When we meet with clients to create or review a financial plan, there’s a section where we try to get a sense of risk tolerance. We’ll show an asset allocation and its long-term expected return, and then, in big red numbers, what this portfolio would have lost in the 2008 financial crisis.
We show it in percentage and dollar terms, based on the portfolio size at that time. The idea is to see how people react, whether they shrug or object. Part of my standard speech is that we know we will suffer significant losses at some point, even though we won’t know when or why.
It’s a great exercise that has led to good outcomes, but the trouble is that the losses are abstract without a story to accompany them. I never could have dreamt up the pandemic, Lehman’s failure, or the market response to the tariffs.
I’ve heard (and verified) that this is the fourth-largest two-day drop for the S&P 500 since World War II. Three of the drops are related to the above-mentioned events, and the fourth is the 1987 crash. Acropolis didn’t exist in 1987, but we’ve been around for three of the four sharp downdrafts.
In retrospect, it’s easy to say that hanging on was the right thing to do, but it wasn’t so easy at the time. Still, hanging on was the right thing to do for the three times that significant downdrafts that occurred during our tenure. And that’s what we did: hang on. We rebalanced, we did some tax-loss harvesting, but the most important thing was staying invested.
It is very tempting to try to time the market. At this moment, it may seem ‘obvious’ that stocks will fall further. And, don’t get me wrong, they probably will. And how far they fall is anyone’s guess.
That said, it’s easy to imagine scenarios where stocks recover quickly. If the President announces that he’s secured deals with some of these countries and is pulling back on the tariffs, stocks could shoot higher. It’s unpleasant to be so headline dependent, but that’s where we are right now, and all we can do is wait and see.
While we wait and no doubt endure many ups, downs, and uncertainties, it might be useful to know what happened in the year following the other three post-war downdrafts that were worse than this one.
By October 18, 1988, the S&P 500 was 30.4 percent higher. By November 2009, one year after the Lehman debacle, the S&P 500 was 48.8 percent higher. And, by March 12, 2021, the S&P 500 was 61.8 percent higher.
Let me quickly add that I am definitely not promising such magnificent returns one year from now!
I say that not just to satisfy our compliance officer, but because it would be insane to make such a promise!
First, a sample set of three doesn’t tell you much, even if you like the story. Second, in two of three of those events, the government came riding to the rescue with giant stimulus packages. Maybe you liked them or perhaps you thought they were wrong, but regardless of your views, we can probably agree that there is no stimulus waiting in the wings today.
The Fed may cut rates, as it did after the three episodes I’ve listed, but it probably won’t come as quickly or dramatically. Part of the sell-off was in response to Fed Chair comments after the tariff announcement that basically said, ‘We’ll see what happens.’
Nobody knows what will happen next, and there is nothing new about that. Our approach is to keep a balanced portfolio all the time. That means missing some of the upside and having some cushion on the downside.
You can see from the table above that having bonds and international stocks this year is helping buffer the losses, albeit not eliminating them. That will cause the allocations to get out of line, which will then cause us to sell the things that are up (bonds) or didn’t fall as much (international), and buy the things that are down (US stocks).
Although the overall market is still not cheap, some areas are attractive. Naturally, we will be looking at everything, but we’re satisfied with our portfolios so far. And that makes sense, since we want them to be all-weather.
As noted, we’ve been investing as a firm for periods like this and other shocks, such as the tech bubble bursting, the inflation shock a few years ago, and protracted bear markets.
Hopefully, and this is our big test, we’ve set the right allocation for you. I’ve used this quote from Vanguard founder Jack Bogle during many bad times, but it’s so good, I can’t resist using it again: The optimal portfolio is the one you can live with.
