2017 was an amazing year for the stock market with the S&P 500 gaining over 19%. Even more amazing was the lack of volatility in the market – the swings in prices that make your stomach lurch like the Mystic Timbers roller coaster at King’s Island. For the first time EVER, the S&P 500 did not decline more than 3% in one day for an entire year! So, with that experience, it is easy to perceive the market as less risky.
Here is my prediction: the stock market will go down….someday. It may be today, it may be next week or it may be 2 years from now, who knows? Trust me on this – no one knows. And if you learn just one thing today, let that be it. In fact, if someone tells you they know for sure run, don’t walk, the other way.
So, if we don’t know what the market will do, how do we know what to invest in? Answer: We diversify our investments so all our money isn’t tied up in the same kind of investment. We want some of our investments to zig when others zag. In investors’ parlance, we want as little correlation among our various investments as possible. Why: Because over the long haul, less volatility in our portfolios should mean better returns that will help us reach our goals sooner.
To best illustrate, let’s take another peek into the financial lives of Monica and Chandler:
Monica and Chandler are now both in their early 40’s working at steady corporate jobs. Most important, the financial plan they prepared with their financial planner sets a goal to reach “financial freedom” by age 55. At that point, they both intend to still work, but earn less income in their dream jobs: Chandler as a yoga instructor and Monica as a fishing guide.
Now, Monica listens to a financial talk show on the radio and is absolutely convinced the stock market is going down this year because it went up so much last year. Chandler, on the other hand, loves the feeling of his account going up each month and wants more, more! In fact, he wants to invest even more aggressively and thinks Bitcoin might actually get him into the yoga studio by age 50.
If they follow Monica and move their money into “safer” or less volatile types of investments, like bond funds, they risk missing out on major gains if the stock market behaves this year like last. If they follow Chandler’s instincts and decide to invest more aggressively – maybe putting almost all their investments into stock funds, for instance, they risk a large drop in the value of their portfolio if the market tanks this year. Fact: Since 1871 the market has spent 40% of all years either rising or falling more than 20%. But, remember, we never know which direction, up or down.
Here is my advice to Monica and Chandler: Ignore the noise and even your gut feelings and stay the course. Maintain a portfolio that has a mix of different types of investments. Their particular mix should be constructed to support their goal to reach financial freedom in less than 20 years.
Let’s look at a little math to support the case: To use a round number, let’s assume Monica and Chandler’s investment assets, their portfolio, totals $1 Million. If all of it is completely invested in the stock market and the market falls by 10%, the new value of their portfolio is $900,000. To recapture that loss and have $1 Million again, the market must gain 11%.
Now, if their portfolio is diversified and only 60% of their investments are in the stock market and the market declines by 10%, that portion will decrease from $600,000 to $540,000. If the other assets stay level (an unlikely scenario but it helps explain our example), their portfolio only declines to $940,000, rather than $900,000. That’s a decrease of only 6% when the market declined by 10%.
Most important, now the market only has to increase 6.4% in order to get back to their original value of $1M, instead of 11%. Monica will be that much closer to the fish now.
Diversification is important but diversifying in a way that is right for your particular situation is even better. For help designing a portfolio for your specific needs, contact us at Steve@Moneywatchadvisors.com.