Investing During a Market Downturn

Investing During Market Downturn

Burton Malkiel is a widely respected economist who was trained at Harvard and Princeton University, where he currently teaches, served as dean of Yale School of Management, was a member of the President’s Council of Economic Advisors, and spent 28 years as a Director of The Vanguard Group. He is perhaps best known for his book, A Random Walk Down Wall Street. To help our clients better understand the tactical and strategic landscape of the market, we are presenting this synopsis and recap of Dr. Malkiel’s 9/21/2022 article in The Wall Street Journal.

Despite Uncertainty, the Right Mix of Stocks & Bonds Can Yield Portfolio Stability

Equity investors have a mounting list of worries. It appears the Federal Reserve will have no choice but to continue raising interest rates. Simultaneously, other factors may continue to hamper supply chains and restrain growth prospects. While none of this necessitates dire economic results, it is worth asking whether reliance on equities to produce generous long-term returns needs to be modified.  

Fortunately, we can look to two recent periods of prolonged stock market downturns for critical insights into how to balance stocks and bonds for portfolio stability.  

Despite these uncertainties, it is clear that long-term investors can rely on a portfolio sufficiently weighted in stocks. Stocks represent the ownership of real assets, and for more than a century, they have proven their worth in building retirement assets and protecting those assets against inflation. We have every confidence they will do so in the future.

But the long-term can test even the most patient among us. What happens when we experience a significant period of years of depressed stock values? Do we try to time the top and bottom, exiting and entering the market to avoid losses and capture gains? No, history and multiple academic studies show the futility of this approach. But we also don’t have to sit back and do nothing. There are constructive tactics we can employ.

Here is where the lessons of history can be incredibly insightful. Consider the two recent long periods of stock-market declines. 

  • From January 1968 through the start of 1979, the U.S. economy suffered from stagflation and volatile stock markets. The 11 years ended with a zero gain in the major averages. 
  • The 13 years from January 2000, the height of the dot-com bubble, was just as bad. Stock valuations fell from bubble-high levels, and market averages at the start of 2012 stood at the same level from where they started at the beginning of the millennium.

Despite the market doldrums in both periods, investors were able to prosper using dollar-cost averaging. Despite the flat performance over these periods, this process earned positive returns. Per dollar invested in the broad S&P 500, dollar-cost averaging earned 5.2% a year during the stagflation period and 5.7% in the post-bubble period, assuming all dividends were reinvested. While these may be modest returns, they exceeded inflation. It shows that even during these extremely rocky times, the steady equity investor can still come out ahead.

By way of a quick refresher, dollar-cost averaging is a process of periodically investing a fairly regular amount into a portfolio. This process,

  1. ensures that all holdings are not purchased at temporarily inflated prices, and 
  2. ensures that some shares will be bought at sharply reduced prices.

This strategy may seem a little like smoke and mirrors, but it is just one of those mathematical phenomena which we don’t understand until we delve into it. In essence, the fairly regular contributions mean you will buy more shares when prices are low than when prices are higher. As a result, you’ll have more shares purchased at low prices than those purchased at higher prices. These then generate significant gains when the price recovers. Investors can gain positive returns even when the market averages don’t increase, and the greater the volatility of stock prices, the greater the potential for gain.

Strategy in Retirement

For those who are in retirement mode and need to withdraw from their portfolio to fund living expenses, a slightly different tactical strategy is helpful. The right strategy here is to fine-tune the asset allocation to favor one type of bond and one type of stock. You still need to maintain a properly diversified portfolio, but the composition becomes very important.

Within bonds, the holdings should favor short-term bond funds, which are less susceptible to interest rate increases and can be liquidated to meet living expenses without creating significant capital losses.

Within stocks, the holdings should favor value-tilted funds, which hold stocks paying significant dividends. The value of the equities will eventually rise to overcome inflation and reflect the eventual economic recovery, but the dividends can be used to supplement withdrawals for living expenses. 

Stay the Course

We will never be able to predict the next turn in the market, nor predict when a down market turns around. Any advisor pitching that is selling a product you don’t want to buy. However, we can fine-tune portfolios to provide greater stability during the downturn, fund retirement expenses, and buy time to allow stocks to recover and ultimately thrive.

The devil is always in the details. Too many investors are tempted to listen to media soundbites or doom-and-gloom prognostications and either panic or try to time the market. A consistent long-term strategy with appropriate tactical turns from time to time should ensure a successful financial future.

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