Tag Archives: asset allocation

The Importance Of Having An Investment Discipline

In investing, it’s necessary to have a system. Even if you’re a buy-and-hold investor, that’s a system. In fact, buy-and-hold investors have to do a little more than buy and hold – they have to rebalance their portfolios periodically. That involves a decision about whether to rebalance quarterly, semi-annually, or annually. And once you’ve made that decision, you have to follow through and do it. You can’t say, “Gee, the market is running so hard; I don’t want to take some money of the table now.” Or, “This decline is so painful; I can’t bear to throw more money at stocks now.” But you won’t be successful if you don’t stick to the discipline you established.

Other investors, who want to be more tactical or “enterprising” as Benjamin Graham called them, should have rules too. It can be overwhelming to try to apply valuation metrics and momentum metrics to asset classes, sectors, currencies – anything that moves – every single day, and to decide which metric to emphasize and which to jettison. I’ve seen more smart people mismanage money because they couldn’t boil down their intelligence into a system, or, once they did, follow it. Investing isn’t about intelligence as much as it’s about controlling your emotions.

Let’s say you follow momentum in the stock market. You might apply the 200-day moving average to tell you if the market is in an uptrend or a downtrend. Michael Batnick wrote an excellent post about this recently where he showed how a simple system or backtest using the 200-day moving average could beat the market with lower volatility – at least since 1997. But simple to understand doesn’t mean simple to execute for a variety of reasons. As he notes, there have been plenty of times since 1997 when simply owning stocks when they were above the 200-day moving average and exchanging them for bonds when they were below would have tested your patience. He asks rhetorically if someone would have been able to follow all the 160 signals the indicator produced over the 20-year period, if someone would have been able to take the 10 signals it delivered in 30 trading sessions, and, finally, if someone would have been able to stick with it when it was badly underperforming the S&P 500 Index.

Not following that simple rule – owning stocks above the 200-day moving average and exchange them for bonds below — wouldn’t have been the result of a lack of intelligence. It would have been the result of not being disciplined enough or not believing in the indicator when it was failing – or, more likely, convincing yourself that there’s another indicator you should be following just this one time because yours was failing. St. Augustine was noted for praying, “Lord, make me chaste, but not yet.” That’s the way many investors wind up operating. “I’ll follow my model or indicator, but not yet. Something else looks more attractive or like it’s working right now; so I’m going to go with that.”

Another problem besides multiple indicators that can distract you or seduce you away from the main one, is applying your indicator to many different things. Are you doing something like Batnick’s simple example of a moving average to the S&P 500 and bonds? Or are you applying the indicator to foreign stocks too? And what about emerging markets stocks. And how about different sectors and industries of the stock market and different areas of the bond market like corporates, Treasuries, mortgages, high yield, and emerging markets? And are you trying to build a portfolio from many asset classes to which you’re applying one or multiple indicators? Things can get complicated and dizzying in a hurry.

Any system you set up will disappoint you at times. No system exists that’s 100% foolproof. The trick is if you can keep using the system when it disappoints so that you’ll still be using it when it starts working again. This isn’t about how smart you are; it’s about how emotionally intelligent and focused you are.

It’s Not A Bad Time To Rebalance

Maybe you don’t like a lot of fuss as an investor, and you want to buy-and-hold a simple portfolio for the long term. That’s fine, but you do have to rebalance periodically. And people who favor simplicity may do that rebalancing on a pre-set schedule – quarterly, semi-annually, or annually.

But if you want to be a little more active regarding your rebalancing, now’s not a bad time to consider doing it. Here are some asset class returns for the year through January 30, 2019:

You can see that stocks have done well, with the S&P 500 Index surging by around 8%. Small cap stocks have done even better, with the Russell 2000 Index rising more than 11%. Emerging markets stocks have bounced back too from a poor showing in 2018 with a n 8.67% return for the first month of this year. And finally, with interest rates seemingly under control, REITs have topped the list with a gaudy 11.78% return.

If you started the year with a balanced portfolio of, say, $100,000, the $60,000 you had in stocks could now well be over $63,000. The $40,000 you had in bonds, by contrast, might not even be at $40,500 at this point. It’s not necessary to rebalance, but if you have a tax-advantaged account like a 401(k) or an IRA, and you can switch funds without paying fees or commissions, it’s not a bad idea. If your $100,000 is now close to $104,000 because of the $3000 you’ve made in stocks and a few hundred dollars in bonds, go ahead and move around $1,000 from stocks to bonds. That will get your stock exposure back to 60%.

That’s not a huge move, but the great investor, Benjamin Graham, who understood investor psychology before behavioral finance became an academic discipline, knew that investors get antsy to do something. And if fees, commissions, or taxes aren’t an issue, rebalancing is a good way to satisfy that itch to trade without doing yourself harm.

Besides satisfying the desire for activity, rebalancing can help you in other psychological ways. If you rebalance, and the market drops, you can feel happy that you took at least some money off the table – even if it was only a small amount. If, on the other hand, the market goes up, you can be satisfied that you didn’t alter your target (60/40) allocation; you just returned your portfolio to it after the January gains altered it, booking some profits in the process. You still have 60% of your money working in stocks.

There will always be woulda-coulda-shoulda thoughts when markets move. When stocks go up,  you wonder why you didn’t have more money exposed to them. And when they go down,  you wonder why you didn’t have less. But a balanced portfolio is one that most people can live with psychologically. It provides enough exposure when stock go up to minimize regret. And it provides enough bond exposure when stocks go down to minimize regret.

Investors should understand, however, that a balanced portfolio isn’t perfect. It may well return much less over the next decade than it has over the very long term. That’s because bond yields are so low that it will be virtually impossible for bonds to deliver more than 3.5%-4%, depending on your mix of Treasuries and corporates and your average maturity. Also, stocks are trading at high prices relative to past long-term earnings, which is usually a situation that produces lower-than-average future returns. That’s more incentive to rebalance in accounts that won’t hit you with transaction fees or a tax bill for doing so.

Last, if you think we may get some inflation, you can take that $1,000 away from stocks and put it in gold or leave it in cash. The economy isn’t robust on many indicators, but, according to DoubleLine fund manager Jeffrey Gundlach, inflation can come from all the quantitative easing the Fed has done and the large amount of U.S. debt outstanding. If a balanced portfolio is likely going to deliver subpar returns, and debt turns out to be a problem, holding some alternatives to stocks and bonds is reasonable.

Gundlach’s Remarks Mean It’s Time To Check Your Allocation

“This is a capital preservation market.” So says Jeffrey Gundlach who can’t argue with anyone who wants to invest in the 2-Year U.S. Treasury, currently yielding around 2.7%. If you choose the 10-year, by contrast, and saddle yourself with 8 more years, you get less than 20 basis points of extra yield.

Gundlach is one of the world’s best investors, especially when it comes to bonds, And that means investors can’t always follow him literally because they’re not paying attention to global markets the way he is and can’t move as adroitly has he can.

Still, his remarks, delivered in a CNBC interview yesterday, are a warning for investors to check their allocations. Most investors shouldn’t try to time stock markets to the extent of being all out of or all in stocks with their long term money. But it’s a good time to check your allocation and see if it lines up with where you decided you wanted it when you started investing.

If you want to alter that allocation, and you watch the markets carefully, you can cheat a little with some extra cash. In fact, I think anyone about to embark on retirement and planning to use something like the “4% rule” (taking 4% of your assets the first year of retirement, and then increasing that initial dollar distribution by 4% every year thereafter) should have around 30% in stocks right now.

That kind of conservative portfolio will be able to withstand stock market declines if they occur while distributions are also depleting a portfolio. At least it has since 2000 when stock markets were wildly overpriced and subsequently delivered a 5.4% annualized return for the next 18 years. Retirees should think hard about revising the “4% rule” to the “3% rule,” however, given how low bond yields are now.

Novice investors should also understand that Gundlach isn’t making a prognostication out of thin air. The U.S. markets have been up for nearly a decade without a meaningful interruption. In 2017, U.S. stocks were up every month, which is the only time in history that has happened. Also, the best valuation indicators such as the Shiller PE and Tobin’s Q are forecasting low returns for the next decade. That doesn’t mean a crash will happen tomorrow; no valuation indicator is any good at predicting that. But it means stocks will have to remain at nosebleed prices relative to earnings, sales, and book value to produce returns that can beat inflation by 4 or 5 percentage points. The S&P 500 Index is now yielding a little less than 2%. Another 4% or 5% earnings per share growth annually for the next decade will produce a 6% or 7% annualized return, which sounds good. But stocks must remain at current prices relative to earnings (currently 30 or so on the Shiller scale) in order to pocket those returns. That’s unlikely. A “valuation reversion” or investors deciding that they should pay less for earnings will detract from that 6% or 7% annualized return — possibly in a significant way.

If you’ve been invested in stocks for the past decade, you’ve been given a gift. But the market can take that gift away if investors decide they want to pay lower prices for earnings than they have over the last decade.

Investors should do three things (at least), and  one of them won’t be possible to accomplish immediately — 1. Study market history and cycles 2. Check your allocation 3. Find an advisor who can help you.

What Your Advisor Believes (And Why You Should Question It)

Chances are your financial advisor believes in two related intellectual theories that you should question them about.

In a recent article, the excellent columnist Brett Arends wrote about the two theories governing most financial advisors – the efficient markets hypothesis (EMH) and the capital asset pricing model (CAPM). These sound like impossibly complicated things, but they’re not. The first theory says prices are right, or nearly right all the time, and that it’s, therefore, basically impossible to beat markets. The second theory says historical asset class returns will repeat and that the more risk you take (with risk meaning volatility), the more return you will make. So, for example, stocks are very volatile, but they’ll produce the best returns — something like 10% annualized (or 6.5%-7% after inflation) – over longer periods of time.

Theoretical Problems

But the theories aren’t always right. For example, if stock prices reflect all available information, why are they so volatile, as Arends asks? It may be because that information is always incomplete, and as more information emerges prices change accordingly — and correctly. But extreme volatility may also exist because people are irrational or emotional, and substitute stories or “narratives” for more rigorous analysis or even basic common sense. The rise of the tech bubble, for instance, wasn’t an example of new information being priced in as much as it was an instance of people’s imaginations getting the better of them, andcausing them to inflate the prices of stocks that had no underlying earnings or even revenues.

More problems: why have U.S. stocks (the S&P 500 including dividends) produced a less than 6% nominal return from 2000 through November 2018? Why did they deliver nothing but dividends from the mid-1960s through the early 1980s? And if stocks are such inflation-beaters, why did the S&P 500, including dividends, return only 65 annualized in the 1970s, far underperforming that decade’s inflation?

Future Returns

The facts of the matter are that prices aren’t efficient and asset class returns may not repeat for the, say, 25-year period your retirement plan is counting on them to do so. Bonds returns, for example are easy to forecast. They generally follow the yield-to-maturity. That means a portfolio of 8-year or so domestic investment grade bonds, such as one finds in a fund tracking the Bloomberg Barclay’s US Aggregate Index, now will almost certainly deliver around 3.3%.

And for the S&P 500 Index to return 10% over the next decade, it must trade at a higher P/E ratio than it does now in addition to delivering around a 2% annual dividend payment and 4%-5% earnings-per-share growth. That’s possible, but unlikely, because U.S. stocks are trading at around 30 times their past 10-years’ worth of earnings. They’ve only been that expensive in their runs in 1929 and 2000. Although nobody can be certain, it’s more likely that P/E ratios will decline over the next decade, not increase, cutting into the 6%-7% nominal return from dividends and earnings-per-share growth. Adherents of CAPM, don’t view the world this way, and think prices can keep rising so that it’s almost a long-term investor’s birthright to achieve 10% annualized returns.

If your broker or advisor can’t respond to these objections that their assumed future returns might be off – by a lot – there’s a good possibility that they’re too dogmatic, and have swallowed academic finance without digesting it or thinking about it.

What this means for your portfolio

The problems in these theories mean your portfolio may not be set up to satisfy your financial plan. As Arends mentions in another article, for the decade from 1938 to 1948 a balanced portfolio went backwards relative to inflation. It did the same disappointing thing from 1968 through 1983. With the Federal Reserve taking us into uncharted waters and returns prospects for major asset classes so low, investors should look at cash, real estate, foreign stocks, and commodities, including gold.

None of these by themselves is foolproof. Some of them have performed well in some instances when stocks and bonds have faltered, and others have performed well at other times when stocks and bonds have faltered. The most important thing is that an advisor sensitive to how warped the current market and situation are right now may be your best defense against tepid stock and bond returns. Making sure your advisor hasn’t fallen hook, line, and sinker for the Efficient Market Hypothesis and the Capital Asset Pricing Model may be the best way for you to navigate the next decade or so in the markets.

