byline: Simon Hamilton

The past 18 months has been a roller coaster for recession risk. Last summer, headlines and talking heads screamed of a looming recession, pointing to factors like the inverted yield curve. Those screams are ringing out again as investors are fleeing to safety and bond yields have plunged around concerns of a coronavirus-driven global economic slowdown.

An inverted yield curve occurs when short-term Treasury bonds yield more than long-term Treasury bonds; and has historically been a predictor of recessions. But you should never look at one metric in isolation; rather you should look at metrics in the context of the greater economic data. And some signals, including the unemployment rate, the quit rate and residential building permits do not point to a major slowdown ahead.

The other prevailing concern is that consumer sentiment won’t hold up with slumps in the industrial and manufacturing sectors. Yet consumer confidence remains relatively high. It has dropped slightly since last year, falling eight percent from last December, but when entering a recession, it tends to drop closer to 15%. The U.S. service sector represents some 70% of our economy and so far has been very resilient in the face of troublesome news overseas.

The U.S. economy has been growing for the past decade now, the longest run on record. As the market rises, investors have become increasingly concerned. Should you fear all-time highs? Market highs give many investors flashbacks to the dot-com bubble or the financial crisis of the last decade, because they recall how quickly gains can evaporate. But it is hard to be a successful investor if you always interpret all-time highs as a breaking point.

There is a cliché uttered around stocks: “What goes up, must come down.” And while this phrase makes sense if you’re throwing a baseball, it’s an oversimplification of the market and assumes that it operates around a flat trend line. Long-term investors know that isn’t the case.

Over the past 60 years, the average one-year return for the market has been 10.2%. The average 12-month forward performance following an all-time high has been around 12%. So, rather, highs generally bring about further highs.

This does not mean a recession won’t strike in the future, but exactly when the next economic downturn will come is extremely uncertain and is not a guarantee just because the market reaches new highs. Markets don’t die of old age — investors typically need to anticipate a significant fundamental shift in earnings, profit margins, inflation or interest rates to sustainably change their speculative appetites.

Recessions are notoriously hard to predict, as there are typically lag times of varying lengths between economic indicators turning cautionary and the manifesting of recessionary data. And, the stock market cycle rarely lines up perfectly with the economic cycle. In fact, the stock market tends to perform well during the start of the recession. In five of the past eleven recessions, markets saw double-digit gains while the recession was underway.

Many people don’t even recognize we’re in a recession when it’s unfolding. The recession during the summer of 1990 wasn’t declared by the National Bureau of Economic Statistics (NBER) until April 1991, a month after it was over. And in late 2008, NBER didn’t announce it was a recession until December, a year after it began and just six months before it was over.

If you are trying to predict the economy just by reading headlines, chances are you will be off on how the market reacts. It’s not just the news that moves stocks, it’s the news relative to expectations that moves stocks. Good or bad matters a lot less than better or worse and it’s entirely possible that the markets will discount economic contraction before it’s actually captured in those headlines.

For example, earnings reports late last year were not as bad as what was feared and markets were able to rally despite flattish overall growth versus 2018. However, they sold off in 2018 despite double-digit growth. Forces such as monetary and fiscal policy can influence stock prices in ways that one might miss by just focusing on economic data.

While risks are still elevated in light of the world’s second-largest economy effectively shuttered due to the virus outbreak, that should not dissuade you from having balance in your portfolio and looking towards reasonable valuations on companies that have good, long-term value. As an investor, it’s important to remember that staying invested has historically been a sound strategy.

Simon Hamilton is a portfolio manager with Reston-based The Wise Investor Group at Robert W. Baird & Co. Incorporated

If you look at the New York Stock Exchange’s advance/decline line between December 2018 and February 2019, you’ll see a dramatic V shape. In periods of volatility like this, it’s a challenge not to react to the short-term market swings and remain true to your long-term investment goals. But if investors want greater returns, risk is a part of the process — the fleas that come with the dog, if you will. Here are some recommendations for riding out the waves of a volatile market:

Put it into perspective
According to the WSJ Market Data Group, in 2017 the Dow Jones Industrial Average and the S&P each experienced the smallest absolute daily percentage change since 1964. With such a low level of volatility, any sort of uptick last year was going to surprise investors. And indeed, the fourth quarter of 2018 was a wake-up call for some. It's not that the volatility of 2018 was abnormal, it's that we became accustomed to the tranquility of the preceding years. The stock market’s standard deviation last year was actually below the average of the past 60 years. But factor in the all-time high the market reached last September, and it’s understandable that such a drastic drop in a short period of time would be startling.

Stifle your emotions
In my experience as a portfolio manager, market volatility can bring out the worst in people when it comes to managing their investments. When the market takes a downturn, they tend to become myopic. A common pitfall is to start thinking of investment accounts like checking accounts, equating market losses with actual spending. With this intense focus on short-term results comes the risk that they will abandon their long-term financial plan.

The best way to combat this reaction is to take emotion out of any financial decisions. There’s a difference between selling when things are bad and repositioning. If you sell near the bottom, as many people did back in 2008-2009, you lock in negative returns without any recovery potential. And buying back in when the market is “good” again can be a mistake — it’s often the worst time to buy stocks when valuations are high.

Instead of chasing previous performance, it’s important to preserve the integrity of your asset allocation. For example, if you've allocated a certain percentage of your portfolio to bonds or a certain percentage international stocks and those percentages have changed with the market, it makes sense to rebalance back to your desired allocation.

Examine your situation
Everyone’s financial plan is different, so it’s best to think about your individual goals for your portfolio. Is it there to provide current income? To cultivate a long-term nest egg? To provide funding for a specific purchase?

