Investors should take great care to choose an investment strategy they can stick with for the long term – in both good times and bad.
The problem is we make our decisions about risk tolerance and asset allocation in a vacuum. Our retirement portfolio isn’t at stake when we fill out a questionnaire. Then markets open the next day and our original target mix gets immediately thrown out of whack.
Overconfidence and Risk Tolerance
It’s easy to feel overconfident about our risk tolerance and investing ability when markets are soaring. And, without proper rebalancing, there’s a good chance your portfolio was overweighted to stocks after markets climbed 20+ percent in 2019.
Then March 2020 happens and stocks fall 35 percent in just one month. Suddenly, investors were scrambling to “de-risk” their portfolios. But the damage had already been done.
I’ve answered many reader questions about changing investment strategies after a market crash. One asked if I still recommend my one-ticket investing solution, Vanguard’s VEQT, given the recent market turmoil. My answer: a resounding yes!
To be clear, I didn’t invest in an all-equity portfolio like VEQT thinking global stocks only go up in price. In the 30-year period dating back to 1990, U.S. stocks were up 21 years and down in nine of those years. That’s a 30 percent chance in any given year that stocks would fall in value.
Investors also talk about volatility, and perhaps waiting on the sidelines until things return to normal. But I’d argue when exactly are things “normal” in the stock market? Volatility is the name of the game. In nine of the 30 years between 1990-2020, stocks were up more than 20 percent. In three of those years, stocks were down 16 percent or more. What’s normal?
I get it. Nobody wants to lose money in their investment portfolio. And losing 35 percent of your portfolio in such a short time is shocking to see. But stepping back to see the big picture reveals that Canadian stocks are down 17 percent on the year, while U.S. stocks are down just 13 percent. That’s hardly outside the normal distribution of short-term stock returns.
What I think I’m really hearing from investors is they were taking too much risk in their portfolio leading up to the recent market crash, and now they realize a more balanced portfolio is needed. That’s perfectly fine. It’s just that market crashes are a painful way to learn about your true risk tolerance.
Adding bonds is the best way to reduce the volatility in your portfolio. Vanguard’s VBAL, which represents the classic 60/40 balanced portfolio, fell less than 20 percent at the market low in March, and is now down just 7 percent on the year. That ride is easier on the stomach than VEQT, which fell 27 percent at the low and is still down 11.5 percent in 2020.
Changing Investment Strategies
One trend we saw after the 2008 market crash was for investors to break up with their mutual fund advisor and flock to self-directed investing. After all, active managers couldn’t fulfill their promise to deliver all the upside while protecting the downside. All investments got clobbered.
I can see this trend continuing when investors open their March investment statements and realize their actively managed mutual funds failed to guide them unharmed through the market crash caused by a global pandemic.
This is one time I will advocate for changing investment strategies amid a market crash. If paying high mutual fund fees didn’t deter you from switching to a low cost investing option, perhaps a portfolio decline in the 20+ percent range will be the catalyst.
Investors shouldn’t be changing investment strategies based on market conditions. We know the expected range of outcomes in both the short and long term.
First, we need to ensure that we’re invested in a risk appropriate asset mix that will allow us to sleep at night. If you can’t stand the thought of portfolio falling 30 percent or more in the short term, then you need to dial back the risk and add more bonds.
Next, in the face of stock market corrections, crashes, or crazy volatility, we need to be able to weather the storm and stick to our plan. That could mean ignoring the news, reducing the number of times you check on your portfolio, and continuing with your regular contribution schedule.
Finally, avoid market timing and trying to guess which direction markets are headed. Your active manager can’t do it, and neither can you. Switch to a passive investing approach, with an appropriate mix of stocks and bonds, that will capture the market returns minus a very small fee.
If I panicked and sold VEQT at its low in March I would have missed out on the ensuing gains made over the following month. And if I step back and look at the big picture, I know my investments were up 20+ percent last year, and they’re only down 11.5 percent so far this year.
Investing is a long-term game and we shouldn’t make investment decisions based on short-term results.