Lessons From Thanksgiving Dinner

Talking to friends and family at Thanksgiving dinner made me realize how unprepared for volatility investors are. The gathering I attended was filled with a wide mix of investors, from the young and novice interested in technology stocks and (somehow still) in Bitcoin to older, seasoned veterans. The veterans, however, didn’t exhibit much more savvy than the novices; everyone was spooked by the recent volatility.

Based on my Thanksgiving Dinner experience, here’s what I think investors need to learn now.

Re-Set Your Expectations

First, I think investors are spooked because they are being unduly influenced by the market action of 2017. But that was an unusually calm year that saw a 22% gain in the S&P 500 without a down month. That’s a Bernie Madoff-like performance — straight up every month like clockwork with no hiccup to the downside. That kind of performance usually only occurs when someone makes it up. Investors should realize that 2017 is an anomaly and that volatility is part of investing. Financial markets are rarely that smooth and stable. Do your best to expunge 2017 from your memory.

Below is a monthly chart of how the S&P 500 Index performed in 2017 and for the first 10 months of 2018. It may surprise you to see that the index was still in positive territory at the end of October. A $100 investment in the index at the start of the year was still worth more than $102 on Halloween. As of this writing (Nov. 23), the index was still in positive territory, albeit barely ((0.19% for the year, including dividends).

I don’t point out that the market is still positive to give investors encouragement to take more risk though, or to argue that markets have delivered solid returns this year. I do so in order to impress on you that large cap U.S. stocks are still positive, and that your sense of markets might be warped. This year feels awful to investors, but the returns really haven’t been bad. There’s a disconnect between the year’s returns and what the year has felt like. That’s because 2017 was so strange in the index posting positive gains for every month.

Reconsider Your Allocation

I also don’t mean to encourage investors to think they can time markets perfectly. The point is not to dance in and out of stocks adroitly, missing losses and capturing gains; it’s having an allocation that gives you enough of the upside and allows you to live with the downside without shaking you out of your investments. If the recent volatility makes you want to sell, chances are you have too much stock exposure, or you have to re-calibrate your expectations from financial markets.

I think most investors I meet with have more stock exposure than they can handle. Or at least they strike me as being badly prepared for declines either because they don’t have advisors or because they have incompetent advisors who don’t disclose risks and historical volatility. When declines come, many of them will bail out at or near the bottom despite the fact that Morningstar’s most recent “investor return” numbers suggest investors are getting better at mistiming markets. Instead of falling into that trap you should reassess your allocation now, before any damage has occurred. That’s not a prediction that a crushing decline is around the corner; I wish I could be that clairvoyant. But you should always be prepared for one. And you should have an allocation that encourages you to buy after a big market decline, not sell.

Hold Extra Cash, But Avoid Bunker Mode

Having just given all those warnings about market timing, I still think it’s fine to hold some extra cash. Every reasonable market valuation metric, including the Shiller PE and Tobin’s Q, is flashing expensive. None of these indicators are good at forecasting short term market moves; markets can get (and have been) more expensive. But they are good are forecasting the next decade’s worth of returns. Returns will likely be low from current valuations. That means holding some extra cash is warranted. But, for goodness sake, don’t go to 100% cash with long term assets, thinking you’ll time your reentry perfectly. The paradox of sidestepping a decline is that if the market crashes, there’s a good chance that you’ll feel so good for having missed the decline that you’ll have a lot of trouble getting back in. But 10% or even 20% more cash or shorter term U.S. Treasuries than usual for long term assets isn’t unreasonable either.

Do You Really Need Half Your Money In Stocks?

We’ve all been conditioned to think the balanced portfolio is a touchstone of investing. For many investors, it provides enough exposure to the stock market (60%) to produce a healthy return and enough exposure to the bond market (40%) to provide ballast and a little income to a portfolio. Along the way, advisors like to say that investors have counted on beating inflation by 4 or 5 percentage points. Supposedly.

But, as MarketWatch’s Brett Arends points out, a balanced portfolio hasn’t always performed as advertised, and the upcoming decade might be one of those times. That means investors should consider other allocations (depending on their individual circumstances, of course).

First, from 1938 to 1948, a balanced portfolio trailed inflation. Then, again, from 1968 through 1983, a balanced portfolio trailed inflation, eroding a third of its value in real terms, according to Arends. Basically, a balanced portfolio struggles against inflation. And while it’s obvious why inflation hurts bonds with their fixed dollar payments, it also tends to hurt stocks, despite their assumed ability to benefit from companies passing on higher costs to customers through price increases.

There aren’t easy ways for investors to combat inflation, if it should arise. Gold and commodities helped in the 1970s. Real estate can help too, as inflation can cause property price appreciation and push rents higher. Some foreign stock markets might help. Arends points out that Japanese and Singaporean stocks took off in the 1970s. Corporate bank loans and floating rate corporate debt might also help, though, Arends notes Ben Inker of Grantham, Mayo, van Otterloo (GMO) in Boston says credit protections aren’t what they once were. Finally, Inker notes that cash is a reasonable choice in times of inflation. And cash, as Arends says, doesn’t have to be in U.S. dollars. It can be in Swiss Francs, for example.

The 1970 also saw observers like Harry Browne advocate a different kind of portfolio mix – 25% each in cash, long-term bonds, stocks, and commodities. The cash and commodities would help in inflation, while the long-term bonds would help in times of deflation.

That leads me to the argument that, if you’re going to maintain a static portfolio allocation, something like 30% stock exposure, with the rest in short-term bonds and cash might be reasonable for someone about to retire soon. My reasons are that stocks are too volatile for a portfolio in distribution, and they’re likely too expensive to deliver good future returns in any case.

First, although I cherry-picked the start date so that two severe bear markets are baked into this hypothetical study, this portfolio in distribution phase shows that 30% stock exposure is better for a retiree in a bear market than a more aggressive portfolio. A balanced portfolio worked reasonably well, but only dropping down to 30% stocks allowed the portfolio to remain intact in a nominal sense (though not in an inflation-adjusted sense). Taking money from a portfolio during a volatile stock market is a tricky business. Too much stock exposure – even when using the famous “4% rule” (4% withdrawal the first year and 4% more than the first withdrawal annually thereafter) can destroy someone’s retirement.

