Avoid Investor Complacency
In periods of higher market volatility, like we’re experiencing now, it’s important for investors to avoid becoming complacent and to have plans in place for inevitable market dips. Wednesday, 26 January 2022
In our last episode, we discussed expectations for 2022 - including higher volatility than we’ve seen in the last few years. We’re seeing it already, so this episode will delve further into why we expected this to happen. We’ll talk about inflation, back-to-back years of strong market performance, and the Federal Reserve. We’ll also discuss why it’s important for investors to avoid becoming complacent in times of higher volatility, and why you should have plans in place for inevitable market dips.
We finished our “Expectations for 2022” by stating that higher volatility should be expected this year. Since the first few weeks of market activity this year have been pretty volatile, it might help to explain why we expected this to happen. The first is that higher inflation rates have historically led to more volatility because investors are forced to re-evaluate their earnings expectations as some companies struggle during an inflationary environment while others thrive. We are also coming off back-to-back years of strong stock market performance despite an ongoing global pandemic. In addition, expectations for what the Federal Reserve will do to fight inflation while supporting economic growth vary on a daily basis.
There were 52 trading days in 2021 when the market moved up or down by 1% or more, which is below the average of 63 days. We experienced 70 new all-time highs for the S&P 500 Index last year despite having negative returns on 43% of the trading days. The worst single trading day was down 2.6% and the biggest cumulative drawdown for the year took place in September when the market fell by a little over 5%. All things considered, those are better than average results and a stark contrast from 2020 when there were 109 days when the market was up or down by more than 1%, including 7 of the 20 most volatile trading days in market history.
It’s important for investors to avoid being complacent during periods of market volatility, which has definitely been the case in the early stages of 2022. Over 220 companies with market capitalizations over $10 billion are down at least 20% from their market highs. We have witnessed the highest volatility levels in the Nasdaq Index which is dominated by Technology companies. Although the Index is down about 7% for the year, about 40% of the stocks in that index are down 50% from their highs. It can be difficult to explain that investors maximize their return opportunities by being long-term investors who stay patient through market downturns while also stating the importance of avoiding complacency. I want to explain the strategies we use at Flourish during periods of market volatility.
The starting point is to have plans in place for the inevitable market dips. A drop of 10% is defined as a “market correction” and typically happens at least once every 18 months. It’s been almost 2 years since the last market correction in February and March of 2020, so a market correction in the first half of this year should not be a surprise to anybody. The bigger question is how to react when the correction occurs while staying invested in case a correction doesn’t happen.
At Flourish, we look at two data points simultaneously. The first is to confirm that clients who are taking periodic withdrawals from their portfolios to support their lifestyle have a safe multi-year cash flow plan in place. It is reassuring to know that a stock market dip of 10% or more will not influence a client’s ability to access the cash they need. In addition, we closely monitor the impact of a market dip on client allocations, looking at how the target allocation to stocks and bonds is being affected by market movements. In many cases, a correction is a buying opportunity for long-term investors who can sell a portion of their bond holdings to buy stocks at a discount. Corrections are also an opportunity for clients who have cash reserves outside of Flourish to add to their portfolio through additional stock purchases. For investors who measure success based on 5-, 10-, and 20-year returns, a market dip measured in days, weeks, or months is a relatively short time period.
Market volatility can also extend into the Bond market, although our focus on shorter-term bonds with high credit quality ratings typically benefits from stock market corrections. At the same time, this environment creates an opportunity to evaluate the mix of bond investments to identify new investment options that could be added to client portfolios. We are currently exploring a few different bond investments that are designed to do well in a rising interest rate environment along with alternative investment strategies with a non-traditional approach to minimizing risk while earning moderate returns. Sticking to the same mix of preferred investments despite changing market conditions is the definition of complacency, in my opinion, so it’s our responsibility as a Fiduciary to constantly be in search of investment options that capitalize on a changing market environment.
We also take a proactive approach to Tax Loss Harvesting trades during market downturns. Tax Loss Harvesting involves identifying positions in a taxable account with a current value lower than what was initially paid at the time of purchase, also known as cost basis. We run reports that analyze client holdings by tax lot to identify opportunities to sell those investments and capture or harvest the loss to offset other taxable gains. In addition, we reinvest the proceeds in a similar investment so the client’s asset allocation stays aligned with their long-term goals. Tax Loss Harvesting is an example of avoiding investor complacency because we maintain the same long-term approach to the market while reducing the future tax burden for our clients. Staying diversified across investment opportunities is an important concept that we do not abandon just because part of the market may be experiencing short-term headwinds.
Hopefully, this has been a helpful overview about how you can stay proactive with your investment decisions while maintaining a long-term buy and hold investment philosophy. This will likely be an important mindset to maintain throughout 2022 as the volatility we’ve experienced in the first part of January could extend throughout the year in one form or another.
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