Today I’m discussing the current stock market volatility.
As of a couple days ago, U.S. stocks were off to their worst start since 2016.
Bonds are also in negative territory.
And inflation is at its highest level in 39 years.
Many retirement investors are [understandably] worried about the current state of the financial markets.
If you want to learn why + how to respond as a smart investor, you’ll love today’s episode.
How to Listen to Today’s Episode
Episode Links & Resources:
- 👉 Get Your One-Time Retirement Plan
- Stay Wealthy – Investing in Bonds Series
- Price to Book Ratios: Growth vs Value [Dimensional]
- Projected Withdrawal Rates and Your Asset Allocation [Morningstar]
Why the Stock Market is Falling (and How to Respond!)
Taylor Schulte: Welcome to the Stay Wealthy Podcast. I'm your host Taylor Schulte, and today I'm addressing the current state of the financial markets.
As of a couple of days ago, US stocks were off to their worst start since 2016. Bonds are also in negative territory and inflation is at its highest level in 39 years. Many retirement investors are understandably worried about the current state of the markets.
So if, like them, you want to learn why the markets are down and how to respond as a smart investor, you're gonna love today's episode. For the links and resources mentioned today, head over to youstaywealthy.com/142.
As of this recording, small-cap growth stocks are down about 15% so far in 2022. The NASDAQ has dropped about 10% and the S&P 500 is down close to six. In response to their rocky start to the year, here are just a few of the headlines that I've seen, and maybe you've seen them as well.
“The stock market is a super bubble about to burst.” “Panic is setting in as the S&P 500 enters correction territory.” “Catastrophic stock market crash isn't over.” Before we get too into the weeds today, I just thought it'd be helpful to revisit a couple of the statistics that I shared late last year in our surprising facts episode.
The first comes from bestselling author and friend of the show, Morgan Housel. Morgan shared that the stock market has dropped at least 10% on average every 11 months for the last 100 years. Again, the stock market has dropped at least 10% on average every 11 months for the last 100 years.
In other words, if someone predicts, if someone goes on CNBC and predicts a 10% or more decline in the stock market, they really should just say everything is normal, and this happens on average every 11 months.
To build on that statistic, it's also interesting to highlight that the average intra year drawdown, meaning the average percentage that the stock market falls during a calendar year, the historical average intra-year draw down going all the way back to 1928 is 16.5%. So if the broad US stock market drops 16.5% at any point throughout the year, the event would be in line, but the historical average and really shouldn't be much of a surprise to anyone.
To clarify, that doesn't mean that the stock market ends the year in negative territory. It just means that during any point throughout the year, and at some point during the year, the stock market could fall 16.5% or more, and maybe it recovers by year-end, maybe it doesn't. As I've shared many times on the podcast, the stock market, the US stock market historically does end the year in positive territory 75% of the time, three out of every four years.
The media loves to reference Black Monday in 1987 when the Dow Jones dropped 22% in a single day, but they don't ever seem to mention that the market ended in positive territory that year. The other statistic that I wanted to resurface from last year's episode was from Peter Lynch, where he compares two investors investing in the stock market from 1965 to 1995. That's a 30-year time period.
Investor A was a terrible market timer, and they invested at the peak of the market every year during that 30-year time period that investor's average annual return during that 30-year time period was 10.6% per year pretty good.
Investor B on the other hand was the best market timer, and that person invested at the exact low point every single year. During that same time period, investor Bs average annual return was 11.7%. In other words, the difference between great timing and lousy timing was only 1.1%, which reinforces the famous quote that timing in the market is wildly more important than timing in the market.
So back to present day, yes, the markets are shaky, and while the market going down is totally normal, it's never fun. And it's okay to acknowledge that it's okay to feel anxious or worried. It's okay to ask for help or vent to a friend or family member or even your financial advisor or your favorite podcast host. Shoot me an email at firstname.lastname@example.org. Talking about money and our emotions is a good thing and, we really should encourage more of it.
We just have to be careful not to let our emotions drive us to make irrational decisions with our money that can hinder our long-term retirement plans. In response to what's going on right now, in the financial markets, Morgan Housel recently shared two things to keep in mind that I thought were just really good reminders to pass along.
The first was nothing is free. There's a cost of admission that must be paid to do well over time. The world is not so kind that it'll deliver big returns to people who sacrifice nothing. All durable, long-term investing returns have to be earned. A good recent example of this is the crypto markets and the recent catastrophic drop in that asset class. Some crypto investors have experienced huge returns over the years, but those returns didn't come without any risk. In fact, those returns required more risk than most of us are probably willing to take.
The second point that Morgan made was that the highest cost that investors pay is enduring volatility and uncertainty. I'll say that again. The highest cost that investors pay is enduring volatility and uncertainty.
A big decline doesn't necessarily mean that you did something wrong. Most likely you're just paying the cost of admission to earning good returns over a long period of time. Having success with investing isn't all that different from Napoleon's definition of a military genius, which is quote, the person who can do the average thing when everyone else is losing their mind.
Since we don't know when these market drawdowns will occur, how long they'll last, and how long it will take to recover, I'm a strong advocate for building a portfolio that takes these events into consideration knowing that they are going to occur from time to time. If you've ever reached out to my firm and inquired about our services, you know that one of the first things we do in our retirement planning process is shocking your portfolio.
We want you to see what the worst-case scenario looks like in dollar terms, because those are the times that require patience and discipline. And if you're not prepared to weather those storms, you're likely not gonna experience investing success. The best investment strategy is the one that you can stick with for the long term, but reducing risk to avoid losing sleep at night or avoid making an irrational decision with our investments is only one potential reason to consider selling stocks.
Other reasons have to do with our stage of life or to match our investment strategy up with our financial plan. You likely know my rule for making major investment changes. It goes like this. Your investment allocation shouldn't change unless your investment policy statement changes and your investment policy statement shouldn't change unless your financial plan changes. Well, one of the biggest changes to a financial plan that can lead to selling stocks and reducing risk is when retirement is around the corner.
The life event is driving the investment strategy, not our emotions or feelings or tolerance for risk. We talked about sequence of returns risk last week, and that's why it's often prudent to reduce risk as you make that transition into retirement. The last thing we want is to start leaning on our portfolio for income.
At the same time, our portfolio is going down, which brings me to the next topic today that I wanted to address and I've been getting a lot of questions about. And that is the concern around owning bonds in today's market because not only is the global stock market negative territory for the year, but investment grade bonds are also down about 2% year to date. I've dispelled the myth on this podcast before that suggests rising interest rates mean that you will lose money in bonds.
And if you missed it, I'll link to it in the show notes, which again you can find by going to youstaywealthy.com/142.
But pushing that myth aside, it's pretty fair to say that we can't expect much of a return from our bond portfolio over the next five to 10 years given today's starting yields, which has led many investors to wonder if they should own bonds at all, especially as they begin to see negative returns from this asset class that has been so kind to them over the last 30 to 40 years.
In short, while bonds have produced some pretty good returns over the last few decades, the primary purpose for owning bonds was never to provide exciting returns. The purpose, especially for those in retirement, was to reduce risk and volatility in the portfolio and also improve what we call risk-adjusted returns.
More on that in a moment, but when we're in retirement and withdrawing money from our portfolios, we need asset classes that zig when others zag.
We need asset classes like US government bonds that were up almost 6% during the covid crash of 2020 when the stock market was down 34%. In addition to reducing volatility and helping us sleep better at night, as we go through a major life transition, those high-quality bonds allow us to continue withdrawing money from our portfolio and supporting our lifestyle without having to make sacrifices or without having to sell stocks when they're in negative territory.
In fact, Morningstar recently put out a research report concluding that a more balanced portfolio with a stock allocation between 30% and 60% will sustain the highest 30-year withdrawal rates. And a big reason for that is the lower volatility. The lower volatility that lower volatility protects the portfolio against sequence risk in the early years and also against catastrophic losses throughout the rest of retirement. Now, if you're not close to retirement and still accumulating wealth, diversifiers like bonds still help in a similar fashion as well.
Adding diversifiers can help you not only lower volatility, but contrary to what many think. They can also help improve your returns.
In other words, you can actually have your cake and eat it too over the long term. If you construct your portfolio properly, you can take less risk and see a higher return. The technical term for this is improving your risk-adjusted returns, and a popular way to measure it is by valuing the sharp ratio of your portfolio.
So just because you aren't in the withdrawal phase of life or close to it, doesn't mean you should remove bonds entirely from your portfolio, even if their future expected return is going to be low. Maintaining a small allocation of bonds, 10%, 20% can actually help improve risk-adjusted returns for a globally diversified portfolio.
To build on that and make my final point here, it's important to acknowledge again that some areas of the market are behaving better than others.
