Market corrections are never fun. After a long period of uninterrupted stock market gains, Mr. Market finally decided last October to turn down with a vengeance.
From the peak in early October to late December Mr. Market (aka “the stock market”) was down about 20%. Since then the market has had a bit of a recovery and as of the second week in February it is down about 7.5% from the peak.
When you look at your Q4 brokerage statements all you feel is regret and shame. How could this have happened?
All your investments are in highly touted exchange traded funds (ETF’s) that track the stock market. Your buddy at Goldman told you so and you even read up on a couple of Morningstar reports.
You were counting on Mr. Market. Yet another scam but this time you are the sucker, not those poor sub-prime holders that took it on the chin during the 2008 Financial Crisis.
You weren’t trying to get rich overnight (maybe just a little) but who likes to throw 20% of your money away like that? Answer: Only a sucker!
Losing feels terrible. It’s not just about the money, but also that you were easy prey.
The only consolation is that you had lots of company.
Joining the winning team felt so good, but now you are no longer so sure
Everywhere you looked people were buying these ETF’s. You felt part of the tribe. And hopeful that finally, you had figured out this investment business.
Now you feel betrayed and frustrated. You thought that these ETF’s were safe.
Who cares that ETF’s have been the investment of choice since the end of the Financial Crisis. From 2008 to 2018 assets in ETF expanded more than 600%.
Wonderful, but how does that help you now?
You were barely familiar with this tribe except for some gibberish on CNBC and select subway ads you saw in passing, but you drank the cool aid anyway.
What are these ETF’s anyway?
Most ETF’s use a strategy called index investing. The strategy is super simple — replicating a portfolio or index of stocks or bonds designed by a third party such as the Standard & Poor’s company.
The best-known index in the US is the S&P 500. Two of the largest ETF’s replicating the S&P 500 index are SPY (offered by State Street) and IVV (offered by iShares).
Not only have ETF’s performed better than most mutual funds but they are substantially cheaper. Better performing and cheaper means more money in your pocket.
While the virtues of investing in this fashion have been known to large institutional investors for decades, the investment public at large was a little slower to catch on.
It took a while to be discovered
It took the cult of personality in the form of Jack Bogle, the founder of the Vanguard Group, to make real people realize what they were missing out on.
Index investing for the masses took hold. Index investing in ETF’s became a religion. They called themselves the “Bogleheads”.
The emergence of ETF’s allowed everyday people to participate directly in index investing. Bloomberg estimates that the US ETF market is $3.7 trillion in size and accounts for 40% of daily US trading.
ETF’s have democratized investing. What only very large pension funds could previously do is now at everybody’s fingertips.
Everybody can be a big boy now. Microcaps, emerging markets, dividend payers, low volatility stocks — all strategies previously unavailable or too costly now available to everybody at a click of a button.
You were eager to join the adults at the big table. You finally scrunched up some savings and took the plunge.
You bought several of the ETF’s recommended by your Goldman buddy. Now all you have to do is sit back and collect some coin, or so you thought.
If ETF’s are so wonderful why do I feel so down?
Recent market events have left you wondering if maybe you were a bit hasty in choosing your investment tribe.
All you have seen since you bought your ETF’s is red in your accounts.
You do realize that the market has taken a tumble but weren’t your ETF’s rock solid and sure winners?
You feel like you are missing something.
Is there a secret that the investment gods are not sharing with you?
You ask your Goldman buddy what happened and you are met with a look of disbelief.
“Of course you can lose money if you are not invested the right way,” he says.
You are puzzled. “But I jotted down all the right ETF tickers on this cocktail napkin.”
Now your buddy looks at you with pity. “Dude, didn’t you first figure out your asset allocation?”
“How much you own in stocks, bonds, and other stuff” he says.
“You can’t just let it rip on one thing — you need to be diversified”.
Always be thinking “AA”.
Nobody told you about this asset allocation or “AA” thing at least not in the context of investments!
“When the student is ready, the teacher will appear”
– Old Tibetan Saying
Your lack of knowledge has cost you dearly. You barely knew what an ETF is and you still plunged into the deep end.
You were hosed on Day 1 and you didn’t even know it. The investment gods kept their asset allocation secret to themselves.
What the Investment Gods didn’t tell you
As Warren Buffet has said before, “Investing is simple, but not easy”.
There are some simple truths to investing that even experienced portfolio managers need to be reminded off from time to time.
There is a link between return and risk:
The higher the return you seek the higher the expected risk of the investment. In terms of major asset classes, stocks tend to do better than bonds but with significantly higher risk.
Risk cuts both ways. During the good times you will make lots of money on your equity investments, but when Mr. Market takes a beating you’ll see lots of red in your accounts.
