Volatility is most often a bad sign for investors, since it’s frequently associated with declining equity markets. Wild swings in a portfolio’s value create anxiety and concern for the future. That concern grows exponentially when market swings are driven by a highly contagious, and selectively lethal, viral pandemic. That’s the scenario we see unfolding around the world and in the United States—and we have no historical precedent to use as a guide for how these events will play out.
Obviously our first concern is for our families, friends, neighbors, clients, and colleagues. But now is a good time to reflect on steps to take to make sure our portfolio stays healthy. Some of these steps may be painful, since our instinct is to avoid what we perceive to be a dangerous situation. However, history has demonstrated that the most painful investment decisions tend to be the most rewarding.
How volatile have the markets really become?
Most investors understand that when they buy a diversified equity portfolio, they’ll inevitably experience volatility. However, what we have experienced recently is exceptional. To be fair, many financial experts have been predicting the end of the bull market for years. We’ve just concluded a decade in which the S&P 500® produced a compound annual return of 13.5%. For reference, since the 1920s, the S&P 500® has produced an average annual total return of 10.3%. In other words, we had a very good run throughout the 2010s that’s quickly come to an end.
Days to reach bear market status in the S&P 500®
Source: Bloomberg, 3/19/2020
Using the definition of a 20% decline in equities from peak to trough, we’ve just experienced the quickest bear market in modern history: 16 days. Sudden shifts in the market of this magnitude are indeed rare. The swiftness of the move has caused both realized and implied (or expected) volatility, as represented by the Cboe Volatility Index (VIX), to skyrocket to levels unseen since the 2008 global financial crisis.
Rising volatility during the COVID-19 crisis
Source: Cboe, 3/19/2020
In this market environment, it’s easy to understand why investors may be apprehensive. But there are a few important things we all need to keep in mind to avoid making decisions we may regret in the future.
How to keep your portfolio healthy
Maintain a diverse portfolio. The working assumption is that we all seek to maintain a high level of diversification in our investments at all times. As Nobel-winning portfolio theory pioneer Harry Markowitz said in 1952, diversification is “the only free lunch in finance.” But diversification in this context doesn’t just mean a diverse equity portfolio in terms of geography and sectors. It also means diversification across asset classes, including both corporate and/or municipal fixed income as well as commodities and possibly TIPS.
Don’t try to time the market. No one is able to reliably call the bottom—or the top, for that matter—of the equity market. Investors often deny that they’re trying to time the market; what we hear instead is that they’re selling equities and moving into cash until markets stabilize. This requires the investor to time their exit and reentry into equities perfectly, which is very unlikely. If you don’t need the liquidity, don’t try to sell equities and move to cash in reaction to the onset of a bear market.
Rebalance your portfolio. Assuming you have a diverse portfolio and aren’t inclined to try to time the market, what should you do? The best action most investors can take is to be disciplined and rebalance portfolios to maintain diversification. Rebalancing in this manner requires selling things after they’ve performed well and buying things that are performing poorly. In today’s market, that requires most investors to sell fixed income securities and buy equities. This action will be painful for many investors, especially if they have to do it for a second or third time as equities keep falling. What investors need to keep in mind is that equities are a long-term purchase. They’ll see the value of their decision to rebalance a portfolio playing out over years, not days, weeks, or months. Keep in mind Warren Buffett’s famous advice to “be fearful when others are greedy and be greedy only when others are fearful.”
Keep harvesting tax losses. Taxable investors may think they’ve realized enough tax losses already and that they should stop or slow down further loss harvesting. However, the way the US tax code is written, realized losses can be carried forward forever and don’t expire, provided the IRS wash-sale rule isn’t triggered. During two prior downturns, we saw investors stop loss harvesting. In almost all of those cases, they decided to resume harvesting as their other investments began to produce gains again. Markets can rebound quickly, and gains can show up in a lot of places. If investors can get losses without harming tracking error—and, in some cases, improving it—then why not keep realizing them?
The bottom line
It’s easy to say that a calm and long-term approach to market volatility is the best one—but it’s not always easy to take that approach. What investors can do right now is boost asset-class diversification and rebalance existing holdings by buying low and selling high. Discipline will be the watchword throughout the COVID-19 crisis, whether that means avoiding public places or avoiding portfolio panic.
A Custom Core® SMA allows investors to take charge of their passive mandates. Portfolios are held as separate accounts, giving investors the ability to customize them to their needs. Investors can select from a wide range of benchmarks and then tailor their exposure to incorporate their unique objectives.
Tom Lee, CFA, Chief Investment Officer, Equities and Derivatives
Tom leads Parametric’s Research, Strategy, Portfolio Management, and Trading teams, coordinating resources, aligning priorities, and establishing processes for achieving clients' investment objectives. Tom has coauthored articles on topics ranging from liability-driven investing to the volatility risk premium. He is a voting member of all the firm's investment committees. Prior to joining Parametric in 1994 (originally as an employee of the Clifton Group, which was acquired by Parametric in 2012), Tom spent two years working for the Board of Governors of the Federal Reserve in Washington, DC. He earned a BS in economics and an MBA in finance from the University of Minnesota. A CFA charterholder, Tom is a member of the CFA Society of Minnesota.
Jeff Brown, CFA, Director, Institutional Portfolio Manager
Jeff is responsible for supporting development and distribution of Parametric’s investment products. Prior to joining Parametric in 2000, Jeff spent two years as a portfolio manager with Laird Norton Trust Company, where he worked closely with taxable clients to design, develop, and implement various portfolio solutions. He earned a BA in business from the University of Washington. A CFA charterholder, Jeff is a member of the CFA Society of Seattle and the Seattle Society of Financial Analysts.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.