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Uncertain Markets Highlight the Importance of Diversification

Uncertain Markets Highlight the Importance of Diversification

With the U.S. stock market hitting all-time highs, followed by downdrafts and increased volatility, we are getting some questions about the timing of and preparation for the next major market pullback. As we all know, stocks don’t always go up and the previous decade included the tech bubble (2000-2002) and the financial crisis (2007-2009). These were two of the worst declines in the last seventy-five years.  No wonder people are anxious.  No one wants to go through another decline like that.

As always, when we tune into the “market experts,” we hear some strong opinions. Unfortunately, or fortunately, these forceful opinions often contradict.  I say fortunately because it reminds us of the folly of market timing.  People who watch the markets second-by-second and have opinions based on either intuition or sophisticated algorithms, are often wrong. Many observations are coincidental and many others have the basis of their correlations evolve and change over time.

One of the best predictors on the direction of the stock market in the sixties and seventies was whether an old National League team won the Super Bowl.  If I remember right, this predicted something like 17 market swings out of 19. Thankfully, with the emergence of the New England Patriots over the last decade, this indicator lost its effectiveness, but if still valid, Philadelphia’s showing would indicate a higher stock market for 2018.  This silly correlation shows how many things may be coincidences instead of causal or leading to market swings.

No one knows where the markets are going, how long trends are sustained or when we will hit tipping points that cause the markets to reverse direction.

But what do we know? First, we do know that time has been the friend of the stock market.  We believe risks of permanent impairment are greatly reduced by longer investment timeframes.  Over time, the biggest risk an investor faces is selling stock at the bottom of a market cycle either to meet cash needs to live or to alleviate the stress of watching their stocks retreat.  Over the last thirty years, the total return of the stock market has provided a compound rate of return of over 10% annually.  For the same thirty years ending December 2017, the consumer price index (CPI) has advanced 2.6% annually.  Stocks have provided a real return of almost 8% a year.  Unfortunately, stocks don’t advance like clockwork and too often go down.

So that brings us to the second thing history has told us. Stocks and bonds have different risk characteristics.  Bonds tend to provide more modest returns over time but tend to be less volatile than stocks.  Additionally, when looking for true diversification, you don’t want to just find asset classes that are not correlated; you ideally would want to find asset classes that are negatively correlated. In other words, you want to find an asset or asset class that often holds its own when your stock investments are sliding.  Bonds and, particularly in the United States, Treasury bonds have exhibited that characteristic.

So bonds should be selected first to provide a source of liquidity in adverse stock market environments, second to provide principal protection when the stock market goes down, third to provide income and finally, through the combination of the first three, help provide peace of mind.  Here is where your financial advisor can be the biggest help in determining your asset allocation, asset placement between qualified and taxable portfolios, and the right type of diversification for you.  

A plan that addresses cash needs, timeframe, tax implications and risk tolerance can be the right plan for you. That is where your financial advisor can really add value.

Disclosure: Past performance is not indicative of future results.   All investments involve some level of risk.  Diversification does not guarantee investment returns and does not eliminate the risk of loss.

Article Topic Expert: Tom Plumb

Thomas G. Plumb is the President/CEO of SVA Plumb Financial, LLC, and SVA Plumb Wealth Management, LLC. He is also the CEO of SVA Plumb Trust, LLC. He serves as manager for many SVA Plumb client portfolios. Tom has over thirty-five years of experience in the investment advisory industry, having served as a trust investment officer, lead manager and president of two mutual fund companies, and primary portfolio manager for many institutional and high net worth portfolios. He has been quoted in the premier investment publications such as the Wall Street Journal and USA Today, appeared on CNBC and CNN financial television programs, He provides a unique perspective to the investment markets.

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