How to Invest During a Financial Crisis
The credit crunch now facing the financial system has led to a bear market in stocks, and is pushing the economy into recession. These are the most stressful of financial times, when it is most important to stick to the fundamentals of an investment strategy. So here we review some of those basic tenets, in the context of today’s headlines.
Our clients have investment policy statements that outline their specific financial objectives and asset allocation. Most portfolios have some exposure to stocks, which represent the volatile, long-term engine of growth. We expect, over long periods of time, stocks to produce annualized returns of 8-10% and provide the basis for wealth building. For investors with a truly long-term horizon, even a 100% policy in stocks can be appropriate.
Classic investment texts like Winning the Loser’s Game and Stocks for the Long Run make the case for long-term stock investing, but the emphasis must be on the long term. As the last year has made obvious, stock investing is not a short-term capital-protection strategy, it is a long-term wealth-building strategy. The point is to ride out the cycles and end up with more wealth at the end of relatively long periods of time (at least a decade or more). One’s starting point can be important: getting started just before a bubble bursts (like in 2000) is less profitable than investing after a bubble bursts (like right now).
Today’s market troubles demonstrate once again that the social context for investing conditions financial returns. In the second half of the 20th century the Marshall Plan, nuclear non-proliferation, environmental regulation, reductions in employment discrimination and the end of the Cold War underpinned strong long-term returns. In the current decade, ill-conceived foreign policy has combined with poor regulatory oversight to create market conditions that are much worse than they should be. Investing in “risk assets” like stocks is best combined with good governance that supports sustainable economic growth and lowers systemic risks. If nothing else, the current disasters should lead to a fundamental change in the U.S. approach to foreign and domestic policy — in and of itself this would improve the market outlook.
While this feels unprecedented, in fact extreme stock market corrections are relatively frequent. The last one was earlier in this decade. In the 12 months ending in March 2003, the stock market declined 25%. The Iraq war was on the horizon and investor fear was comparable to current conditions. Over the ensuing year the market rose 35%.
This is not to say we are currently bullish on stocks. After a long period of optimism on the equity market (that started in 2003), we moved to a more neutral position at the beginning of this year. We became more cautious on energy, materials and banking stocks, all of which have been correcting sharply. While we thought in March that the market might be bottoming, we resisted moving to a more bullish position. Had we better anticipated the extent of the financial crisis that has now unfolded, we would have become even more defensive. Even so, within our disciplines that would have meant keeping some exposure to stocks for the long run if consistent with client policy statements.
Many of our clients have policies that mix stocks with other, less volatile assets. In this case, stock exposure targets can be 20%, 40%, 60%, 80%, or something in-between. We typically allow for some variation, with our clients giving us the discretion to tilt portfolios over time toward or away from stocks. But the key to long-term investing is to stay in the markets consistently, as dramatic market timing (pulling money in and out of the market on a short-term basis) has proven to be a losing strategy.
The “ballast” in a balanced portfolio that is not targeting 100% in stocks usually includes fixed income instruments such as bonds, CDs, and money market funds. Why include these investments in a portfolio? Precisely for times like these. No doubt, many corporate bonds (especially in the financial sector) are falling in value in this bear market along with stocks, but they tend to be less volatile over time. Fixed income investing can be thought of as a form of insurance. In this case, we are “buying” an expectation of some financial protection in a downturn, with the cost being lower long-term returns. We expect bonds to return (pre-tax) 5-6% in the long run, and cash 3-4%. The shorter the investment horizon, the more client policies are tilted toward fixed income investments and away from stocks.
When markets panic it is tempting to be an aggressive buyer on the premise that panics make for mis-priced assets. We take a more tempered approach to such opportunities. After a significant correction such as this (and it may not be over yet), client portfolios will often have levels of stock exposure that are well below their equity targets. Therefore, we will be doing some purchasing of stocks simply to keep clients closer to their policy targets. Buying “low” after a sell-off in order to move to investment policy targets has proven to be an important component of a long-term wealth building strategy. It is the hardest time to buy, but often the best for the long run.