Second, it’s not clear that stocks will outperform bonds over the next decade in any case. Even if you’re not in distribution phase, making volatility less of a concern, you may not add return to your portfolio by adding stock exposure. That’s because the Shiller PE (current price of stocks relative to past 10-year inflation-adjusted earnings) is over 30, meaning stocks have to remain more expensive than they have in history barring one other time for the next decade to deliver more than a 4% or 5% return.

And if you do add U.S. stocks to your portfolio, you’ll likely be adding the same old volatility stocks have delivered in the past. Modern academic finance like to use something called the Sharpe Ratio, which is a volatility-adjusted return or indicates how much return an investment achieved per unit of volatility. This view of the world has its problems, because risk might not be volatility, but it can be useful in helping you decide whether you want to add a certain asset to a portfolio or not. Getting, say, 4% or 5% annualized from stocks and assuming their historical volatility is a lot worse than getting the customary 10% from stocks and assuming their customary volatility. Adding U.S. stocks to a portfolio at current prices makes for what modern academic finance would call an inefficient portfolio.

Foreign stocks are cheaper than their U.S. counterparts, but they’re not screamingly cheap. If a balanced portfolio seems reasonable to you, it may not be under today’s circumstances. Consider trimming at least some of that stock exposure and adding a few other asset classes. Those new additions may not shoot the lights out, but, chances are, neither will U.S. stocks for the next decade. Above all, don’t think there’s some rule that says you need half your money in stocks. The idea of the balanced portfolio has become so popular that it feels like heresy to some people to deviate from it. But investing isn’t about faith; it’s about assessing the circumstances and likely returns in as rational a way as possible. Remember also to get some help from an adviser in constructing a portfolio and completing a financial plan. Many asset classes that weren’t available in the past to retail investors are available now. An experienced adviser can help you use them well and manage the risks they contain.

Q3-Market Performance Review

Yesterday was the first day of the Fourth Quarter of 2018, so it’s a good time to assess where markets are for the year. Nobody should change their portfolios radically based on recent market moves, and, to the extent that anybody does, the long term bias should be gently adding what has dropped and trimming what has surged, keeping in mind that catching absolute tops and bottoms is difficult. But, from time to time, it can be useful to observe recent trends.

The first thing to notice about market returns through the first three quarters of 2018 is that U.S. stocks are up again. The S&P 500 Index closed the Third Quarter up 10.58% for the year, including dividends. Mid-cap stocks were up too, though less dramatically. The Russell Midcap Index gained 7.45% for the year through the Third Quarter. Small-cap stocks have gained about as much as the S&P 500, with the Russell 2000 Index up 11.51% for the year. And the Russell Megacap 50 Index also has a similar gain for the year of 11.69%.

Two Discrepancies

If U.S. stocks are having a good year, international stocks aren’t. The MSCI EAFE Index, which tracks stocks from developed countries, lost 1.43% for the year through the end of the Third Quarter. The MSCI Emerging Markets Index (MSCI EM NR) has done ever worse, shedding 7.68% for the year through the end of the quarter. Much of those losses are attributable to the dollar’s surge against foreign currencies, especially those of emerging markets. When U.S investors buy foreign stocks or a foreign stock fund, they typically get two sources of return, the stock’s return in its own market and the foreign currency’s return versus the U.S. dollar. That second return has hurt U.S. investors in foreign stocks this year, as the dollar has surged. A dollar surge also puts emerging markets under a cloud because emerging markets countries and companies borrow in U.S. dollars, making a dollar surge especially burdensome for them.

A second discrepancy is the difference in value and growth stocks. Value stocks tend to trade with lower price-earnings and price/book ratios, while growth stocks tend to trade with higher ratios precisely because of their anticipated growth in earnings and/or book value. The Russell 1000 Value Index rose a tepid 3.92% for the year, while the Russell 1000 Growth Index surged by 17.09%. the top-5 holding of the Russell 1000 Growth Index are Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Facebook (FB), and Alphabet (GOOG). The only one of the so-called “FAANG”s that it’s missing is Netflix, and the FAANG stocks have gained more than the overall market.

Bonds and REITs

Bonds, represented by the Bloomberg Barclays U.S. Aggregate Index dropped 1.6% for the year through the end of the Third Quarter. Interest rates have been rising in fits and starts. The yield on the 10-year U.S. Treasury has spiked up above 3% (where it rests now) during the year, but also fallen back at times. Bond yields move in the opposite directions of prices.

Volatility in the bond market has also likely influenced REIT returns. REITs pay out 90% of their net income as dividends in exchange for having tax-free status at the corporate level. The high dividend yield, low-growth companies often trade with some correlation to bonds. REITs (MSCI US REIT Index) tumbled in January and February of this year, the soared in March, May, and June. But in September they shed more than 2% to give them a roughly 2% year-to-date gain. That’s not terrible, but it lags the broader market’s return considerably. Large REIT companies that have declined for the year include paper and forest products company, Weyerhaeuser (WY), office landlord Boston Properties (BXP), and medical space REIT Ventas (VTR).

Judging Your Portfolio

If you have a lot of REIT exposure, that has probably been a drag on your portfolio. That’s why gunning after the highest yielding stocks is sometimes not a good idea. Additionally, if you have a lot of international stock exposure, that’s also been a drag. The discrepancy, for example between the year-to-date returns of the Vanguard Balanced Index Fund (5.6%) and an index consisting of 60% MSCI ACWI (All Country World Index) and 40% U.S. bonds (1.7%) is large.

That doesn’t mean you should exit all your international stock positions. What does badly one year can do better the next. In 2017, for example, international stocks outpaced domestic stocks, and emerging markets stocks, the dogs of this year, gained 37% versus the 22% gain of the S&P 500. Picking a single year’s winners isn’t easy.

Overall, investors should know that domestic stocks are considerably overpriced by any valuation metric one chooses to use. That doesn’t mean they can’t get more expensive, but nobody should be anticipating robust long-term returns from U.S. stocks.

Learning Emotional Control From This Year’s Market Moves

Labor Day Weekend has ended, and the year is two-thirds over That means it’s a good time to assess what has happened and where we stand in the markets. It’s also a good time to remember what you might have been feeling earlier in the year when asset classes were behaving differently.  Understanding your emotions is a big part of successful investing, and can help you deal with market volatility in the future.

US Stocks In 2008 – Up, Down, and Up

The S&P 500 Index ended August up 9.94% for the year. But that seemingly happy statistic doesn’t indicate what an investor might have felt at various points during the year. After a blistering January during the first three weeks of which it gained nearly 10%, the market melted down in February and March during which it gave back the January gains.