Once you’ve examined your goals, you should evaluate your liquidity needs. How much do you anticipate withdrawing in the next 12 months? Divide that into two camps: regular withdrawals and extraordinary expenses, such as paying for college tuition or purchasing a beach house. Then, make sure the money you need for the next year is budgeted for, either in cash or through dividends and interest coming that will to cover those expenses. You don’t want to be in a position where you need to sell stocks or bonds to pay your bills.

For example, say you have a $1 million portfolio and need to withdraw $30,000 over the next year. Factor in that withdrawal rate and how much income you have coming in from the portfolio in the form of interest in dividends. Once you know how much principle you need, you will have a better idea of how much risk you can take with your portfolio. If you only need a small percentage of the principle, you can afford to ride out a rough patch. However, if you need to fund a down payment on a house, you might want to remove those funds from the market.

No matter your situation, it’s important to talk to your financial advisor about your concerns instead of getting caught up in blanket buy-or-sell decisions. Your advisor can help you preserve your long-term plan while providing some liquidity to put your mind at ease and help you sleep at night.   

Simon Hamilton is managing director of The Wise Investor Group at Baird in Reston.

For Virginia's top-earning execs, they’ve already done the hard work of building a successful career. The next step is leveraging and protecting their earnings. For the past few years, they've likely been able to get away with a few mistakes when it comes to managing their money. With the market going basically straight up from 2011 until 2015 with no correction and the Fed on the gas, it was almost difficult to go wrong.

But with stretched stock valuations, the potential for higher interest rates, and of course, an interesting pending election to say the least, the investment landscape has become more challenging. To protect earnings, executives and their families can no longer afford to make mistakes that their portfolio might have easily overcome a year and a half ago.

Unlike a single investment decision gone wrong, these portfolio mistakes typically have a much bigger impact. As a professional portfolio manager, here are the most common mistakes I see top earners make and how to avoid each one.

1. Investing without a financial plan.

Investing without a clear idea of what you want your portfolio to accomplish is the most common mistake. Many executives think, “I just want to make as much money as possible.” But that doesn’t count as a strategy or a viable financial plan, because it doesn’t take into account the risk required to achieve that goal. Without a plan, you have no idea how much risk you can afford to take on, whether you should be in stocks or bonds, or how much you should have in cash. It’s difficult to design an effective portfolio without these details.

2. Having a random collection of investments and calling it a portfolio.

Do-it-yourself investors are the biggest violators of this mistake. They’ve bought different things over the years and end up with a stack of stocks and no sector discipline. There is a big difference between sales people and financial advisors, and a random collection of these one-time purchases is not the same as a cohesive, integrated portfolio.

3. Lack of discipline.

Intelligence should go into where you have money. The ratio of 60 percent stocks to 40% fixed income is a common portfolio structure, but it is not right for everyone. You have to figure out what makes sense for you, and then you have to stay true to that balance. Overconcentrating in one type of equity or one sector is a bad idea. For example, holding a bunch of different mutual funds is not diversifying, because they all hold pretty much the same stocks. You have to be disciplined about avoiding portfolio overlap and make sure that you don’t have a few stocks that could sink the whole thing.

4. Rear-view or momentum investing.

Rear-view investing is an easy mistake to make — you look back at those asset classes that have been showing great returns and want to get in on it. It’s a natural inclination for investors, and very easy to get into risk that you don’t properly understand. If everything in your portfolio is “working,” you are doing something wrong. Rear-view mirror investing over the long-term is a return killer and a risk enhancer.

5. Chasing yield.

In a low-interest rate environment, people often make investments they might not otherwise in an effort to get the returns they believe that they need. Unfortunately, this often involves taking on risk that they don’t properly understand. Be careful trying to generate excess yield in your investments while in a low-yield environment. There is always a reason for the higher yields, and that usually involves increased risk, which is almost always going to be bad for your portfolio over the long-term.

6. Satellite investments with no core.

Similar to that random collection of one-time purchases, many investors make the mistake of building up a portfolio of satellite investments without any real core. These satellite investments might be interesting companies or funds that the investor read about, or heard about from friends and family. These investments can be smart additions to a portfolio, but it’s best to keep them reserved for a section of your portfolio designated for experimentation. They should be separate and complementary to your core investments that keep your portfolio on track towards your goals as defined by your financial plan. Start with your core and diversify from there — not the other way around.

7. Trying to match cash flow to income.

Many investors get caught up in how much income they need their portfolio to earn each year. It is important to remember that portfolio cash flow is different from the income you draw from your portfolio. It does not have to be matched up 1:1 to be successful. You do not need to get all of the income from the cash flow. Instead, focus on staying ahead of inflation and building a portfolio that appreciates over time.

8. Not even knowing what you own.

Not knowing what you own is perhaps the biggest portfolio mistake you can make. If you can't explain the rationale for an investment on the back of a cocktail napkin, you shouldn't buy it. This includes investments such as target date funds and annuities — if you don’t know what’s in them or how they work, you probably shouldn’t add them to your portfolio. When it comes to your life savings, being boring is not a bad thing.

To avoid these mistakes, it all comes down to simplicity. With all the investment options available in today’s market, it is easy to become disillusioned by complexity. The idea that the more complicated an investment is, the better, is a misconception. Keep things simple and you’re more likely to be able to manage risk and avoid making mistakes that your portfolio can no longer afford.

A partner with The Wise Investor Group, Hamilton leads the team’s Portfolio Management department and is an instrumental voice in investment policy, asset allocation and client management decision making. A managing director at the firm with more than 20 years of experience, he is also the frequent host of “The Wise Investor Radio Show” that airs weekly on WMAL 105.9 and AM 630, as well as host of the “Midweek Update” podcast..