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Long-term horizon, portfolio strategy, bonds, dividend investing
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Summary

  • When the stocks markets correct, it can take many years for your portfolio to return to its previous total value.
  • In addition to managing the initial price corrections, we should also manage the time period that it takes to move back into positive territory.
  • We'll look at the recovery times in recent market corrections evaluating all-equity and balanced portfolios.
  • It's important to pay attention to recovery periods in the accumulation and retirement or spending phases.

The markets are volatile, we all understand that; a few of us know that fact too well. And when the markets correct, your portfolio value can be on the decline for many years. That doesn't mean you've lost money, depending on your entry period, but you'll have to watch money that was in your pocket leave your pocket for an extended period. There are two ways to protect against losses. One, you can sell your profitable assets and move to safety or a much less volatile portfolio mix that typically includes stocks and bonds and cash. The other way is to ensure that you have the emotional ability to hang on and wait out the correction, with your portfolio eventually moving back to its previous peak and then beyond.

A major component in financial planning and risk management is time horizon. How long are your (majority of) funds likely to stay invested? In addition to matching our risk tolerance level to the potential price declines in our portfolio, we also need to match our portfolio volatility to our time horizon. And as we'll see - the more stock exposure, the longer the time horizon that is required.

The stock market correction of the Great Recession was the most severe since the Great Depression, using the broad market S&P 500 (NYSEARCA:SPY) as the measuring stick. The markets fell by almost 55% from their peak in October of 2007 to the bottom in March of 2009. The markets were in correction mode for a year and a half. But the emotional challenge was not over for investors once we hit the bottom. From there, it's a long climb back. The broad markets would not have recovered (returned to previous peak) until August of 2012. That's 4.5 years from the start of the drop.

The correction at the beginning of this century began in September of 2000 and kept moving down until October of 2002, lasting nearly 2 years. The markets would not recover their declines until April of 2006, a period of over 5 years.

In the market correction of 1987, the recovery would have been quite swift, with markets recovering their "losses" within 2 years.

Given the recent market history, it's prudent that investors who invest in an equity-only portfolio have a very long time horizon if they intend on spending or harvesting some of those funds. The two recent corrections suggest that a 6-year time horizon leads to the probability that you will be in positive territory over that duration. That said, being in positive territory is entirely different than gaining equity-like long-term gains. The 6-10 year suggestion might be some protection against losses, and not much else. A portfolio value from 2000 to present would have delivered average annual returns of 3.9%. Factor in inflation, and now we're in the area just above 1% annual real returns. It can take a long time for your portfolio assets to make money from a market top, as I demonstrated in this article: "There's No Money To be Made From Here, Maybe".

That article stressed the importance of a long-term approach, staying the course and investing throughout the market corrections. Your portfolio holdings of today may or may not have meaningful gains from today moving forward over the next 10 to 15 years, but there will be opportunities to buy the market and companies when they go on sale. As my previous article suggested, there's decent money and sometimes real money to be made along the way. The trick is, an investor needs to be investing on a regular schedule, or have considerable dry power to "be greedy while others are fearful".

I have to admit I use that powerful Warren credo several times a day when chatting with clients. Some of our investors are quite sophisticated, and many have little interest in investing and how their money will make money, and for those who have never heard that phrase before, it usually evokes a chuckle or an "ah, I got it". The challenge today is to change investors' emotional response to market corrections from one of fear to one of "embrace". We need to understand that market corrections are surely a normal part of investing, and corrections should be viewed as an opportunity, the biggest opportunity that is offered to investors. Most of Warren's magic is not stock picking, it's buying when others are fearful. That's when there is obvious value. Warren certainly went shopping for many assets in the corrections, but the broader markets certainly offered a home run as well. Any monies invested in March of 2009 would have delivered a 183% return to-date. And monies invested in March of 2010 would have delivered over 85% over 4 years, an annualized return of 15.8%. There's real money to be made along and near the bottoms. The easiest way to grab the bottom is to simply invest on a regular schedule.

Obviously, many do not have the patience to remain under water for 3, 4 or 5 years. We can typically reduce the time frame that holdings will be underwater by reducing the portfolio volatility. When the markets fall by 50%, they then need to double to get back to their previous highs, that's a tough mountain to climb. A portfolio that falls by 20% can typically get back to even in a much quicker fashion.

The most tried and true strategy to reduce portfolio value and to produce the ability to return back to square is to combine bonds with your equities. Bonds and stocks always present an interesting dynamic, and given that, I would never look at stocks and bonds in isolation when we have a balanced portfolio - that nice mix of stock and bonds. They're always together, sometimes lending a hand when the other is down.

In the market correction of the last recession, if an investor held a balanced growth portfolio of 75% equities and 25% bonds, their portfolio would have fallen in the 35% range, compared to over 50%, and the balanced growth portfolio would have recovered by February of 2011. For the bond component I used the broad-based AGG. The balanced growth portfolio is in racing green. One can also use Long-Term Treasuries (NYSEARCA:TLT) for even greater potential to reduce volatility.

75% SPY / 25% Bonds

Again, the balanced growth portfolio recovered in February of 2011 compared to August of 2012 for the broad market, SPY, some 1.5 years earlier.

To be clear, SPY did return to its previous value in early 2011, before quickly falling again in the modest correction of late 2011. The balanced growth portfolio fell only modestly in that correction, and would have provided an emotional comfort zone.

A typical balanced portfolio can be in the range of 50-60% stocks. Here's what the correction looked like with a balanced portfolio.

50% SPY / 50% Bonds

As we can see, the balanced portfolio was down by only 20%, and recovered twice as fast as SPY. By the time the equity markets made it back to even, the balanced portfolio was approaching 20% returns.

And here's a balanced income model.

30% SPY / 70% Bonds

The balanced income portfolio was down by 10% in its worst days and weeks. You may also note that the portfolio fought hard and remained essentially flat for many months from the onset of the market meltdown.

It was under water from May of 2008 until November of 2009, a period of 1.5 years.

Here's the final scorecard. Performance returns are from October of 2007 to present.

Portfolio

Value Drop

Time Under Water

Portfolio Returns

100 Equities

55%

4.5 years

41.5% (5.4%)

75 / 25 Bonds

35%

3 years

40.3% (5.2%)

50 / 50 Bonds

20%

2.5 years

40.1% (5.2%)

30 / 70 Bonds

10%

1.5 years

39.0% (5.1%)

The equity portfolio has only very recently surpassed the buy-and-hold balanced portfolios. If those balanced portfolios were on a rebalancing schedule, they would still be outperforming the all equity portfolio, as holdings from the bonds would have been trimmed during periods of bond market outperformance, with funds used to purchase the outperforming equity market.

That's the return situation we experienced with our Tangerine Portfolios. We launched our portfolios during the market correction in January of 2008. The portfolio in the lead to-date is the balanced income, followed by the balanced, followed by the balanced growth. Moving through the recession and including the second-best equity bull run over the last 40 years, the more bonds, the better returns. But certainly, we should call it a draw (statistical tie) from market collapse to-date. Portfolio inception: January 2008.

(click to enlarge)

Here are the investing "safety zones" we recommend for clients. Any funds you need within the next three years, keep it safe in cash or CDs. If you need the funds within 4-5 years, stay within the balanced and balanced income area. Balanced growth or pure equity is in the 6-9 time horizon, or longer. Of course, the true return potential of the stock market might require more in the range of 15-20 years than that shorter minimum time horizon suggestion.

International diversification is also important. Many U.S. investors have a home bias, as do most investors around the world. The U.S. market had that lost decade in the 2000s. Here's what a simple portfolio of U.S., Canada (NYSEARCA:EWC) and the International (NYSEARCA:EFA) would have looked like vs. the U.S. market from January of 2002 to December of 2012.

Once again, rebalancing would have worked in your favor, with the high-flying Canadian and international equities being trimmed to purchase the lower-performing SPY, which then went on to be the high-flyer coming out of the recession. U.S. investors have been rewarded for their home bias coming out of the recession. That may or may not be the case over the next 10-15 years. The printing of a few trillion dollars may come into play? Who knows?

And here's what that internationally diversified portfolio looks like over that period, with a 60% equities to 40% bond allocation.

That internationally-balanced portfolio would still be outperforming the broader market, SPY, to-date, some 12.5 years later.

The Takeaways

When we take on the additional risk of the markets, there is not a guarantee (or even high probability) that we will be rewarded for that additional risk even over 10 or 15-year time horizons. If we get another correction, the balanced portfolio might outperform the broader markets over an extended time horizon. Though there is certainly the possibility that we so continue on this market run, and stocks outperform.

Risks

Bonds change in price. If interest rates spike violently, bond prices will fall accordingly, though new bonds available will offer higher income. There are short and midterm price risks associated with bonds. Many will suggest that investors keep their bond durations to the shorter end or mitigate rising yield risk with specialized products or simple bond laddering. I have no idea where rates and yields are heading. Like the stock markets, they could hold steady, they could go up, they could go down.

For more on bond history, click here.

Happy investing, and be careful out there.

Disclosure: I am long SPY, DIA, EFA, EWC, VYM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Dale Roberts is an investment funds associate at Tangerine Bank (formerly ING Direct). The Tangerine Investment Portfolios offer complete, low-fee index-based portfolios to Canadians. Dale's commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process

Source: How Long Can You Afford To Be Under Water?