summary of U.S. recessions and crises going back to the 1780s. During most of these episodes, our country had no social safety net, no bank deposit insurance, and no social security system. Thousands of banks closed, firms collapsed, people lost their jobs, and land prices crashed. The cycle repeated over and over. And collectively, we survived and prospered.
Economic cycles are as natural as breathing. The most important thing is to be prepared for a downturn by avoiding too much personal debt (in relation to your assets), which could force you to sell at the worst possible time. It’s important to have enough steadiness to invest—and stay invested—when others are fearful.
Fear & Financial Instruments
What’s the alternative to a diversified portfolio? Here are some options, along with a few points to consider about each.
The Dollar—Throughout history, people around the world have used a variety of instruments as a medium of exchange. These could be pieces of paper with drawings of dead presidents (our current system) or something entirely different. The Yap Islanders managed to function quite well using enormous stone wheels, which they rarely moved. Shark’s teeth or colored beads have also served this purpose. All that’s necessary is that individuals agree on what to use to represent a store of value, whether financial intermediaries such as banks exist or not.
It’s conceivable that individuals around the world could lose faith in the U.S. dollar at some point in the future. It seems far more likely, however, that civil unrest, natural disaster, or some other calamity will make other non-dollar currencies even less attractive to hold than they are now. Visit any war-torn or inflation-racked country these days, and you are likely to find drug lords and arms merchants trading their wares using U.S.$100 bills. The number of $100 bills in circulation today around the world far exceeds the needs of U.S. citizens to conduct everyday transactions. This article goes into more detail. The upshot is that disaster may make the U.S. dollar more attractive.
Fear of a Financial System Collapse—To the extent that you fear that banks and ATMs will be closed someday, it might make sense to stockpile a substantial amount of cash. The most likely scenario for a bank closure is a huge natural disaster that knocks out electric power for an extended period, such as the monster earthquake some geologists suggest might strike the Pacific Northwest.
Gold—Some people buy gold when fear is the prevalent economic mood. Warren Buffett has an excellent discussion of gold in his 2011 Chairman’s Letter (pages 18 and 19). Needless to say, he prefers owning real, productive assets (such as cropland and oil wells) to a non-income-producing asset like gold. You can purchase productive assets and companies easily through a mutual fund or exchange traded fund (ETF). We wrote about gold in our second quarter 2012 newsletter. Many investors will be content to hold securities that offer interest and dividends—and let gold fulfill their innate human desire for rare and beautiful objects.
As a practical matter, holding a significant portion of one’s assets in gold would be problematic in a worst-case scenario. If the banking system ceases to function, a bank safe deposit box will be of a little use. Plus, gold is very heavy, so moving or traveling with it will be very difficult. And most importantly, a householder with gold presents a prime target for thieves. If you truly expect chaos and mobs in the streets, you will need to defend yourself with some serious weaponry.
Risk Is Inherent to Investing—Holding shares of productive enterprises is also risky. Stocks can lose value, especially during an unexpected disaster. But, every investment has some degree of risk. Keeping gold or paper money stashed in a wall runs the risk of losing it permanently to fire, flood, or theft.
We are only presented with a series of tradeoffs.
Protect Your Assets
Here are some suggestions for protecting your assets in a volatile stock market:
- Maintain emergency cash reserves. Read our blog post on “The 4 W’s of Cash Management.”
- For known expenses within the next five years, set aside up to $250,000 in a savings account (the FDIC insures this amount). Plenty of online banks offer yields of 1.0% in today’s rate environment.
- Maintain global diversification in stock and bond portfolios. If international “players” stop respecting our currency, then the U.S. dollar will depreciate in value, which means international currencies will appreciate in value. A globally diversified portfolio would benefit from this situation, because any exchange of appreciated international investments for the weaker U.S. dollar means more for your money.
- We have thoughtfully chosen investment solutions that serve our clients’ best interests. While we can’t control equity and fixed income markets, we can control the expenses and asset allocation of the portfolio. You will likely lose money temporarily when markets go down, but the last thing we want is for you to lose money because a portfolio manager put his interests before yours.
Warren Buffett and other great investors have pithy words of wisdom for volatile times in the stock market. Read them here.
Finally, remember these points during times of market volatility:
- Markets have rewarded discipline. We have experienced countless crises. Each has manifested itself differently from the last, but our response to each has been the same.
- Many investors follow their emotions. That’s only natural. However, emotionality can lead people to make poor investment decisions. Recognizing and controlling these emotions is the best way forward.
- Reacting can hurt performance. It’s difficult to hold fast when the wheels feel like they’re coming off. Unfortunately, that’s exactly what we need to do.
If you would like to discuss your particular situation, please reach out to us.