There has been no shortage of words to describe the market environment as of late: “worst one day percentage decline, largest single day move, recessionary indicator, trade war, interest rate fears” - and the list goes on and on.
Going forward from here, we believe only one word matters - CHOICE
Investing has always been about choices. Let’s take a look at a few of the decision points when it comes to investing and the current choices we are suggesting.
1) Stay invested?
After a quarter like the one we’ve just been thru, it is very tempting to exit the markets and hold cash. It gives us back a feeling of control and prevents further loss. It’s certainly a choice you can make. But you must consider the longer-term ramifications of that decision
First, look at the expected return of cash. Currently, money market funds yield about 2%, which is also an estimate of current inflation. So on a net basis (return less inflation), cash is a zero-returning asset. That’s better than negative right? Sure - but keep in mind there is little chance it’ll ever be much greater than zero (ie: not much potential for future upside)
Second, you must look at the expected return necessary to help you meet your long term goals, whether that is retirement, career change, travel, etc. A financial planning exercise can help you determine this return number. Of course, there are a lot of variables, but it’ll at least give you some context
Third, match the two up. Does a cash portfolio (at net 0%) equal or exceed the return you need to meet your goals?
What’s our choice as it relates to staying invested? Absolutely! The opportunity costs of not being invested are far too great to bear
2) Where to invest now?
If you also decided to stay invested in #1 (good job!), now the question becomes where to invest?
In order to make this choice, you first need to know where it is you are trying to get to. Yes, I’m talking about your financial plan again. Without that plan and an idea of what return you need to achieve, you’re flying blind. But once you know that target return number, you’ll likely be looking at a combination of the three main buckets for investment - cash, fixed income and equities
Why own it? Serves an important role of a source of immediate liquidity and source of funds that can be added to other asset classes on a pullback
(2) Fixed Income
What is this again? a debt security where you are the lender and the borrower could be a variety of entities including, a municipality, or the US government) exchange for your capital, the entity promises to pay you a stated interest rate and ultimately your money back at maturity
What’s the outlook? While interest rates have risen, they remain low by historical standards. For example, as of this writing, the US 10-year treasury pays ~2.7%. There is also a significant supply of debt available (for a variety of reasons including actions taken by the Federal Reserve in the financial crisis and companies issuing debt at low rates) that may very likely keep rates lower for longer. Also keep in mind that rates are likely to rise from here and there is an inverse relationship between the price of a bond and interest rates. As with all investments, proceed with caution and obtain specific advice for you & your goals
Why own it? Likely to provide a lower long term return but also helps to offset volatility in a portfolio. While bonds may be known as the “safe” asset class, there are still many complexities to these instruments that should be carefully understood - especially in a rising rate world
What is this again? An equity (or stock) is a share of ownership in a business. With an equity investment, you participate in the earnings and cash flow of the business
What’s the outlook? The return you can expect from any equity is based upon how the business does over time - and also on the price you pay for your ownership
Let’s start with how the business will perform. Of course, this will vary greatly by business but lately, some macro concerns have been weighing on virtually all stocks (think recession fears and trade). While we recognize these risks, we remain of the mindset that they have been more than reflected in current prices and that certain businesses and sectors can and will continue to grow and generate meaningful revenues and cash flows in the future. We also don’t see an imminent recession and are expecting a resolution on trade. These risks are not to be ignored but we don’t see them as a reason to avoid equities. You should have at least a 3-5 year time frame with equities and always keep in mind the longer-term averages (see below)
Now, how about the price you pay? After the recent sell-off, the price you’ll pay for an equity is lower than historical averages. Current valuation of the US stock market is about 14x earnings and many stocks trade well below that level. (Note: an earnings multiple can be “flipped over” (ie: divided into 1) to obtain an implied return (in this case, 7% (or 1/14)). Why not buy some equities on sale?
Why own it? While there is more volatility and possible downside risk in equities, they also provide unlimited upside. For past 20 years, compound annual growth rate of S&P 500 is 6% and that return rises to 10.7% over the past 90 years for which returns have been tracked. Depending on your aggregate return goals, the potential upside available in equity ownership may very well be necessary
What would we choose between the three? All of the above! How much of each and what kind? That of course varies for everyone and we suggest you carefully develop a portfolio that meets your specific needs
3) Stay Home or Travel?
When looking at your equity allocation, you also need to choose if you’ll buy US companies or if you’ll travel to international markets. International markets lagged the US for much of 2018 due to a variety of factors included a strong US dollar, trade fears, and rising US interest rates. However, remember what matters with equities - how the business will perform and the price you pay. On both counts, certain international markets are great candidates, as the businesses are benefiting from growing populations, a shift to consumerism and a growing middle class, and strong economic expansions and the current valuations are far below those of US companies, providing an attractive entry point. In addition, you may also consider US companies that have a material amount of international revenue to access these international markets.
Our choice? We’re traveling and including international allocations in balanced portfolios (in accordance with the aggregate plan of course!)
Investing is a series of choices and with each one, we have to do the best we can with the information we have. Take your time, consider the facts, control your emotions, think long-term, and choose wisely. This part of your life is far too important for you to do anything less.