As Markets come unhinged, the disciplined investor always comes out on top
Stock and bond markets have both had a terrible year. This is especially difficult on those who had hoped that their diversified portfolio would shield them from stock market losses. Instead, in the face of rising interest rates, bonds have led the charge lower!
Investors have largely been setup for this downturn. Historically low interest rates have fueled an unprecedented rally, particularly in growth stocks and speculative assets such as crypto. Many investors just assumed things would stay this way forever. Now that it is obvious that low rates are not a permanent economic fixture, there is a LOT of excess in the system that needs to be squeezed out before markets can return to “normal”.
One factor that exacerbates this kind of selloff is the prevalence of investors using “margin”. These are investors (both individual and institutions) who borrowed money to buy stocks, using the stock portfolio itself for collateral. Rules governing margin stipulate that the collateral cannot fall below a certain percentage of the amount borrowed. When stock (or crypto) prices fall dramatically, a “margin call” is generated, requiring the investor to pony up cash to replace the value lost in the account. That cash requirement forces margin investors to sell their stock (or crypto) holdings. A rapid market drop such as we are experiencing now can result in a cascade of margin calls, and the resulting selling pressure will magnify a market drop. This can all unfold very quickly, and be quite scary to those who watch their portfolios tumble. In 2018 stocks lost 20% of their value between October and December. In 2020, stocks lost over 30% in period of only a month or two! Never a pleasant experience – but it is the medicine that is needed to reestablish long term market discipline, which has grown lax of late.
The good news is that as severe as a margin fueled selloff can be, it tends also to be brief. Since margin calls hit all leveraged investors at the same time, the excess can quickly be squeezed out of the markets – and the result for remaining investors (who were not speculating with borrowed money) is often a much more fairly valued market – and maybe a buying opportunity for more the more courageous.
Our portfolios have been defensively positioned all year, and although everyone sees some losses in a market like this, we have generally outperformed both stocks and bonds over both year to date and trailing one year periods. This will leave us well positioned for the market recovery when it does happen. When will that be? Well, no one knows. No one knew how long the COVID downturn would last – most expected it would be worse than it turned out to be. In 2018 we had fears of higher rates drive the market down 20% - only to subside and recover rapidly a few months later. I suspect this might be a longer haul - but investment tides can shift very quickly, and unexpectedly. Already many growth stocks that had seemed extremely pricey are starting to look attractive. And nice safe government bond yields that used to be insulting at less than 1% now seem much more attractive at 3-4%. The best prescription, as always, is to grit your teeth, ride it out, and stick to the long term financial plan.
Feel free to schedule a plan update and review if you are concerned about how these unsettled markets may impact your financial plan. Here are the calendar links clients can use to schedule an appointment: