Transcript of the podcast:
MARK RIEPE: The extreme market volatility and economic decline we’ve seen with the coronavirus pandemic have drawn comparisons to the 2008 financial crisis and even the Great Depression.
Whenever there’s a rapid drop in the stock market, whatever the cause, some investors ask, “Why shouldn’t I just get out of the market now and get back in later?”
It’s a reasonable question that’s applicable to investors in a variety of circumstances.
Maybe you’re just getting started investing, and this is the first time you’ve experienced a bear market.
Perhaps you’re a mid-career small-business owner wondering when your life—and business—will return to normal, and you don’t want the additional stress of watching your portfolio fluctuate wildly.
Maybe you’re nearing retirement and worrying about whether your nest egg will be able to produce the paychecks you were expecting.
Everyone’s situation is different, but if you’ve listened to previous episodes of this podcast, you’ve heard us talk about the importance of having a plan and sticking to it unless your personal situation changes dramatically.
In this special bonus episode, we’re going to talk about some tools and strategies you can use to stay the course with your plan.
I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. It’s a show about financial decision-making and the cognitive and emotional biases that can cloud our judgment.
I’m joined now by David Koenig. David is a vice president here at Schwab and chief investment strategist for Schwab Intelligent Portfolios. He also provides research and analysis about automated investment advisory services and how they can help investors reach their financial goals. David, thanks for being on the show.
DAVID KOENIG: Well, it’s my pleasure, Mark. Thank you for having me.
MARK: David, the decision that we’re tackling on this episode, it’s all about whether an investor who has put a meaningful percentage of their money into stocks should run for the hills when confronting the big negative returns we’ve seen recently and then reinvest or come back into the market when the market hits the bottom. The idea, basically, is to avoid much of the downside and participate in all of the upside. So it sounds like a great strategy. What’s your take on that?
DAVID: Sure. Well, the error in that thinking is that it assumes that an investor can actually know ahead of time when the markets have reached a peak and then again when they’ve reached a bottom. But, of course, that only becomes evident in hindsight. So if we all had perfect foresight, we could exit at market peaks and then reenter at market bottoms, but nobody does have that perfect foresight. It’s really impossible to perfectly time entry and exit points, and all too often what happens is that investors actually get the timing wrong. And so they end up selling after markets have fallen, ending up locking in short-term losses, and then investors are slow to get back in and end up missing the rebound, or a good portion of it. And ultimately, that ends up with a scenario of buying high and selling low, when what we really want to do as investors is the opposite.
So plenty of research documents how this behavior tends to hurt investors’ long-term returns, compared with investing in a diversified portfolio consistent with your goals and your risk tolerance and then sticking with that portfolio as the markets fluctuate over time. And furthermore, the research also shows that some of the strongest gains actually come in the early stages of market recoveries, and by selling after declines, investors risk missing those early stages of the rebound. And just missing a handful of those strongest days can actually have a big effect on long-term returns.
MARK: David, it’s easy for us to sit back and tell investors to be calm, wait it out, but in the day-to-day real world of investing, frankly, that seems like too simple of an answer. The stock market has had these epic gyrations. Policymakers are grappling with economic scenarios that rarely occur. What can investors do to increase their chances of staying in good shape?
DAVID: Well, the first thing I’d point out is that your portfolio should be diversified, and that means across different types of investments, such as stocks, bonds, commodities, and cash. And the combination of those investments in your portfolio, well, that should be consistent with your goals and your risk profile, whether you’re more conservative, have short-term spending needs, or whether you’re saving for a long-term goal like retirement and you’re actually willing and able to withstand these periodic bouts of turbulence. If you’ve invested in a more conservative or moderate-risk portfolio that includes a mix of stocks and bonds, well, it’s likely declined far less than some of the big drops in the major stock indexes that we see in the headlines. So getting that diversification right for you is really the first step.
Now, if you’re in retirement or have other short-term spending needs, you should target an allocation that’s generally more conservative, combining low-risk investments for the shorter-term with some investments with higher return potential for the longer-term, and you may choose to shift to a more conservative allocation as you move through retirement. Ideally, the lower volatility potential in these portfolios can help to reduce the risk of not having money from investments when you need it.
You might also take more of a bucketed approach based on immediate spending needs—perhaps needs a few years off and then also longer-term needs. It’s also critical to remember that while it’s hard for us not to look in the rear-view mirror, markets, well, they’re actually forward-looking, so we want to make sure that your portfolio is positioned with the right amount of risk and potential return going forward based on your current spending needs and future goals.
MARK: And by “bucketing,” you mean sort of divide your future spending needs into, let’s say, a short-term bucket and a long-term bucket and then set up a portfolio designed to fulfill the short-term needs and then a different portfolio designed for the longer term—and then kind of move the money back and forth as needed. Is that what you’re getting at?
DAVID: That’s right. Those different portfolios might have different allocations based on those different time horizons and different needs. One might be more conservative or more aggressive than the other, depending upon the goal and the length of time that it is intended to be invested.
MARK: I think what a lot of it gets down to is, first of all, you got to stay diversified. That’s good advice for everybody. But then you’ve really got to make sure the risk level of your portfolio is going to match up with when you need to be spending the money, right?
DAVID: That’s right. For goals that are shorter-term in nature, there’s less time to make up ground in the event of market volatility and declines. So that type of portfolio, to be able to meet those short-term goals, would typically be more conservative, less fluctuation in terms of responding to market volatility for greater certainty that that money would be available for those short-term needs. Whereas some of the longer-term goals where there’s more time to make up potential losses, and you just have more time to be able to adjust to ups and downs of the markets over time, that money can be in a more aggressive portfolio and perhaps see more fluctuation in the short term but have a higher long-term return potential.
MARK: So that’s good advice, but both of those pieces of advice really are about, you know, creating a good plan and strategy for dealing with the current market environment. Are there any specific actions that investors should take, for example, rebalancing the portfolio? Is that a good idea in a turbulent market like we’re in right now?
DAVID: Sure. So the short answer to that is, yes, that is a good idea. And just to expand on it briefly, if you’ve invested in a diversified portfolio consistent with your needs, well, staying focused on that plan, that’s generally the recommended approach to get through these periods of volatility. But one important action that you just mentioned is that you can rebalance your portfolio, and that’s intended to make sure that it stays consistent with its targeted allocation or its combination of investments, which, ultimately, is intended to keep its level of risk consistent over time as the markets fluctuate.
MARK: So I want to get back to that point, but maybe before diving in on that, could you explain for the, you know, newer listeners, what do we mean by rebalancing? What’s involved with rebalancing a portfolio?
DAVID: Sure. So as markets fluctuate over time, well, typically some investments in your portfolio might go up or down more than others, and that can, of course, cause your portfolio to shift over time, and it can become either more aggressive or more conservative than you originally had intended. So letting your portfolio become more aggressive, that can, ultimately, mean larger potential declines, of course, when the markets become volatile, while becoming more conservative, that can potentially leave you with less return potential than you really need to be able to have a high likelihood of achieving your investment goals. So rather than letting your portfolio’s risk level drift with the markets, well, rebalancing helps to make sure that its allocation, again, stays consistent with your intended risk profile over time, even as the markets are moving up and down.
It’s important to keep in mind, though, that rebalancing, it’s not trading completely in or out of various investments. It’s really designed to trim periodically from some investments that might have grown to be too much of the portfolio and then add potentially to those that have become too little. And that actually results in a systematic process of buying low, selling high, and that’s designed to benefit your portfolio over the long run.
MARK: So David, we’ve had some, you know, big market moves both up and down in 2019 and 2020 so far. So maybe could you walk through a couple of scenarios based on the most recent couple of years that really illustrate the theory behind rebalancing?
DAVID: Sure. So for example, in 2019, when stocks were going up strongly, the percentage of stocks in your diversified portfolio, well, it might have grown, while the percentage of bonds or cash might have shrunk, simply because they just weren’t going up as much as stocks when stocks were strong over that period. And that means that your portfolio might have become more aggressive than intended, which, of course, again, would have resulted in a larger decline during this most recent downturn than if you had rebalanced the portfolio during the year to keep its intended allocation consistent.
Conversely, when stocks tumbled recently, well, cash held stable, and investments such as Treasury bonds actually went up, while the percentage of stocks in your portfolio might have become less than intended. So now your portfolio might not actually match your longer-term risk profile, and it just wouldn’t be positioned to benefit as much during the recovery.
So rebalancing periodically can help to keep your portfolio’s allocation consistent over time with your longer-term goals. And when markets are as volatile as they have been recently, you might actually think about rebalancing a bit more frequently than in a normal market environment.
MARK: Yeah, we talk a lot about creating investment plans on this show, but it’s not going to do any good if you don’t make sure that as markets move, that your portfolio is matching up with your plan.
Why don’t we go to another technique that can help after a market drop?
DAVID: Sure. So another action that you can take in a taxable account is tax-loss harvesting. And that’s a process that can potentially take advantage of market volatility to your benefit by helping to reduce current tax liabilities, ultimately leaving you with more money to invest and potentially grow over time.
MARK: So let’s do what we did before. Define what you mean by tax-loss harvesting, and then maybe go through an example explaining how it works.
DAVID: Well, tax-loss harvesting is a process of selling an investment that’s fallen below the price that you paid for it to capture that loss. And that’s actually valuable because those captured losses accrue over the course of a year, and they can be applied when you file your taxes to help offset realized capital gains from investments that you sold during the year, and also actually up to $3,000 in ordinary income if your captured losses exceed capital gains for the year. So again, it’s a valuable process that can help potentially reduce current tax liabilities. But the sale of that investment is just the first part of the process, because once you’ve made the sale for tax purposes, well, now you no longer hold that investment. And if it was an investment, let’s say, just for example, in maybe a large company stock fund and that was part of your overall diversified portfolio, well, now you’re no longer holding large company stocks, which really isn’t what was intended either, and you wouldn’t be positioned to benefit from the gains when the markets do recover.
So the second step of the tax-loss harvesting process is to replace the investment that you sold with a similar, but not substantially identical, investment to the one sold. So with individual stocks, this is oftentimes accomplished by selling a stock in a particular industry and then buying a highly correlated but different stock in the same industry. And with mutual funds or exchange-traded funds, it’s often done by purchasing a fund that tracks, well, the same asset class or market segment but that tracks a different underlying market index than the fund that was sold. And you can’t, just for example, sell a particular investment to capture the loss and then just repurchase it back for your portfolio. That would violate what’s called the IRS Wash Sale Rule, and that rule dictates that you can’t purchase the same or a substantially identical security 30 days before or after the sale. And if you violate the Wash Sale Rule, then the loss is disallowed for tax purposes.
So tax-loss harvesting is a valuable but somewhat complex portfolio management process. But thankfully, there are actually managed solutions, such as Schwab Intelligent Portfolios, that are designed to do both of these processes we’ve been talking about, both rebalancing and tax-loss harvesting, and do them automatically for enrolled clients.
MARK: David, let’s talk a little bit about people with different time horizons and are at different stages of their life. Let’s start with people who are in retirement, who are depending … they’re depending on their portfolio for cash flow. What should they keep in mind before taking action right now?
DAVID: Well, if you’re in retirement with cash flow needs, it’s really important to keep in mind why you’ve invested in a more conservative portfolio to begin with and really try to avoid letting the stock market declines and the news just drive your investment decisions. So this helps to highlight the importance of having a financial plan that really explicitly identifies spending needs, other income sources, and then how much income your portfolio needs to provide. This is also where having a year’s worth of expenses in cash, plus an extra short-term reserve for unforeseen expenses, can really help. If you have the resources to wait out the market turbulence and not sell more volatile investments, you will ultimately be better off. And when it comes to financial planning, it’s also helpful to perhaps bucket spending into needs, such as we talked about earlier, such as living expenses and healthcare expenses, versus things that you might consider wants or even wishes. And those might include something like maybe a college fund for a grandchild or maybe travel when that again becomes possible. It may be important to you, but if you’re able to postpone some of those discretionary expenses to focus on today’s most important needs, well, that might buy you time to be able to focus on some of those wants and wishes in the future.
MARK: Yeah, I think trimming expenses a little bit in a down market is a surprisingly powerful tool for extending portfolio longevity.
But let’s talk now about people who are, say, three to five years from retiring. What are some actions that they should be thinking about?
DAVID: Sure. So investors in that group, well, they really kind of face the challenge of trying to balance upcoming spending needs in the short-to-intermediate term but also along with potentially a longer-term need for continued portfolio growth, because for somebody just entering retirement, that can often mean maybe a 20- or even a 30-year time horizon. So these investors should generally be in a more moderate-risk, diversified portfolio. So they’ve likely seen smaller declines than the major stock indexes. However, the bucketed approach that I described earlier could make sense for these investors, as well. And that might mean maybe a moderately conservative portfolio based on their upcoming spending, along with, perhaps, a moderate growth portfolio for some of those longer-term needs. And if they’re able to increase contributions to retirement accounts, well, folks aged 50 or older should really try to take advantage of their ability to make catch-up contributions to their 401(k), potentially, or their IRAs. If you believe you’re in a lower tax bracket now than you will be in retirement, something like a Roth conversion could be a good strategy, as well. And this would allow those assets to grow tax-free, and as long as you meet certain requirements, distributions are also tax-free. What makes sense for you really depends on your specific situation, so as always, we would recommend speaking with your financial consultant first. That’s really important to help guide your decision-making.
MARK: Yeah. I think that Roth conversion idea is interesting, and our most recent episode talks about traditional IRAs and Roth IRAs for people who want to learn more about that.
For those investors who are younger, they’re not really planning on withdrawing anything from their portfolio for decades, maybe they’re saving for retirement, what advice do you have for them?
DAVID: Well, for those longer-term investors, the best course of action really is generally to stay the course. The portfolio should still be diversified, but it probably does emphasize … likely emphasizes stocks because you’re investing for the long term, so it might be down quite a bit this year. And it’s especially important not to panic and abandon your long-term plan even if it has seen a significant decline, because one of the most detrimental actions you can take for your long-term investment success is to sell your investments in the short term after a market decline. We really have to try to remember why you invested in the portfolio in the first place, which, of course, was for retirement or another long-term goal. Financial markets, they’re volatile, they will have ups and downs periodically, but if you don’t need to withdraw for years or maybe even decades, again, you have plenty of time for your portfolio to recover and to continue to grow. Because in order to achieve the long-term gains of various investments, well, you have to stay invested over the long run, and as we discussed earlier, trying to successfully time markets, well, it’s really impossible, while staying focused on your long-term goals is among the keys to long-term investment success.
MARK: Yeah, I think it’s important sometimes to remember that these different risks that we face when investing, there’s a trade-off in those. If you’re young and you get really conservative, then you’re reducing one type of risk, namely, your portfolio is going to be much less volatile, but at the same time you’re increasing the risk that you won’t earn enough on your retirement investments to meet your retirement goals. So people need to keep that in mind, I think.
But no matter what the person’s age, it seems like, at least I’m reading a lot more about people who want to stop contributing to their 401(k) or their other investment accounts. What do you think of that strategy?
DAVID: Yeah, I hear that sometimes, as well, Mark, but unless you have an immediate spending need that prevents it, continuing to contribute to your 401(k) and other investment accounts, well, that’s generally one of the best courses of action that you can take, and that’s regardless of market volatility. And the recent stock market declines actually mean that each dollar invested now, well, it’s likely able to buy more shares of various investments than it could just a few weeks or months ago.
It’s also important to remember that successful investing, it’s rarely an all-or-nothing proposition. Instead, the disciplined process of making periodic, regular contributions—we often refer to this as dollar-cost averaging—that can help you to avoid trying and likely failing to time the markets effectively. And that can help you avoid the regret that can come with potentially investing all at once, because it means that money invested today, well, it will have a chance to grow, but if the markets were to move lower again, well, you have the chance to continue investing at potentially lower prices.
Also, remember that each market and economic downturn is unique, so nobody really knows for certain the path that this period will take. But we do know from history that bear markets tend to be shorter than bull markets, and despite some major pullbacks along the way, well, financial markets recover and they go up over time.
