As originally published in Forbes.
This article is not an attempt to predict the future, but to prepare for it. Equities have historically been a great investment, and at FutureAdvisor we see no reason for that to change. However, in finance everything has a cost, and though equities have historically been a strong performing asset class, this is, perhaps ironically, only possible because they periodically fall in value. As a result you typically see good returns from equities, but, we believe, in exchange for that long term growth you must be able to tolerate occasional declines. What stops everyone from piling into equities is that those who need to get access to their money in the shorter term, realize that they may be taking too much risk by owning equities, and have to manage that trade off by earning a lower return with another investment.
Pundits often talk about stock declines as if they are all the same. They aren’t. As the Russian author Leo Tolstoy wrote, “All happy families are alike, each unhappy family is unhappy in its own way”: something similar is true of market decline. Markets can fall based on a host of economic factors whether unexpected inflation, deflation, declining economic growth, a geopolitical crisis or a shock to the financial markets. Each of these sorts of economic issue require a slightly different approach to asset allocation.
Most importantly, you need to take action before a stock market crash, not after it. Since stock market crashes are not predictable, you need to take action today. If you knew your income was going to fall 10%, that would get your attention and you’d probably spend some time on a job search, or at least financial budgeting. The truth is that your investments (which are hopefully larger than your annual salary, if you’re out of your 20s) will likely rise over time, but if you invest in stocks they are going to fall at some point in the future. No one will tell you in advance. The time to prepare is now.
Here’s what you need to do. Firstly, you need to have some bond exposure in your portfolio bonds offer a useful hedge to equity exposure. If economic growth unexpectedly declines, deflation hits or there is a geo-political crisis then bonds could rise in value at the same time as equities fall and this is generally how they have behaved in the past. However, though buying bonds through a fund such as AGG is a great way to help your portfolio it’s not a cure all. Certain scenarios have the potential hurt both stocks and bonds simultaneously, rising inflation is the most obvious one here. To address this scenario you need to consider assets in your portfolio that benefit from rising inflation, here REITs (Real Estate Investment Trusts) such as VNQ and TIPS (Treasury Inflation Protected Securities) such as VTIP can be good options, we believe both assets should do well in times of rising inflation. TIPS should do well because they explicitly incorporate inflation in returns. REITs may benefit because real estate is what economists call a “real” asset that can rise in price even if the dollar falls in value. Bonds are nominal assets and so very dependent on the value of the dollar and would likely fall in that scenario.
The important thing with the next crash is to take action before it and not after. If anything, historically, market declines have, in retrospect, been great opportunities to buy equities and not sell them. If you remember the level of fear in 2008 all the press concerning how the economy had hit a “new normal”, the US auto industry was gone and banks would never recover, bear in mind that the S&P 500 is up over +190% from the lows of March 2008. Clearly, those who decided that stocks were too risky an investment after the 2008 crash missed out on great subsequent returns. On the other hand those who had managed their asset allocation ahead of time were in a great position. Prior planning can set you up well, if you invest in stocks with awareness of the risks ahead of time and some diversification within your portfolio then you’re less likely to jump ship if a decline in the stock market occurs.
A further layer of safety can come from international diversification within stocks. Holding just US stocks can be sub-optimal from a risk/return perspective and holding stocks in other countries has the potential to smooth returns. Good low-cost examples here are VEA for developed markets and VWO for emerging markets. These are unlikely to be the solution in a stock market crash as markets increasingly move together, but occasionally regional issues do surface where international diversification is beneficial.
Market timing is another thing to avoid. Remember that the data on historical equity performance includes the crashes. For example, Jeremy Siegel’s Stocks For The Long Run dataset finds returns of 6.5%-7% for stocks for the past 200 years. Trying to be cute with timing is only likely to hurt your performance because you’ll spend less time invested in the market. You want to create an allocation that will work before, during and after a crash. The time to create that allocation is now. The rise in equities recently may make you feel you’re missing out with every dollar that isn’t in stocks, but that’s greed talking, you need to zoom out a little with your historical perspective and realize the bonds, TIPS and REITs are potentially the assets classes you need to protect your portfolio for the next stock decline however and whenever it comes.
So, stock declines are neither predictable nor enjoyable, but they are a fact of life and the necessary evil for having the benefit of stocks in your portfolio. No two stock declines are identical since the causes differ, but holding bonds, TIPs and REITs together with international diversification within stocks can all help get you in a better position before the next crash happens.
The views expressed represent the opinion of the author and are not intended to reflect those of FutureAdvisor or serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities.