This week I want to focus on a seventh step investors can take: write down how you will behave in the next market crisis. Today markets are great, the economy is strong, volatility is low, and we’re calm and serene. Now is the time to memorialize our best thinking about how to behave in a market crisis. If we wait until the crisis is crashing down around our ears, it will be too late — we’ll be terrified, certain we’re going broke, and we won’t be able to think straight.
So let’s prepare a memo to ourselves and attach it as an exhibit to our investment policy statements. (You do have a written investment policy statement, don’t you?) Our memo might look something like this:
Managing Portfolios During Significant Capital Markets Dislocations
The purpose of this memorandum is to set forth now, while markets are calm (and so am I) an outline describing how I plan to manage my portfolio during the next market crisis.
The Likelihood of Encountering Severe Markets
If investment returns were truly randomly distributed along the familiar Bell Curve, then extreme market conditions would be quite rare and most investors would have little reason to worry about them. In fact, however, investment outcomes are abnormally distributed, that is, they have “fat tails.” Extreme outcomes are much more common than we might expect.
Just within the last half century, extreme market outcomes occurred in 1973 – 74, 1987, 1997, 2000, and 2008. Some of these negative markets were, if truly random, 25 standard deviation events — that is, they would not have been expected to occur even over billions and billions of years. Successfully managing portfolios through market crises is key to the preservation of my family’s capital, since mistakes made during such periods can be catastrophic. For example, most investors who panicked and converted their portfolios entirely to cash during the severe market conditions mentioned above never recovered from the losses they incurred.
Navigating Treacherous Markets
The process of navigating treacherous market conditions consists of a series of steps beginning before the crisis happens and continuing well after the crisis has passed:
a) Market crises don’t happen out of the blue. They almost always begin with a long period of appreciating prices which eventually exceed reasonable valuation levels as measured by historic metrics. Thus, the first step in dealing with treacherous markets is not to “drink the Kool-Aid” in the first place. As prices rise well above historic norms, thoughtful investors will begin to take profits off the table, reinvesting in lower-risk assets and maintaining their long-term asset allocation targets. It is important to remember that as equity prices increase and, therefore, equity allocations in the portfolio increase, the risk level of the portfolio increases far beyond the level originally established as appropriate for my family.
b) Prices eventually lose touch with reality. As equity prices continue to rise, losing touch with any sense of economic reality, I will begin to sell enough stocks to move below my target equity allocations and toward my minimum equity allocations. With pricing at extreme levels, the risk is all on the downside, and therefore even target equity allocations are dangerous to the health of my portfolio. I also recognize that losses are more harmful to my capital than gains are helpful. To take an extreme example, if a $1 million portfolio rises 80% it will be worth $1.8 million. If it then declines by 80% the capital will be worth only $640,000. (This exact math occurred to investors in technology stocks in the late 1990s and early 2000s.) Of course, it is difficult to measure precisely when markets are approaching extreme levels of pricing. However, traditional metrics such as the price/earnings ratio (or the Shiller P/E ratio), price-to-book ratio and dividend yield are all useful indicators.
c) Being patient is key. Patience is required during stages (a) and (b) because markets will still be rising and other, less thoughtful, investors will be making better returns than I am. As noted, however, the risk they are exposing their portfolios to is growing rapidly. At the same time I will remember that it is typically unwise to allow my equity allocations to fall below their minimum range, as this puts my portfolio too far out of the market. In addition to lightening up on equity exposure, I will also consider engaging more defensive managers and avoiding capitalization-weighted index funds or ETFs.
d) Market crises always present opportunities. Eventually, equity markets will reprice, that is, they will decline in value, and investors who have continued to own — or worse, have continued to buy — overvalued stocks will get clobbered. In the broad panic, investors will sell stocks in large quantities and equity prices will often plummet far below fair value as measured by historic norms. At this point, most investors will be in a state of shock and unable to think sensibly about market valuations. However, investors who were less exposed to equities (as I will be) will be presented with an opportunity to buy back into the market at attractive prices.
e) Buying back in. I will begin to repurchase equities at approximately the point when stock prices have fallen below their long-term averages and will continue to buy as stock prices decline until I have reached my target equity allocations. I may even continue to purchase stocks until I am above my target allocations (though not above my maximum allocation), so long as attractive pricing remains available.
By the time the economic crisis is over and stock prices have resumed their normal valuations, I will — by following these steps — have outperformed the great majority of other investors and will have significantly increased my wealth while others were losing theirs.
Now all that remains is to sign this memo in blood.
Next up: The Talk