MARK: Yeah, I think you’re right, and I think the one caveat I would add is for people whose financial situation really has dramatically changed for the worse, then that’s a situation where they might want to reconsider their contribution to retirement accounts. But again, that’s also a good idea to revisit your overall plan and make sure your portfolio is matching up with your … for your investment plan.
I want to switch gears here a little bit. Any time you buy an investment product, there’s always a risk that it will lose value. What advice do you have for people who are discovering their risk tolerance might not be what they planned for? In other words, they thought an aggressive portfolio made sense for them, but now, now that they’ve had a chance to live through the ups and downs associated with an aggressive portfolio, they’re having second thoughts. What do you say to them?
DAVID: Sure. So this is … this is really an important question, and it, ultimately, gets into some of the behavioral aspects that go along with investing, because when markets are rising, what tends to happen is that investors tend to chase after investments that have done well recently. And often, they tend to shift their portfolios to become more and more aggressive as they try to keep up with some of the major stock index returns or, potentially, hear about investment success stories from their friends and neighbors. But that, of course, often results in bigger portfolio declines than they were prepared to weather when the markets inevitably become volatile, which then often leads them to sell at or near the bottom, as we discussed earlier. So now, these investors have gotten just completely off track from their plan. And oftentimes, they’re also afraid to get back into the markets and so end up missing the recovery.
Again, investment success really depends upon identifying your goal first, what you’re investing in and why, and then thinking about whether that’s a short- or long-term goal, and how much short-term market volatility you’re honestly willing and enable to withstand. Rather than focusing on returns first, which often leads investors to take far more risk than they really need to in order to have a strong likelihood of achieving their goals, it’s really important to understand risk, willingness and capacity first. That’s really key, because potential returns, well, they’re an outcome based on the risk that you take as an investor. And what’s important is investing in a portfolio that has both the right risk characteristics and return characteristics based on your needs. And that’s intended to set you up with the return potential you need to be able to achieve your goals, while also allowing you to sleep at night and avoid panicking when the markets inevitably become volatile. Determining that right mix of risk and return characteristics, well, that often can be challenging for investors. But again, that’s where a managed solution, such as Schwab Intelligent Portfolios, can really help.
MARK: This has been really helpful, David. Thanks for coming by today.
DAVID: Well, thanks, again, Mark. It’s a pleasure to be here.
MARK: Thanks for joining us on this special bonus episode. David gave us lots to think about but before we go, I want to leave you with three additional thoughts.
The first thought is to ask, “What do you know that the market doesn’t?”
We started out this episode with a decision: “Should I get out of the market now and get back in later?”
The stock and bond markets are places where millions of investors are, in effect, voting with real money on what the future will look like.
These investors, collectively, are well aware of all the economic damage that countries are experiencing now and are likely to occur in the future.
That’s why, as we’re recording this, prices have dropped so much from earlier in the year.
The investor who wants to get super bearish and go all to cash is implicitly forecasting that things will be worse than what the market believes.
Before you take that step, you should identify what you know that the market collectively doesn’t know or doesn’t fully appreciate.
Another way of thinking about it is, what are you seeing that the market doesn’t see as clearly as you do?
You also need a strategy to get back in. It’s one thing to sell, but you also need to know when to rejoin the game, so to speak.
What are those milestones that will tell you when it’s all clear?
Historically, very few investors are able to get the timing right—both on getting out and getting back in. And that timing matters because, as David said, market recoveries are often front-loaded.
The second thought is to beware of quick decisions made during emotionally fraught periods. Studies show that quick decisions made during periods of stress tend to be of poorer quality when compared to decisions made with more deliberation.1
Now is an especially stressful time. So don’t rush to make a quick decision. Think about the consequences of that decision. For example, a portfolio that’s heavy in cash will have less volatility, but over the long term it will have a lower expected rate of return. Does that make sense if you don’t need the money right now? If stocks quickly recover as medicine comes to grips with the virus and the global economy regains its footing, will you be wracked with regret for not participating in the recovery?