It’s hard to remember now, but many investors were euphoric in January and terrified in March. If you examine our phone logs, they will bear that out. We always get more calls from clients and prospective clients when things look difficult, and our phones were silent in January and ringing non-stop in March. My colleague Danny Ratliff and I also fielded a memorable call on our radio show from an investor in his mid-50s with a balanced allocation whose portfolio was down 5% from its peak. This person was unnerved by that decline, but it didn’t occur to him that he should expect that routinely from a balanced portfolio.


The first lesson investors can learn from this year’s market moves is that short term (say, month-to-month) forecasting is virtually impossible. Don’t even try it. We try to manage risk as much as any advisory firm, but no advisor can deliver all of the market’s upside and none of its downside or time every wiggle and squiggle in all asset classes. Some of the burden of achieving good returns falls on you and your ability to control your behavior and to be realistic about volatility.

The person who called in to our radio show probably wasn’t just upset by the 5% decline in his portfolio, but also by the prospect that the declines would continue. And he was right to be thinking about that. Investors should always contemplate a 50% stock market drawdown because that’s how big the last two stock market drawdowns were. That implies a loss in a balanced portfolio on the order of 25%. Accepting volatility is the price of admission to the financial markets. the good news is you can choose how much to accept. Nobody is forcing you to have a lot of stock exposure.

The second obvious lesson is not to get lulled into a false sense of security. The market’s blistering run in January – after a nearly 22% gain in 2017 when the S&P 500 Index experienced no down months – caused investors to be shocked by the February-March declines. But it shouldn’t have. A run like that should have made you suspicious and girded you for volatility. Now that the markets have been calm again through the summer, you should be prepared for volatility again. Nobody knows for sure when it will arrive; the calm may continue for a while longer. But after such calm you’d be foolish to be surprised by turbulence. Stop getting fooled by the same things, and by thinking markets will calm down once and for all at some point. They never calm down once and for all. The calmer they are, and the longer the calm lasts, the more suspicious you should be. You should think that the next big decline is always at hand — and that’s because, often enough, it is. That’s just the way markets work.

The third lesson is to have an asset allocation you can live with. Don’t count on any risk management system to save all your bacon all the time. Investing means taking periodic losses – at least on paper. Get used to it. It’s part of the game. If you’re near retirement or in retirement, and you can’t tolerate losses, there’s nothing to be ashamed of about that. Get yourself into an allocation that will inflict less volatility on you. Reduce your stock exposure for goodness sake. The right amount of stock exposure is the amount you can live with and that will not cause you to sell if the stock market goes down by half. If you’re tempted to sell during declines, you have too much stock exposure. Take this opportunity to think hard about your allocation, and whether it will cause you to do something stupid like sell hard into a decline.

The Case of REITs

REITs have also had a year of distinctly opposite moves. Unlike the rest of the stock market which roared in January, REITs opened the year poorly. They dropped around 10% in January and February on interest rate fears. REITs are required to pay 90% of their net income as dividends, which gives them some bond-like qualities. That means when rates rise REITs can go down, even if they are the stocks of companies that can pass inflation costs on to tenants in the form of higher rents eventually.

After their 10% drop, REITs began to rebound in late February, and they haven’t looked back since. They are now up around 5% for the year or more than 15% from their lows. But the lessons are the same as with the broader stock market’s moves this year. Don’t try to time every wiggle and squiggle. And now that REITs have put together a strong run, be more suspicious than excited about them. Last, get exposure to them that you can tolerate. Chances are, you won’t time big moves into and out of them well. Make an appointment with us if you need help identifying a reasonable asset allocation.

Dump Your Stocks; Get A Financial Plan Instead

If you own an individual stock, can you say how much revenue its underlying business realized last year? Can you say what its operating margin was? Can you say what its earnings-per-share were? Can you compare those three metrics from last year to the past five years?  And if you don’t know any of these metrics, should you really own the stock?

Lately I’ve met with investors – if you can call them that — who own individual stocks, but can’t answer any of these questions about the stocks they own. They know something about how the stock has performed, but they know almost nothing about the underlying business. Perhaps they know the industry the business is in because they work in that industry or because they are otherwise enamored of the business – Tesla and electric cars! — but they don’t know how a lot of the revenue is generated, what might sustain it, what might threaten it, etc… Being enamored of a business or industry doesn’t mean you understand it. And just because a business or an industry is new doesn’t mean you have a good way to judge how profitable it will be. Airline travel has changed people’s live, but up until recently, when a few major carriers decided to divvy up routes and keep competition at bay, the airline industry has burnt through an astounding amount of capital.

Keep the technicals in their place

Buying a stock without understanding the underlying business is one of the dangers of emphasizing 200-day moving price averages and other technical metrics. The academic evidence is in, and momentum is a legitimate “factor” that drives stock prices. But over-emphasizing technical statistics or stock price movements runs the risk of directing investors’ attention away from the performance of the underlying business. Technical statistics are very democratic – can we call them populist? — because they flatter everyone with a computer screen who can look at a stock price chart. The truth is they render owners of stocks into something other than investors because investors must be concerned with a stock’s underlying business at least as much as the stock.

Have you heard the phrase “the stock is not the business”? Well, ultimately, it is, and you will get destroyed if you don’t realize that. Just ask former Enron shareholders. An ironic thing about those who doubt the validity of the “fundamentals” of a business is that they don’t dispute why the stock of a bankrupt company is worthless. Nobody disagrees that if a company is bankrupt, the stock price should reflect the status of the underlying business. So why do they dispute that the price must relate to the business in every other circumstance but bankruptcy?

Some might say that technical analysis would have gotten you out of Enron before it went to zero. But a good fundamental analyst realizing that it was impossible to understand how Enron made money – that it was impossible to answer the fundamental question about Enron’s business (or the fact that Enron wasn’t a legitimate business) — would have avoided it altogether.

You’re up against stiff odds

If technicals distract you from the underlying business, studying the underlying business pits you against the best fundamental analysts.

Knowing the business doesn’t only mean knowing — without needing to consult the financial statements, because you’ve studied them already — what revenues, operating margins and earnings-per-share are. Far from it. Knowing the business also mean knowing what a company sells to achieve its revenues and earnings, and what the competitive threats are to those products and services. Do other companies sell the same kind of good or service? What makes the things your company sells better? Or what makes the stock underpriced based on the quality of its products and the future prospects for sales and earnings? Knowing the business also means understanding the financial health of the business. If it has debt, can it cover its interest payments comfortably?

