Q1 2016 Recap: Don’t Make Long-Term Decisions Based on Short-Term Events

If you were to pick up a copy of any financial publication such as the Wall Street Journal or Investor’s Business Daily after the first week of trading in 2016, it may have been concerning to read that the Dow Jones Industrial Average and S&P 500 were off to their worst ever starts to a new year. The NASDAQ Composite was off to its worst start since 20001, declining 6.4% over the same timeframe. Mid and small cap indices had declined 6.42% and 12.72% respectively, continuing a trend that began in the middle of 2015. No matter where one turned, there was overwhelmingly negative sentiment emanating from just about every news outlet. From their 2015 highs to their 2016 lows, performance numbers for the major market indices did not look
pretty.

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As you can see, all of the major U.S. domestic indices entered correction territory for the year at one point or another over the past year. A correction is defined as a negative movement in a stock, bond, or index of ten percent or greater. While these pullbacks occurred, one did not have to look too far to come across headlines in the Wall Street Journal such as “Time to Say Goodbye to (the) Long Bull Market,” “Gloom Hangs Over China’s Economy Amid Market Turmoil,” or “5 Reasons to be Scared of the Market Selloff.” While everyone recognizes The Wall Street Journal as a widely respected and reputable news source, basing investment decisions on the most recent “Markets” section article would have caused one to miss out on the

subsequent rebound towards the end of the quarter.

A rising tide lifts all boats, and the most recent upswing in the market has seen each of the above asset classes appreciate by an amount approximating or surpassing where they stood at the end of 2015. Broad market concerns regarding China that weighed down markets in January and February appear to have subsided, replaced by the narrative of a stronger U.S. economy. At the same time, headlines appearing on market related articles have been noticeably more subdued. A Wall Street Journal market recap from mid-March led with the headline “U.S. Stocks Rise” after a good day compared to the header “Dow Tumbles” after a volatile trading day in January2. If you were to look back at turbulence the market experienced last August, you would find similar comparisons, albeit with different antagonists. Greece’s default on their International Monetary Fund (IMF) loan, Puerto Rico’s debt crisis, and the threat of a potential Chinese economic slowdown were the main stories during this time, only to fade away once markets began to recover in October. The reason for the difference in language again goes back to what the news media is trying to accomplish with their reporting. Rising and/or stable period tend to decrease viewer traffic whereas volatile periods bring new readers in droves. If an article with a divisive headline can keep readers engaged within a website or newspaper, then it is likely considered a success.

The swings in the markets we have seen over the first quarter help to illustrate an important point when it comes to investing: BE CAREFUL WHEN MAKING A DECISION TO SELL IN THE VALLEY. It is during these periods when faced with a plethora of noise-related market advice that a decision to sell out of stocks can be highly detrimental to the success of one’s long-term portfolio. If considering such a decision, it is important to remember the initial investment strategy and allocation you had originally implemented. Doing so can serve as a reminder of the long-term goals that you wished to achieve when you first invested funds into the market.

Possessing the correct mix of assets inside of your portfolio is critical when volatile markets are encountered. A balanced portfolio containing a blend of large, mid, small, and foreign stocks in addition to bonds will tend to weather the storm better than holding a portfolio with too large a concentration to any one asset class or sector. Doing so will effectively “smooth the ride” and reduce the urge to sell your holdings in the valley. The chart below shows the benefits of risk reduction through diversification.

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As shown above, the balanced portfolio of 50% stocks and 50% bonds was never the best performer nor the worst performer over the period sampled. Holding 100% bonds or 100% stocks resulted in either the best return or the worst return during this timeframe. During periods of extreme duress such as 2008, each of the allocations possessing both stocks and bonds provided a cushion on the downside when compared against the all-equity portfolio. For the risk adverse investor, holding a balanced portfolio with multiple asset classes can help to lessen the impact of down market results while potentially allowing recovery to take place much quicker. If you are balanced and you choose to sell during down periods, however, the sells further impact recovery.

Rather than fear the possibility of a valley, it is often a good idea to use market volatility to your advantage. Prices of high quality companies tend to revert to historical averages of multiples such as price-to-earnings (P/E) over time, and a market pullback often represents an opportunity to buy stocks at attractive valuations. As Warren Buffett stated in his famous 2008 New York Post op-ed piece, “Be fearful when others are greedy, and be greedy when others are fearful”.3 Assuming your portfolio is balanced, adding to weak asset classes while they are down often can be beneficial long-term.

The urge to sell in the valley can be dampened by both developing and maintaining a long term focus. While equity assets generally experience greater performance swings than bonds over short time frames, their returns tend to smooth out over longer time horizons.

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The above chart shows annual returns to the major asset classes over 2001-2015. As you can see, each asset class experienced a wide range of annual outcomes over the period. The legend in the bottom left hand corner provides perhaps the greatest evidence of the benefits a long term perspective can bring. Even though the economy experienced two recessionary periods (2002 and 2008) over the measured timeframe, each of the asset classes shown produced a positive annualized return.

While the major indices have taken a more circuitous route to get to where they are at present, there are still plenty of reasons to for the disciplined long term investor to be excited. Regardless of what point we are at in the market cycle, an investor who maintains a long term focus will both be prepared for the opportunities presented by volatile markets and a beneficiary of market upswings.