It’s been about a year since the market bottomed in 2020, and stocks around the world have rebounded strongly from their pandemic lows.
What lessons can investors draw from the past year as they look toward what’s ahead through 2021 and beyond?
At the end of March 2020, the S&P 500 was down nearly 20%1 and the world was scrambling into lockdown. Many experts wrote articles telling us where we would be in a year. I don’t remember reading any that said the S&P 500 Index would be up 56% over the next 12 months. But that’s what happened.
I didn’t predict any of that. I never do. For my entire career, I have educated my client’s that we should be prepared for market downturns once or twice a decade, while accepting that we can’t know when they’ll happen. We can’t predict financial crises, but we should plan for them. That’s why I always recommend having a Bucket Plan® and an understanding of the range of possible outcomes based on your goals and acceptable levels of risk.
So, let's take a look at 2020!
Lesson 1: Stay The Course
Sticking to long-term investment plans in the face of such extreme uncertainty wasn’t easy. As a personal investor and an advisor to many, I know that no one ever likes to see their account balances go down.
We were all stressed out last March. Many of you may have felt pressure to “do” something, to make changes just for the sake of reacting. You may have felt that it would be best to get out of the market in an effort to reduce uncertainty. But getting out of the market can actually increase uncertainty because it can force investors to make a difficult decision: choosing the best time to get back in.
If you stayed in the market, it might be time for a victory lap.
Let's start with the basics.
Had you been invested in a simple S&P 500 index fund (SPY) on 01/01/2020, closed your eyes and not paid attention to the media, you would have returned a gross return of 18.37%2. As we know, markets are volatile and 2020 certainly exhibited that. At the height of the market downturn (a term we call max drawdown) on March 23rd, 2020, the S&P 500 was down -33.70%. It took 140 days to recover back to its pre-pandemic highs and then was off to the races.
LESSON 2: Don't Abandon Your core investment philosophy
When markets go haywire, like they did in 2020, not only is it difficult to stay invested in the market, but it can also be difficult to hold true to your investment philosophy. It is important to remember that investing is about making long-term decisions, while trading is about trying to profit on short-term price movements. Most of you are investors and not traders, although lately the media has made it look like "trading" is easy with message boards like WallStreetBets and stocks like GameStop. Unfortunately, many investors end up learning the hard way that trading is not easy, but that will be part of our 2021 story!
At Alison Wealth Management, our investment philosophy is a quant model driven by academic research and data analytics. Rather than relying on futile forecasting or trying to outguess others, we draw information about expected returns from the market itself and tilt the portfolio towards those asset classes that have exhibited outperformance over long periods of time.
I often get asked by clients, why not just buy an S&P 500 index fund vs paying for professional asset management. While this response can be uniquely different for each client, I would say there are three consistencies to how professional management will enhance your investment experience.
- The S&P 500 is a small sample size of investments that are available. When it comes to public markets (not to mention the vast universe of private equity investments), the S&P 500 represents 500 companies out of a universe of hundreds of thousands of companies. While these companies are the 500 largest in the world, I always share with clients, would you rather own Amazon today or would you rather have bought Amazon when it was a small bookstore and held on over the years? Well, that is simply the difference of investing in large cap (large companies such as the S&P 500) vs small cap (small companies such as the Russell 2000).
- When you have all of your money in similar investments, you lack negative correlation. For example, while all 500 stocks in the S&P 500 are different in nature, many of them are correlated (they move up and down together) in terms of their price movements. If the market crashes, many of them crash together. One key of a diversified portfolio is holding non-correlated assets. As a simple example, you may hold stock funds and bond funds. When the stock funds are up, generally the bond funds are down slightly or flat. When the stock funds are down, generally the bond funds are up or flat. The benefit of holding non-correlated assets in a portfolio is our ability to rebalance. For example, in March of 2020 many of our clients had stock funds and bond funds in their portfolio. When the stock funds fell 20%- 30%, the bond funds remained stable (non-correlated). This allowed us to sell off some of the bond funds and buy more stock funds at a discounted price of 20%-30%. This is investing 101, buy low and sell high!
- For many of our clients, they have achieved a level of wealth that has provided them financial freedom. Whether it is a work-optional lifestyle, retirement, or just the luxury of having a large income during your accumulation years, your financial situation can be complex and ever-changing. By having a custom approach to your asset management, we are able to implement a plan that is as flexible as your unique lifestyle. This could be related to tax-planning or custom blended out retirement distribution planning. One example of this is how we engaged in tax-loss harvesting to create deductions for our client's without sacrificing performance.
The bottom line is while the S&P 500 will offer growth and is an important component of a bigger portfolio, a properly structured actively managed portfolio should reduce risk and increase expected returns as well as tighten up the potential variance of outcomes (less surprises). For additional research, check out my article on a tale of two decades.
As we look back at 2020, a few examples of this can easily be illustrated in our professionally managed mutual fund portfolios (Valor-Dimensional Portfolios). One of our core holdings within our equity allocation is the Dimensional US Core Equity 2 fund (DFQTX), which holds a diversified mix of broad US equities and is our largest core holding, which returned nearly 72%, as Exhibit 1 shows.
