Investing in Difficult Times
August 5, 2011
- You can't control the financial and economic environment, but you can take an active role in your own portfolio.
- We show you how to take a more dispassionate look at the market and your investments.
- Designed for all types of investors.
It's hard to find good news lately. The daily headlines show a slowing economy, shaky government finances, and a sharply declining stock market. And we're not alone—many countries are suffering from similar afflictions.
Investors can't control the financial and economic environment, but they can take an active role in their own portfolios. So, our best advice is to take a cold, hard look at the hand the markets have dealt, combine that with a dispassionate view of your own situation as an investor, and think before you act. To that end, we've put together some do's and don'ts to help guide you through that process.
As of market close on August 4, 2011, the S&P 500® index was down 12% from its recent high on April 29. The natural inclination of many investors is to take that recent downward movement and extrapolate it into the future ad infinitum. However, of the 25 market corrections greater than 10% during bull markets since 1962, only 9 have turned into full-fledged bear markets.1 The point of trotting out this statistic isn't to forecast what the market will or won't do in the near future. As we've said many times, short-term market forecasting can be perilous. The point is that when the market is dropping like a stone, many assume it will just keep on moving in that same direction. But more often than not, that has not historically been true.
The same thinking can be brought to bear on the economy. Regardless of what you call the current situation—"soft patch," "slow growth," or "anemic growth"—the U.S. economic engine is not firing on all cylinders. Annualized growth for the United States was 0.4% in the first quarter of this year and 1.3% in the second quarter. The knee-jerk reaction is to presume that the economy will keep decelerating until it stalls altogether and then begins to actually contract.
While a recession is not out of the realm of possibility, that is not our expectation at this time. Our chief investment strategist, Liz Ann Sonders, has pointed out that low-growth quarters don't always mean pending recession. Since World War II, 25 quarters have had GDP growth of less than 1%; yet only 12 of them signaled a coming recession. Liz Ann also listed several economic positives worth thinking about before restructuring your portfolio into recession mode:
- Soaring corporate profits and healthy capital spending that comprises 11% of the economy, as measured by GDP.
- A renewed downturn in the number of people filing new unemployment claims.
- Pent-up consumer demand, especially within the auto sector.
- A weaker dollar, which makes US exports—13% of the economy—more attractive.
Understand your holdings
It's always a good idea to understand the holdings in your portfolio, but this is especially true during turbulent times when the inclination is to make broad, sweeping decisions about all of your holdings, irrespective of their individual merits.
Whether you own mostly stock-oriented investments (individual stocks, stock mutual funds or exchange-traded funds that hold stocks), bonds, or a healthy mix of the two, consider the following.
- Review your sector exposure. Individual sectors react differently in times of economic stress. What is your exposure to sectors that have tended to be more resilient in times of economic weakness? How about your holdings in those sectors which have tended to shine only when growth is proceeding at full tilt? Historically, sectors tend to move with business cycles: Cyclical sectors such as technology, industrials, and consumer discretionary tend to do better during upswings, while defensive sectors such as consumer staples, health care and utilities have historically performed better in anticipation of downturns. Keep this in mind if you have your own opinions about the direction of the economy. If you don't have an opinion, take into account our current Sector Views from Brad Sorensen. As of this writing, our 3-6 month outlook is more favorably disposed toward the tech and industrials sectors, given our still favorable view on the economy. Conversely, we're less impressed by consumer staples and utilities. Of course conditions change and we revisit these views periodically, so we strongly suggest checking back frequently.
- Review the quality of your individual holdings. We've always felt that Schwab Equity Ratings—our proprietary methodology for identifying stocks that we believe will outperform or underperform the market over the next 12 months—are a useful tool for helping assess individual stocks. In fact, our model portfolio of individual stocks just received two first-place finishes in Barron's latest survey (as of June 30, 2011) of stock selection performance.2 We rank stocks from A-F according to a variety of factors, and as a general rule, we don't believe there's ever a good reason to continue to hold D- and F-rated stocks. If you are currently holding them, we suggest you revisit your original rationale for buying them and consider selling.
- Don't forget bonds. With the debt ceiling debate and the risk of a Treasury default settled for now, you may have forgotten about the bond portion of your portfolio. That could be a mistake. Our fixed income strategist Kathy Jones reminds us that government bonds and non-financial investment grade corporate bonds tend to significantly outperform riskier bonds in times of economic stress. High yield bonds and other credit-sensitive bonds have historically behaved more like stocks and that correlation has often increased during times of market stress.