If you own a stock, you are competing against investors who are studying financial statements and trying to assess the prospects of the underlying business as their full-time jobs. Warren Buffett reads 500 pages of financial statements everyday. You can score some trading victories without knowing anything about a stock’s underlying business, and, yes, sometimes analysts know so many details about the underlying business that they lose sight of its two or three most important drivers when evaluating what it’s worth. But how long can that game of trading things you know nothing about go on? Can you really compete with this folks studying the underlying business full-time, if you’re operating on a part-time basis?

Every stock purchase is an act of arrogance, says hedge fund manager, Seth Klarman. When you make your purchase, you’re saying that you know more than the market about what the stock is worth. You’re saying you know more than others whose study of the underlying business is their full-time job. If you’re an ordinary retail investor, why should you be able to compete with such people? The fact is, you shouldn’t, and your arrogance in making the purchase is almost certainly unwarranted.

Get a financial plan

Instead of trying to pick individual stocks, go see a financial adviser and get a financial plan. Get yourself on the road to saving steadily for the important goals in life – retirement and sending your kids to college. See a financial planner who can help you put a budget in place so that you control spending and have some money to save every pay period. Figure out a plan that gets you saving periodically, allocates your assets in a way that won’t force you to sell when markets swoon, estimates future returns in a realistic way, and lets  you know when you might be able to retire and what retirement might look like financially. All of these things are much more important than wasting time thinking about individual stocks.

Don’t let trying to figure out which stock to buy, when to buy it, and when to sell it, get in the way of the steady business of saving money for your long term goals. If you’re finished spinning your wheels trying to pick individual stocks, and you’re ready to see an adviser, click this link.

Why We Trumpet Our Worry

Many clients and prospects who meet with us ask why we’re so pessimistic. There are a couple of reasons. First, although we don’t set out trying to be pessimistic, we report economic numbers and security valuations the way we see them. Bonds are giving poor yields, and stocks are at nosebleed valuations on any reasonable metric — Price/Sales, Shiller PE, etc… Consumer debt is high, as the middle class tries to maintain it standard of living on stagnating wages by borrowing. Economic growth since the last recession has been tepid. There’s no way to sugar-coat that, so we don’t try. We owe our clients our honest opinions.

The other answer has to do with managing investors’ behavior. We have a lot of collective experience in the financial services business, and we’ve seen investors make a lot of mistakes. And, yes, we’ve made a few ourselves, because we’re not perfect. Undoubtedly, we’ll make more. But our experience tells us that investors sell at bottoms. Everyone in our business knows this is a classic problem. Morningstar investor returns data often show that there is a 2 percentage point gap between mutual fund returns and the returns fund investors capture, though the last report Morningstar issued on this subject was admittedly more hopeful. If we are pessimistic it’s because we are trying to let investors know the stock market usually provides a bumpy ride, and tests your patience. It delivers gut-wrenching declines at times, and we prefer to see investors not sell during those declines. In fact, we want to prepare our clients so well for declines that they have a bias towards buying stocks when markets swoon.

All advisers want what we want; we are not unique in wanting to see our clients not sell at the bottom. The question, then, is how to combat the inherent urge to sell at the bottom. One possible tactic is to inculcate a buy-and-hold mentality in investors, and that’s a reasonable approach. But, although it doesn’t have to entail this, that approach often glosses over how painful declines can be, or just counsels investors to fight through them. That’s likely what investors should do, but telling them to grit their teeth may not be the best strategy to get them to do that. The buy-and-hold message emphasizes that investors usually come out better on the other side of a big market decline at the expense of focusing investors’ attention on how they might feel during the decline when they are likely to do the most damage to themselves.

We’d rather focus investors’ attention on how they might feel during the depths of a decline, and say to them,

The last two market declines have consisted in 50% drawdowns, so forget about the market’s long-term 18% standard deviation. You will be inclined to behave badly when you see your portfolio value declining, if you don’t think hard about that moment now when you’re more calm. You will want to sell everything to stop the losses instead of buying at cheap prices. And that will lock in your losses and potentially cause you to miss the eventual upswing. You will likely do yourself permanent damage. You will focus on how much your account has declined instead of focusing on how cheap stocks might be at that moment, and if you get too much stock exposure now you will not be inclined to buy at that moment. You will want to fire us as advisers, and you will never want to invest in stocks again. Or you will find an unrealistic and/or unscrupulous adviser who will tell you they can deliver all the market upside with none of the downside.

Try to remember how you felt and behaved in 2008-9, and then consider how much stock exposure you really want to have. We will do our best to manage your downside, but much of your success depends on your choosing an appropriate amount of stock exposure to begin with. That amount is usually less than you think it is, especially after a 9-year bull market.”

We think saying these things, and working hard to assess a new client’s risk tolerance, are more effective than emphasizing coming out on the other side of a bear market. Coming out on the other side isn’t the problem; the decline is the problem. Investors can’t see their way to coming out on the other end in the middle of a bear market, and encouraging them to do that at that moment isn’t helpful. We’d rather address bad behavior at a moment when investors — especially retirees, who are most vulnerable to fluctuating account — are in a better psychological state to listen.

We encourage investors to access the fear they’ve felt during past declines, before the next one ensues, and we never shame them into owning more stocks than they can handle. We think a lot of advisers subtly shame investors into owning more stocks because of how stocks have performed over the last century or so relative to bonds. Much of these gains owe to a price multiple expansion that was likely a one-time event during the 1908s and 1990s, as Rob Arnott and Peter Berstein have argued. And there are long periods when stocks have delivered poor returns.

No adviser knows exactly when bottoms and tops occur, but an adviser with experience can often judge the psychological temperature of clients well. An experienced adviser can often surmise how clients will react under different market conditions better than clients themselves. Clients are notoriously poor judges of how they will behave under adverse market conditions. They tend to block out how they felt in 2008, for example. And they are poor judges of how much stock exposure they can handle.

Clients will have to assess for themselves which approach and which kind of adviser will help them withstand market volatility, and help them buy — or at least not sell — into steep declines. The buy-and-hold approach, after all, is really a buy-and-rebalance approach, and investors adhering to it must rebalance in down market by purchasing stocks.

We are grateful to the clients who have entrusted us with the management of their capital, and we look forward to meeting new ones who seek an alternative approach. Click here to schedule an appointment with us if you are interested in hearing about our approach to asset management and financial planning.

