We have recently been receiving many questions and concerns from clients regarding the current political environment and what it means for their portfolios and the economy overall. I’m typically hesitant to write about subjects like this since markets are by nature volatile, and in my opinion, responding to volatile markets can have the effect of drawing even more attention to them and thereby increasing rather than decreasing anxiety around current events. However, given the consistency of client inquiries I thought it would be appropriate to communicate my thoughts and reflect on basic Fifth Set investment principles.
As mentioned, markets are inherently volatile. Markets can and do fall for any number of reasons (i.e., overvalued internet companies (2000-2002), overvalued housing markets (2007-2009), pandemics (2020) and potentially, political figures and their policies) and even sometimes for no reason at all. The question in all these cases is the same, “What should we do?” and the answer is always the same.
But before I get to that answer, let’s back up a bit, back to before the launch of Fifth Set PWM. All the way back to 2001 when I met a lady who eventually became my wife. Through diligent working and saving, she saved enough money in the bank to invest in a portfolio. I suggested she should invest in an investment portfolio that would help grow her wealth in a way that bank savings could not. At the time, I was an equity research analyst, a role that included research and buy/sell recommendations on individual stocks. It was clear to me already by then that buying individual stocks was not the best way to manage investments.
The opportunity to invest hard earned savings for someone in my personal life set me on a pursuit to understand how best to design portfolios that would accomplish three primary goals. 1) provide sufficient exposure to compensated market risk so that the portfolio can grow over time, 2) minimize to the extent possible diversifiable risks that do not provide additional compensation and 3) combine different asset classes in the portfolio such that losses in some asset classes can be offset by gains from others thereby reducing the overall portfolio volatility. That research formed the basis of Fifth Set’s investment philosophy and, coincidently, the answer to the question of what we should do during periods of market volatility or more precisely, what should we be doing to prepare for periods of market volatility. If you are a Fifth Set client, your portfolio design already checks every one of the following concepts.
Equity exposure – Investors must have some amount of equity exposure so that the portfolio has an expected return that exceeds the rate of inflation. The longer the investment time horizon, the more important equity exposure becomes to maintaining or exceeding the current portfolio purchasing power. The key is to align the amount of portfolio equity risk with the willingness and ability each client has for taking risk.
Diversification – individual stocks and bonds expose investors to uncompensated and therefore, unnecessary risk. Diversification through mutual funds and exchanged traded funds (ETFs) enable investors to spread company specific risk over tens of thousands of securities.
Asset Allocation – The global market is not composed solely of the large U.S. growth stocks that have powered the market over the last several years. Asset classes such as small and value, international developed and emerging markets stocks and a variety of fixed income asset classes can be combined in a portfolio to reduce overall volatility.
Global Investor Frame of Reference – Investors should invest through the lens of the global equity markets rather than any particular country (otherwise known as Home Country Bias). In 1990, the U.S. stock market accounted for only 32% of the global equity market, while Japan accounted for 41%. By the end of 2023, the U.S. accounted for 61% of the global market and Japan had declined to only 6%. By using the global investor frame of reference, you’ll see that the “stock market” is not the headline describing how the Dow Jones or S&P 500 are performing.
Reduce Portfolio Volatility with Fixed Income – Purposeful utilization of very safe fixed income allocations to reduce equity volatility is an important component in the risk management tool kit. This disciplined approach to fixed income means that we do not reach for additional yield by extending to longer term or lower quality bonds which in both cases increase risk.
Minimize Frictional Costs – As John Bogle, founder of Vanguard famously said, “investors as a group must fall short of the market return by the amount of the costs they incur.” The implications for this are clear: reducing costs (expenses and taxes) maximizes the amount of the market return investors can capture. By utilizing index and index-like mutual funds and ETFs, we are able to maintain low investment expenses and a high level of tax efficiency which enables our clients to capture a large percentage of available market returns.
These principles are always expressed in Fifth Set client portfolios, so they are fully prepared for market volatility, whether that volatility is caused by overvalued internet companies or unstable politicians. As an investor your only responsibility is to focus on the things that matter most to you in your lives (and possibly reduce your news consumption for the next four years😊 )