The combination of high inflation, the Federal Reserve’s aggressive program of rate increases, and economic and geopolitical uncertainty has meant volatile markets and the vanishing of traditional sources of portfolio diversification.
Progress has been made, but as the new year unfolds, it will bring additional challenges, including a potential recession.
How will that affect financial plans and investment portfolios? How should short-term assets be managed relative to long-term assets?
There are some things you can do to help your plan ride out more volatility and also keep things on track.
Are You Diversified?
Equities and bonds have historically been negatively correlated, meaning that when market or economic factors drive one down, the other is usually up. This reflects a push-and-pull between these two asset classes that is partly driven by investor behavior.
Equities generally carry more volatility than bonds but offer higher potential returns. Historically, equities have offered significantly higher returns. And they should! If a company goes bankrupt, investors who hold company debt in the form of bonds get paid back a lot sooner than shareholders.
Environments in which the prospects for equities are positive result in investors piling into equity positions and pulling money out of bonds. When investors are concerned about economic conditions, the “risk-off” trade goes into effect, and investors exit equity positions for the relative safety of bonds.
This has worked for decades, but there are some environments when equities and bonds move in tandem. We may see more volatility with inflation far from under control and the Fed insisting it is not done on interest rates.
Assess your existing portfolio:
- Have market moves resulted in positions that have crept above or fallen below your target allocations? This can result in overconcentration. Consider a rebalancing strategy that incorporates tax-loss harvesting.
- We are clearly in a new phase of the business cycle. If you spent the last several years exposed to one part of the market (or one country in the global market), you should not expect the 2015-2021 market results to continue in perpetuity. History would tell us to expect quite the opposite.
- Assets that are not correlated to the public markets – meaning either equities or bonds – may provide sources of diversification. These may include real estate, commodities, private equity, and private credit.
- As we’ll mention later, financial planning (specifically duration matching) can play the most important role. If you have sufficient short-term/cash assets to withstand upcoming expenses in your life, a downturn can be an opportunity instead of a threat.
On that last point, the question, “Am I a net-buyer or a net-seller of equities?” plays a large role in how you land after market downturns. For the 45-year-old not planning to spend their assets for more than a decade, a downturn can be a huge opportunity with significant annual investments into stocks as they move downward. For parents of a college-bound student in the short-term with a 529 entirely invested in stocks, they’re a net seller (this is bad!) during a downturn. For a retiree, proper planning can still make you a net-buyer or at least neutral.
Tax-Loss Harvesting and Re-Deploying Cash
Once you’ve identified where your portfolio is out of line with your target allocation, you’ll need to determine what to sell. Keep in mind:
- The IRS has created a hierarchy for how losses can be used to offset gains. Short-term losses offset short-term gains, and long-term losses offset long-term gains. If your short-term losses exceed your short-term gain, the excess can be applied to long-term gains and vice-versa.
- If you are selling a position you acquired over time at different costs, look at the cost basis and maximize your tax benefits by selling the highest-cost-basis shares.
Once your strategy for selling is in place, you need to consider how to redeploy the cash that results. With market volatility likely to remain elevated, selecting an entry point can be difficult. But timing the market perfectly isn’t just difficult–it’s an impossible task only achieved by pure luck.
Cash Is King?
After years of earning almost zero, certificates of deposit and some savings accounts are now paying significant amounts of interest. Does this mean cash should be a bigger piece of your investment strategy? A better way to answer the question is to think about the role of cash.
If you’re still working, you should have enough in cash to cover three-to-six months of living expenses. Think about this as an insurance policy. You want your insurance policy to cover the replacement value of the asset, like a car or a house. Translating this to your rainy day fund, you want to have enough saved to cover all your expenses, not just the big things.
If you’re retired, you need what we call a “war chest.” A war chest is a bucket of assets that can be used during a market downturn to avoid forcing you to sell a large portion of equities while they’re at depressed prices. You likely want to keep as much as five+ years of living expenses in accessible, fixed-income assets (not necessarily all cash). Having a cushion this big can help you ride out downturns in the market without having to draw from investments.
In either case, this is already a substantial sum. Does it make sense to pull even more of your assets out of higher-growth potential assets? No–duration matching is a critical key in allocating assets properly. Some of your nest egg will not be needed for 15+ years. A market crash isn’t remotely the largest threat for these assets–running out of money (hint: inflation) is. Duration matching means these assets need to be invested in assets that have historically far outperformed inflation. Over long periods of time, being an owner (stocks) solves the inflation risk far better than being a lender (cash/bonds).
Lastly, it can add material value to your cash investment to rethink where you are holding it. There are (as of the date of writing this) far better options if your savings account is still paying near zero. But be careful–earning 4.5% today is very likely not going to solve the problem of long-term purchasing power (inflation).
The Bottom Line
One way to think about the past few years is that they marked a transition. The nuts and bolts of managing your portfolio were less important when the stock market increased every year.
We are now entering a period when gains may not be as robust and where it will pay to invest time in tuning up your portfolio so it can be positioned to ride out volatility.