Key Lesson: The riskier the investment the more you can lose, know how much you are comfortable losing
Markets go up and down, sometimes violently:
That is what the pros call volatility. During normal times, prices move within a tight range. But when markets get nervous, volatility tends to spike up at the speed of light and even the savviest investor feels a pit in their stomach.
When markets go up being an investor is fun. Everybody is a genius on the way up. When markets go down many novice investors throw in the towel while the pros assess the situation for ways to cut risk and/or ways to profit from the panic of others.
Key Lesson: Volatility is part of investing, the worst time to sell is when you and others are panicking
Investment risk can never be eliminated but it can be transferred:
All asset classes — stocks, bonds, real estate, CD’s — carry risk. The risk emanates from the health of global economies and the preferences of investors as a group for postponing current consumption.
You as an individual can’t eliminate these top-down risks. You’re too small to do anything about it! Markets are composed of collections of individual investors all too small to eliminate risk on their own.
As a group, you are stuck with the risk. The only thing you can do is transfer the risks from one investor to another, but the size of the pie remains unchanged.
Key Lesson: There is always investment risk, but you can change how much risk you want to take
Most people focus on easy, not right (Hint: they are solving the wrong problem)
By focusing on what ETF’s to own you are disrespecting the investment gods. You are starting at the finish line and skipping all the hard work.
The truth is that you got it backward. You took the easy way out by casually asking your buddies for help. You skipped your homework and now you want to be an Academic All-star?
Here’s the thing.
- The ETF’s you own matter a lot less than you think.
- What matters is how much risk you are taking in your portfolio.
If you own all stock ETF’s, you are overwhelmingly taking equity risk. You and Mr. Market are fraternal twins.
When Mr. Market catches a cold, so do you. Nothing will save you from Mr. Market’s mood swings.
If you want to be like Mr. Market you are all set with your stock ETF’s. End of story. Learn to live with the rollercoaster.
But if you don’t like the moodiness of Mr. Market and see yourself as a more down to earth person you might want to dial it down a bit.
“Dial what down?” Your portfolio risk, of course. Or, in English how much you are willing to lose if Mr. Market catches a cold.
And for that to happen you need to include investments other than stocks into your portfolio. For example, lower risk bonds, CD’s, or real estate.
Got it little grasshopper?
Less risky investments like bonds mean you are less likely to lose money when Mr. Market sneezes.
This is the miracle of diversification sometimes called “the only free lunch in investing” by Nobel Prize winner Harry Markowitz.
Think Big First, Then Small
Figuring out the asset allocation mix that suits you is the first step to take. It is also by far the most important one.
Always be thinking “AA”.
Large institutional investors have known this for a long time. At least since the 1990’s when a variety of academic studies showed that asset allocation accounts for over 80% of portfolio returns.
Isn’t it better to start with the 80% that counts?
Picking ETF’s may be more fun, but are you into fun or into making some dough?
Work on your big problem first by figuring out your asset allocation. Only then figure out what ETF’s you might want to use. Make sure you do it in this sequence.
The whole process of deciding what proportion of your portfolio should be in stocks, bonds, CD’s and other investments is called asset allocation or,(“AA for short).
It starts with figuring how much risk you are willing to tolerate.
How much risk you will tolerate in your portfolio should be your starting point, not getting a list of ETF’s from your buddy at Goldman.
You really should consider AA if you want to stay sane
Just know that whatever you do, picking the right stock ETF’s won’t help in the event of a correction. You will still be at the mercy of Mr. Market like everybody else!
What will help you smooth out Mr. Market’s mood swings will be holding a diversified portfolio of stocks along with less risky investments such as bonds, CD’s and real estate.
This may all sound a bit technical and complicated but you don’t t have to do this alone. Here are some options for you:
- Buy a pre-packaged asset allocation strategy. If you want to take only a little bit of risk consider AOK. For a little more risk AOM might be right for you. And if you are ok being aggressive consider using AOA.
- Invest your money with a robo-advisor such as Betterment or Wealthfront. Based on a short questionnaire these firms will suggest and manage a suitable asset allocation strategy for you.
- Hire a registered investment advisor to fully customize a portfolio for you based on a comprehensive assessment of your needs and risk profile.
- Do it yourself by first figuring out your desired asset allocation and then picking appropriate ETF’s or other investments to get exposure to the various asset classes in your portfolio.
It is time to get serious about your money.
Even small differences in return can compound to very large amounts over the long term.
Hot dogs versus steak — which would you rather have for dinner?
Having a solid asset allocation strategy in place is a great first step toward fulfilling your financial goals while allowing the moodiness of Mr. Market not to keep you wide awake at night.
Always be thinking “AA”!
If you would like to subscribe to my blog sign up here. Thanks for reading and Pura Vida!