There’s no right answer for everyone, but my suggestion is to think through these types of issues before making any trades.
Finally, investing doesn’t have to be an all-or-nothing proposition. Phrases like “get in” and “get out” imply big movements in your portfolio. It doesn’t have to be that way.
A series of smaller, incremental changes over time is often more emotionally satisfying because it reduces the regret that will often accompany a big change that doesn’t work out.
As David mentioned, there are numerous tools and strategies out there to help you stay the course. One that brings several of them together is what we call a robo-advisor, or automated investing service.
That’s what Schwab Intelligent Portfolios is. The idea with these portfolios is that the emotional decision-making process is taken out of your hands. If you’d like to learn more about it check out intelligent.schwab.com.
We know these are volatile times for your portfolio. For Schwab’s perspective on the ever-changing state of the market, you can visit schwab.com/volatility.
We also have answers to some of your most commonly asked questions at schwab.com/FAQs.
Thanks for listening to this special bonus episode. We’ll be back with regular episodes when our new season starts in June.
If you’ve enjoyed this episode, consider leaving us a rating or review on Apple Podcasts or your favorite listening app.
For important disclosures, see the show notes and schwab.com/financialdecoder.
1 Jennifer S. Lerner, Ye Li, and Elke U. Weber, “The Financial Costs of Sadness,” Psychological Science, 2013.
Baba Shiv, George Loewenstein, Antoine Bechara, Hanna Damasio, and Antonio R. Damasio, “Investment Behavior and the Negative Side of Emotion,” Psychological Science, 2005.
Robyn S. Wilson and Joseph L. Arvai, “When Less is More: How Affect Influences Preferences When Comparing Low and High-Risk Options,” Journal of Risk Research, March 2006.
After you listen
- Many investors have questions for us during this turbulent time. See if your question has already been answered at schwab.com/FAQs.
- Many investors have questions for us during this turbulent time. See if your question has already been answered at schwab.com/FAQs.
- Many investors have questions for us during this turbulent time. See if your question has already been answered at schwab.com/FAQs.
When the market drops quickly, many investors scramble for the exits. Yet that decision is usually an emotional one rather than a rational one. In this special bonus episode, Mark Riepe discusses some tools that can help you stay the course with your plan. Mark talks with David Koenig, vice president and chief investment strategist for Schwab Intelligent Portfolios. They discuss how you can use rebalancing, tax loss harvesting, and other strategies to your advantage during a down market.
Subscribe to Financial Decoder for free on Apple Podcasts or wherever you listen.
Financial Decoder is an original podcast from Charles Schwab.
If you enjoy the show, please leave us a rating or review on Apple Podcasts.
More from Charles Schwab
Please read the Schwab Intelligent Portfolios Solutions™ disclosure brochures for important information, pricing, and disclosures related to the Schwab Intelligent Portfolios and Schwab Intelligent Portfolios Premium programs.
Schwab Intelligent Portfolios® and Schwab Intelligent Portfolios Premium™ are made available through Charles Schwab & Co. Inc. ("Schwab"), a dually registered investment advisor and broker dealer. Portfolio management services are provided by Charles Schwab Investment Advisory, Inc. ("CSIA"). Schwab and CSIA are subsidiaries of The Charles Schwab Corporation.
Schwab Intelligent Portfolios® and Schwab Intelligent Portfolios Premium™ are designed to monitor portfolios on a daily basis and will also automatically rebalance as needed to keep the portfolio consistent with the client's selected risk profile. Trading may not take place daily.
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.
Diversification, periodic investment plans (dollar-cost-averaging), and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.
This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.
Roth IRA conversions require a 5-year holding period before earnings can be withdrawn tax free and subsequent conversions will require their own 5-year holding period. In addition, earnings distributions prior to age 59 1/2 are subject to an early withdrawal penalty.
Investing involves risk including loss of principal.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.
Apple Podcasts and the Apple logo are trademarks of Apple Inc., registered in the U.S. and other countries.
Google Podcasts and the Google Podcasts logo are trademarks of Google LLC.
Spotify and the Spotify logo are registered trademarks of Spotify AB.0420-03US