The Two Rules Of “Stockbroker Economics”

How an advisor should talk to clients and what rhetoric leads to big sales are often at odds. It can be death to an advisory business if the advisor is negative. Clients tend to want reassurance from an optimistic advisor. That’s why economist Andrew Smithers refers to broker happy talk asstockbroker economics.”

The two rules of stockbroker economics are:

1. All news is good news, and;

2. It’s always a good time to buy stocks.

On the role of news, a strong economy fills clients will all the optimism and willingness to buy that they need. A weak economy simply prompts a broker to say that falling interest rates and future rising profits are good for stocks, never mind that profits and prices had only moved in tandem 54% of the time when Smithers wrote his 2006 article. On the second rule, nothing has succeeded as well as what Smithers calls the “bond yield ratio,” another name for which is the “Fed Model.” That model compares bond yields to the earnings yield of the stock market (the reciprocal of the P/E ratio or E/P). This ratio worked from 1977 to 1997, but didn’t from 1948 to 1968. Using the full dataset shows no relationship between bond yields and earnings yields, according to Smithers.

Other forms of nonsense used to support the second rule include using a current P/E ratio to appraise stocks. Of course, a current P/E ratio has little ability to forecast long-term returns. It sometimes shows stocks are expensive when they are actually cheap, and vice versa.

A third piece of nonsense that Smithers doesn’t mention is the assertion that all forecasting is bunk. While forecasting next year’s returns might be bunk, metrics like the Shiller PE and Tobin’s Q have strong records in forecasting future long-term returns. Even if the Shiller PE has been elevated for the past 25 years, the S&P 500 Index has delivered tepid returns (5.4% annualized) from 2000 through 2017 with the entirety of that return occurring only in the last 5-years.

All of this means the first rule for investors judging their advisors is whether their advisors engage in too much happy talk – especially about future returns. If an advisor says a balanced portfolio should deliver a 7% annualized return for the next decade with starting 10-year U.S. Treasury yields at 3% and stocks at a 32 CAPE, be wary.

Second, investors should avoid advisors who avoid making forecasts to the point where they disparage anyone who does. That’s because it’s not hard to make a bond forecasts. With high-quality bonds, yield-to-maturity will get you close to the total return. Although stocks are harder, the Shiller PE can help. And, the more it’s stretched by historical standards, the more accurate it gets. No advisor should be dogmatic about pinpointing future returns; anyone who thinks they can be precise is crazy. But it’s also outlandish to expect long term historical returns from the stock market when valuations are as stretched as they are today. Stock market forecasts are hard, but don’t let your advisor squirm out of them completely.

Making a forecast is also necessary for constructing a financial plan. And, while it’s true that an accurate forecast doesn’t have to be available just because advisors and clients need one, decade-long projections are easier, if imperfect, than guessing what next year’s market move might be. When the Shiller PE stretches to more extreme levels, low future returns become more likely. So, when you hear an advisor making fun of something, that should raise warning flags.

We think advisors with integrity aren’t afraid to tell clients stocks are expensive even when it might hurt the advisor’s business. An advisor constructing a financial plan owes you an honest assessment of future returns. Currently, the Shiller PE is at 32. And while nothing is impossible, it’s very unlikely that stocks will deliver more than a 2% real annualized return for the next decade.

Third, consider if your advisor goes beyond the risk questionnaire he gives you. Nearly every financial advisory firm has a risk questionnaire that it gives to prospects and clients. The questionnaire often has many questions about how much risk the investors think they can handle and what portion of their assets they’d like to put at risk in exchange for possibly getting a higher return than a low risk investment will deliver. But risk questionnaires ask about percentages, and most people don’t think in percentages. Consider if your advisor asks you how you might feel if you opened up your statement and your account was down by a certain dollar amount. That’s more meaningful than a percentage question. Consider it a positive thing if your advisor pursues this line of questioning a bit, including asking you how you felt and how you reacted to the market plunge in 2008.

Risk often boils down to how much of a portfolio decline a client can tolerate before selling out, and everyone has a point at which they sell. This is important because it shows how investors do themselves damage. The tendency should be to buy stocks when they get cheaper, not sell them. But investors rarely think of buying when the prices of their holdings are declining.

Advisors have other ways of trying to train clients about how to treat price declines in their portfolios. Many advisors focus on long–term asset class returns, trying to persuade investors that they can overcome declines if they have the willpower to stay the course and not be discouraged. Other advisors do the opposite, focusing on how severe declines can be and trying hard to get clients into allocations that they can live with at the outset and to prepare them for the difficulty that lies ahead in the inevitable downturns.

The advisors who emphasize long term returns often come close to shaming clients into owning stocks. In my experience, such has made some clients feel inadequate for not wanting to assume more risk – or have encouraged clients to take more risk than they would have for fear of being deemed inadequate in the eyes of the advisor. Make sure your advisor isn’t shaming you into owning more stocks than you can handle.

At Clarity Financial, we focus on the growth of savings and on the minimization of emotional duress that can lead to poor investment decision-making.

Volatility Is Back

After a bad week in early February when the S&P 500 Index dropped 10% to meet acknowledged definition of a correction, the market has rebounded and investors have mostly regained confidence. On Monday, March 5, the Index bounced over 1% higher making its year-to-date return over 2% — a perfectly respectable return in the early days of March.

However, one can’t help but have an uneasy feeling that it’s a different market environment in 2018 than it was in 2017 when, for the first time in history in one calendar year, the market posted positive gains in every month. Using the S&P 500 Price Index (not including dividends), The market was so anesthetized in 2017 that it posted only 8 days of gains greater than 1% or losses more severe than -1% from the previous day’s close. This year, the market has already posted 16 days of gains greater than 1% or losses more severe than -1% from the previous day’s close.

Moreover, the index experienced no one-day 2% gains or losses in 2017. It has already had three such days in 2018, all of them to the downside.

Another way to look at volatility is to measure the average daily volatility, using absolute value of daily changes. As our chart shows, over the roughly five year period from the start of 2013 through March 5, 2018, the S&P 500 Price Index moved an average of 0.54% on a daily basis. For 2017, that number shrank to 0.30%.

It’s also useful to look at standard deviation, a statistical measure that indicates the range of most, though not all, moves from an average. For the five year period, the standard deviation of the index was 0.77%, while for 2017 the standard deviation was 0.42%.

Lessons for Investors

Investors should learn from this graph that the low volatility of 2017 was unusual and that it’s not reasonable to expect that environment to persist. Investors should also take the opportunity to review their asset allocations. The fact that markets have rebounded since their declines in early February shouldn’t be so much cause for joy as an opportunity to reassess how much volatility is tolerable.