Revisit your allocation
Given the inherent risk of stocks, it is paramount that investors understand at all times how much of their hard-earned portfolio they have at stake. Ask yourself the following questions:
- What's my target asset allocation to stocks? Reacquaint yourself with the long-term allocation to different categories of investments like stocks, bonds, and cash investments. This target asset allocation is intended to match up with your long-term needs, circumstances and risk tolerance. If those circumstances have not changed and your portfolio has roughly the same percentage in stocks as your target asset allocation, that's a good thing.
- Has my portfolio drifted away from my target allocation? Given the large run-up in stocks since March 2009, it is entirely possible that you may have an over-allocation to stocks—even after the recent correction. If you're over-allocated to stocks it usually means you're taking on a higher level of risk than is warranted by your tolerance. It is perfectly fine under these circumstances to take some money off the table. As a general rule, we recommend investors take action when their allocations to specific asset classes deviate by more than 5 percentage points. With interest rates so low bonds may seem like an odd choice, but bonds may provide a buffer when the equity market gets volatile. The return of principal allows high quality bonds to be the safe haven for investors in times of turmoil.
- Is my stock allocation consistent with my life stage? Retirement is consistently cited as the top investing goal by Schwab clients. If you're employed, it makes sense to adjust the size of your stock holdings based on the number of years you are away from retirement. As a rough rule of thumb, we recommend about 50% stock exposure for those who are near retirement and a diminishing exposure for those in retirement.
- Is my stock allocation consistent with my capacity for taking on risk? If you're near or in retirement and suffered large losses recently, get acquainted with our retirement tools and calculators on schwab.com. Investing is about risk and return. Even if you have a strong stomach and aren't terribly bothered by the ups and downs of the market from a purely emotional standpoint, it doesn't necessarily mean that you're financially situated to take on that much risk. By that we mean, it's important to understand your portfolio in relation to the money you plan on taking out of it to fund your retirement. Don't place so much of your portfolio at risk that you're placing your retirement at risk.
- Is my stock allocation consistent with emotional willingness to take on risk? The ability we have to endure the ups and downs of the market is our risk tolerance. If you can’t sleep at night because of market swings, you're probably taking on too much risk. However, think twice before making wholesale adjustments to the level of risk in your portfolio. We're all human, and as such we tend to assess our ability to handle risk as high when prices are rising and low when prices are falling. This is one reason so many investors underperform performance benchmarks. When prices are high and rising, there's a tendency to load up on riskier assets; when times are tough, we shun them. Buying high and selling low rarely works over the long term.
Think hard before going to cash or cash investments
Investors commonly seek cash or cash investments when they desire a shelter from the market storms. This is perfectly reasonable; all our asset allocations should include a cash component—even the more aggressive ones. Cash investments help provide some degree of protection in periods exactly like the one we're currently experiencing.
However, it is imperative that investors realize the costs associated with outsized allocations to cash investments. Money fund yields are near zero and, after taking into account inflation, the "real" yield right now is actually negative. In small doses, this is a reasonable price to pay for the capital preservation cash investments can provide. However, for large allocations over long periods of time, the price can be higher than many realize, especially for those who rely on their portfolio to generate income.
Our advice with respect to cash investments is simple. If you're working, keep enough cash to constitute an emergency fund. If you're retired, keep enough cash to cover known expenses over the next year. Depending on your comfort with portfolio volatility, please make use of our model asset allocations to determine a starting point for the size of your cash holdings.
An ongoing process
It's not always easy to keep the emotion out of investing. But if you can resist over-extrapolating, reacquaint yourself with the quality and type of your holdings, make sure your allocation suits your risk tolerance and life stage, and think hard before you allocate a significant amount of your portfolio to cash or cash investments, you may at least be able to weather difficult markets with a little less heartburn.
1. Source: Birinyi Associates.
2. Survey compiled by Zacks Investment Research.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative (or "informational") purposes only and not intended to be reflective of results you can expect to achieve.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.
Schwab Equity Ratings and the general buy/hold/sell guidance are not personal recommendations for any particular investor or client and do not take into account the financial, investment or other objectives or needs of, and may not be suitable for, any particular investor or client. Investors and clients should consider Schwab Equity Ratings as only a single factor in making their investment decision while taking into account the current market environment.
Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by marketing capitalization) U.S. headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Each of the approximately 3,000 stocks rated in the Schwab Equity Ratings universe is given a score that is derived from several research factors. The assignment of a final Schwab Equity Rating depends on how well a given stock scores on each of the factors and then how that stock stacks up against all other rated stocks.