Small-cap growth stocks are down close to 15% year to date, the NASDAQ is down around 10%, and the S&P 500 is down about 6%. Meanwhile, small-value stocks here in the US are only down about 4%, and large-cap value stocks are looking even better, being down around two and a half percent as I shared a couple of weeks ago.
We have to be careful about reading headlines and drawing quick conclusions. If the headline says Catastrophic market crash isn't over, which was a real headline, ask yourself what market? Because if you clicked on that article, you would've seen that it was discussing some of the individual companies inside the NASDAQ index that were truly seeing catastrophic losses around 50%.
So unless you're betting your retirement on tech and growth stocks, that headline could have been ignored completely instead of instilling fear and potentially causing someone to make irrational changes to their investments.
The other reason that I wanted to bring this up again is because I came across some data recently on current stock market asset class valuations. That one I just found interesting and two reinforces my concern around US growth stocks. The researcher used price to book ratios to measure the valuation levels for us, value stocks and US growth stocks, and the difference or the spread between the two, to keep things simple, the higher the price to book, the more overvalued the asset class is.
And as a reminder, when we say an asset class is quote overvalued, it doesn't mean that the asset class can't continue to go up. It just means that if it does continue to go up, you're simply pulling future returns into the present and that you would continue to expect lower and lower and lower future returns from that asset class.
If an asset class is undervalued or has lower valuations, well, we would say the opposite, that if it continues to lag behind or go down, we would expect higher and higher and higher future returns from that asset class.
So in March of 2000, before the last growth tech bubble burst, US growth stocks had a price-to-book ratio of 9.5. At the same time, US value stocks had a price to book of 1.2, so the spread between those two asset classes was 8.4, well above their historical average spread of 2.9. We all know what happened next, and I recently shared the little known stat about how well value stocks actually performed during that tech bubble bursting.
Fast forward to today as of November, 2021, which is when I was able to see this data, US growth stocks had a price to book of 12.2 and value stocks had a price to book of 1.3.
The spread between the two are almost 11, which is again well above their historical spread average and almost 30% higher than what we saw in 2002. Takeaways from this data, one, growth and tech stocks might be stealing the headlines for the foreseeable future. So just be aware of that. It's important to dig into the details of a scary headline before letting it scare you into making an irrational decision.
It's very possible that the headline is referring to an asset class that you don't have a huge allocation to, while other asset classes that you do own are behaving much more positively. My other takeaway from this is that you do have that if you do have a, a high allocation to US stocks or growth or tech stocks, there are ways to reduce risk in your portfolio without increasing your allocation to bonds.
And at the same time, it might even improve future expected returns. Remember, lower valuations mean higher expected future returns. So if you construct your portfolio properly, it's possible to have your cake and eat it too. Just know that those higher future returns don't always come overnight. You have to be a patient, long-term investor to reap the rewards of smart evidence-based investing.
Bringing us home, let's try to best summarize why stocks are down right now. Why has January been such a rough month for the markets? Well, for one, let's remind ourselves that this is normal. It happens, and in the very near term, we can't always pinpoint the exact reason. The media won't necessarily tell you that, but it's true. Some of the smartest investors will be the first to tell you that they don't know why the markets are behaving the way they are right now in the short term and as a long-term investor, it's just simply not worth speculating about.
What might be more worrisome is if the stock market never went down, if we didn't have volatility or meaningful drawdowns and we weren't forced to take any risk with our investments, well, we wouldn't be rewarded with healthy returns. Remember, nothing is free. The world doesn't deliver big returns to people who sacrifice nothing.
While we can't control what the markets are gonna do next, we can control how much risk we are comfortable taking, how much risk we need to take, aka risk capacity, and where we allocate our hard-earned dollars across the global markets. Those decisions are wildly more impactful than trying to guess what's happening right now in the short term or letting current events derail you from your long-term goals.
That said, I think we can definitely point to a few specific things that have been creating some worry and some uncertainty in the markets, some of which investors are already feeling better about, given that the market has recovered a bit since the low on January 27th.
So for one, tensions in Ukraine have certainly had investors worried. The Fed's plan for interest rate hikes in 2022 have certainly created some uncertainty, and of course, the elephant in the room inflation, inflation was 7% in 2021, the highest level in 39 years, and lucky for you, that's the exact topic that I'll be covering next week here on the podcast.
In the meantime, you can grab the links and resources for today's episode by going to youstaywealthy.com/142.
Thank you as always for listening, and I'll see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.