If an investor was unnerved by the market drop in early February, that likely means their allocation was inappropriate. Too many investors have piled into stocks because bond yields are low and long-term historical stock returns promise to make up the difference for under-saving for retirement. But century-long or longer stock returns mask the fact that stocks go through decade-long and two decade-long fallow periods, especially when valuations are as high as they are now.

Investors tend to forget how they feel during bear markets, especially when those bear markets are in the distant pass. We tend to have what behavioral finance professors call an “empathy gap” regarding our own feelings and behavior in stressful markets. But since early February isn’t that far away, investors should use it as an opportunity to reassess how a downturn might make them feel. If you wanted to sell stocks instead of stay put or buy them as prices got cheaper, it’s time to reassess your allocation – while you still can without having to change it after a decline.

Investors should also consider that bonds, though offering lower than normal historical yields, still have a place in portfolios. Their stabilizing influence is often most welcome when investors have written them off as boring next to stocks, their more exciting cousins. As other investors forget risk and unnerve their brokers and advisors with extreme bullishness, it might be a good time to be cognizant of just how much excitement you can tolerate. Investors feeling themselves capable of accepting more risk should also consider the words of investor Howard Marks, — “The truth is, risk tolerance is antithetical to successful investing. When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so, and risk compensation will disappear.”

Why Recent Volatility Is a Gift For Investors

Warren Buffett’s teacher, Benjamin Graham, once wrote:

“The investors chief problem – and even his worst enemy – is likely to be himself.”

The market’s recent volatility can give investors an opportunity to reflect on some common psychological pitfalls and not be their own worst enemies.

Investors damage themselves mostly by selling stocks when they get cheap and buying them when they get expensive. Morningstar’s most recent investor returns study shows that investors in diversified stock funds are giving up nearly one percentage point of returns annually due to bad trading. While the numbers don’t tell us what’s causing investors to lag the returns of their funds, it may well be due to certain behavioral problems. Advisors see the behavior constantly in their practices. And advisors aren’t immune from the behavior themselves.

Behavior Gap

Damaging though it can be, it’s understandable why investors sell low and buy high. Nobody likes to see their portfolio declining, so the inclination is to sell when stocks are going down. And nobody likes to see their neighbor making more money than they are, so the inclination is to buy when stocks are going up. The fear of losing money permanently and the fear of missing out on gains (which may really be just greed) are always at play.  Of course, if you’re supposed to adhere to a target allocation, you must sell when stocks go up to maintain your allocation. And you must buy when stocks go down to maintain your allocation. But investors forget that in times of euphoria or panic.

Sometimes being in the right parts of the market can help, whether you’ve emphasized the right sectors or the right parts of the world. But, as this Morningstar article notes, there were few places to hide during the stock market’s recent unpleasantness. And that may be the case next time as well, since all asset classes seem to have risen in tandem after the financial crisis.

That leaves the question of owning more bonds. From February 1st through February 9th the S&P 500 Index dropped around 7%, not including dividends. Over that period, the iShares 10-20 Year Treasury Bond ETF (TLH) lost only around 1% in price – a considerable improvement over stocks. And, of course, cash didn’t lose anything.

An Opportunity To Reassess Risk Tolerance & Allocation

The lesson investors should take from the recent market turbulence is to think about whether it frightened them and how much it frightened them. After all, an investor’s bias should be to buy when the market is going down. That’s not to say the roughly one-week correction we had is all the downside we’ll see, and that buying stocks while it was happening would have guaranteed rock-bottom purchase prices. But an investor should be inclined to buy when markets are falling, not sell. Similarly, the bias should be toward trimming stock from a portfolio during market surges. Use the recent turbulence to take the temperature of your emotions. What were you inclined to do when you saw your portfolio’s value declining?

When investors complete the risk questionnaires that their advisors give them, it’s difficult for them to remember how they felt during the last bear market. Behavioral finance calls the inability to access old feeling the “empathy gap.” As a result, many investors indicate on risk profile questionnaires that they are more risk-tolerant than they really are. Don’t’ squander the gift last week’s recovery gave you to think about how the week before felt. If you wanted desperately to sell, you probably have the wrong allocation.

I talked to an investor during the correction whose portfolio was down around 5%. We surmised he probably had a balanced – roughly half stocks and half bonds – allocation, and that’s normally considered reasonable for his age (early 50s). But he was rather disturbed by this volatility, and we couldn’t help but conclude that his allocation was too aggressive for his personal taste and comfort.

Advisors tell clients that a 5% decline isn’t much. It’s really the price of admission into the stock market, which experiences 10% drops with great regularity. That may be true, but many investors don’t realize what it will feel like when they see their account decline. Many investors indicate that they can handle a 20% decline in their portfolios on risk questionnaires. But a 5% decline, after all, will reduce a $500,000 portfolio by $25,000. That’s usually not catastrophic, but it’s unnerving for someone who hasn’t experienced it before. And it can push them to sell stocks at lower prices. A full 20% decline will reduce a $500,000 portfolio by $100,000, and the older you are, the more unnerving that can be.

A balanced portfolio (50%-60% in stocks) should a reasonable one for many people 15 years from retirement into early retirement, but many investors are unaccustomed to its volatility, and many advisors are unaware of how unaccustomed their clients are to its volatility. Investors should use this opportunity to decide if they need to reduce their stock exposure, and advisors need to reassess how well they’re preparing clients for inevitable downturns. Advisors don’t like to be negative. They think, with some justice, that negativity will make it harder to attract and retain clients. But they must focus on the downside and educate clients better. It’s arguably their fiduciary duty, and it will make for better client experiences in the long run.

Think In Dollar Terms, Not Percentage Terms

Investors should do at least one more thing in response to the recent volatility. Think in dollar terms, not percentage terms. Most investors don’t know what a 5%, 10%, or 20% decline really means for their portfolios. They’re not used to thinking in percentage terms. Go through the exercise of thinking about what each of these declines means in dollar terms for your portfolio. It will help you understand how much risk you’re taking and whether you can tolerate it. We’ve had two 50% top-to-bottom stock market drawdowns within the past 20 years. Valuations are stretched now, and there’s nothing to say we can’t have another one – though, as always, there’s no certainty that we will have one. The time to prepare is now – after the gift the market just gave you in dropping a lot, but then recovering a lot.