This fund is actively managed and holds over 2,584 stocks as of 02/28/20213. While it's top 10 holdings resemble similarities to an index fund such as the S&P 500 or Russell 3000 (Apple, Microsoft, Amazon, Google, Johnson & Johnson, JP Morgan, Facebook, Intel, Visa, & Verizon), this fund puts a greater emphasis on small-cap stocks, value stocks, and profitable stocks - all asset classes that have historically outperformed the broad market over longer time horizons. As a result of "tilting the positions" exhibit 1 shows the results against the S&P 500 or Russell 3000 benchmarks.
Within the US market, small cap value stocks4 were among the hardest hit during the pandemic. As mentioned above, small cap value is a major quantitative "tilt" (exposure) within our portfolios as it has historically delivered greater returns than the broad market over time. To illustrate an example of the volatility of small cap value investing in the US, Dimensional’s US Small Cap Value Portfolio was down 39% in the first three months of 2020 and subsequently returned a showstopping 112% over the next 12 months.
Rise and Shine: Dimensional Funds vs. Benchmarks
Past performance, including hypothetical performance, is not a guarantee of future results.
Lesson 3: Understanding The Risk & reward of gambling vs investing
While all investments have risk, many people who think they’re investing are actually gambling. It is a really simple distinction for me; if you’re trying to time short-term market movements, you’re gambling. If you are buying into companies because you believe in their long-term outlook (3-5 years or longer), you are investing.
Now don’t get me wrong, some of our clients have an appetite for “gambling” a portion of their money for the opportunity for high returns. In early April I did a webinar for our clients and spoke about this market downturn as a potential "buying opportunity of a lifetime". Some of our clients who had a greater appetite for risk and potential reward deploy capital into individual stocks that they wanted to “bet” would recover quickly and even excel in a pandemic environment. For those clients, my advice was simple:
- Understand the risks & rewards
- Don’t use money you cannot afford (or stomach) to lose
- Try and pre-determine an “exit price” which you would sell
- Try and hold for 1-year (long-term capital gains tax treatment)
- Be ready for volatility
For client's that want to "gamble" as an overall part of their investment plan, I generally recommend setting a budget. The budget is the overall amount of your liquid investable assets that you are willing to allocated towards this strategy. My key recommendation is do not "gamble" with any short-term money (i.e., money you may need sooner rather than later).
As an example, if you have $1,500,000 of liquid investable assets (total assets excluding illiquid investments such as real estate, private equity, stock options, businesses, etc..), you may be comfortable with a budget of 10% or $150,000 to invest in things like individual stocks, cryptocurrency, alternative investments, or private equity investments. That means 90% of your liquid investable assets is invested in a core strategy. If you have a large appetite for risk or a level of wealth large enough where you couldn't even spend all the money you have, maybe your budget is 20%, 30% or more.
Of course, many of our clients don't want to deal with the added risk or stress associated with "gambling" on the stock market. For them, our professional management to deliver steady, reliable results is all they need to achieve their goals and objectives.
Wrapping up 2020
While staying focused on a long-term strategy during times like the past year is hard, it is important work. Short periods like the first quarter of 2020 and the past year are not signals of future performance, but reminders of just how hard being a long-term investor can be. We didn’t know returns like that would come this past year, but we knew we needed to be in the market the entire time to capture them when they do show up.
As I’ve said before, every crisis is different, but I think the best way to deal with them is always the same. We can’t control crises, but we can control our response to them. You want to be prepared to deal with the unexpected before it happens. Not when you’re stuck in the middle of it.
What is the next? It’s expecting uncertainty and committing to a plan that addresses it. It’s rising above the temptation to panic when things get tough. It’s understanding the difference between investing and gambling. And it’s remembering how good it feels when things work out according to plan.
If you are not a client of Alison Wealth Management and don’t already have a plan that includes crises among the range of possible outcomes, it’s never too late to create one. This is not the last crisis any of us are likely to experience. If we make thoughtful planning the reality of the stock market, we’ll all be ready for the next downturn.
To conclude, as we look at the results of Q1 2021 and backwards, you can see that for investors that stayed the course, they have been rewarded. While these are just two samples of the allocations we implement, they glean insight into our quantitative approach to structuring a portfolio.
Performance as of March 31, 2021
In comparison, the S&P 500 was up 56.35% over the same 1-Year time frame (04/01/2020 - 03/31/2021)5.
As a note for some of our existing clients, if you look at your portfolio you may not have DFA US Small Cap Value as a direct holding because DFA US Core Equity 1 and 2 already carry the small cap value tilt within the fund based on our US Equity target.
If you have any questions or want to schedule a time to discuss your investments, please click here.
Dave Alison, CFP®, EA, BPC
1Past performance is no guarantee of future results.
S&P data © 2021 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.
Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Decrease of 19.6% was from Jan. 1, 2020–March 31, 2020. Increase of 56.35% was from March 31, 2020–March 31, 2021.
2As analyzed by Kwanti.com portfolio analytics.
4 As defined by the Morningstar Small Cap Value Category.
5As analyzed by Kwanti.com portfolio analytics.
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and charges and expenses of the Dimensional funds carefully before investing. For this and other information about the Dimensional funds, please read the prospectus carefully before investing. Prospectuses are available by calling Dimensional Fund Advisors collect at (512) 306-7400 or at us.dimensional.com. Dimensional funds are distributed by DFA Securities LLC.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. These risks are described in the Principal Risks section of the prospectus.