Almost every day in the investing world, you hear the terms “bull” and “bear” to describe market conditions. The origins of these terms are unclear, but one explanation is that they come from the way the animals attack their opponents. A bull thrusts its horns up into the air while a bear swipes its paws down. If the trend is up, it’s a bull market. If the trend is down, it’s a bear.
In early March the current bull market celebrated its seventh anniversary and it is now the third longest in history. APCM does not expect a bear market based on current conditions. The recent spike in market volatility after several years of calm has resurrected apocalyptic headlines and has some investors feeling as if a mattress, freezer or sock is a viable investment strategy.
Saving and investing is particularly challenging because as humans, we have a strong tendency to prefer avoiding losses over acquiring gains. So naturally, the recent bout of volatility has investors wondering how to prepare for the inevitable bear. But, like most things in life, there is always a tradeoff. With every decision we make we face an opportunity cost, sometimes these costs are too high.
Sock It Away
A sure way not to lose money, right? Unfortunately, wrong. Inflation causes money to lose value (or more accurately purchasing power), and nearly all investments are subject to this risk. Although the record inflation of the 1970s is history, inflation is still a reality and has averaged 1.5% per year since 2009. As a result, if $200,000 was socked away in 2009, it could only purchase the equivalent of $180,000 today. While maintaining liquid savings or reserves might be necessary, if your time horizon is long the opportunity cost of lost purchasing power could be significant.
Time the Market: Sell High and Buy Low
While timing the market is alluring and sounds easy, it really is difficult. Often many investors end up doing the exact opposite – buying high and selling low. In 2014, the S&P 500 delivered returns of 13.7%, but the average equity investor as measured by Dalbar gained just 5.5%. Even if you do correctly time your exit and get out before a decline, many investors often miss a substantial portion of the subsequent rebound (which tend to be front loaded). This inevitable opportunity cost can impact your ability to achieve your investment goals.
Investors who are focused on capital preservation can buy insurance in the form of long dated put options. A put option allows the owner the right to sell a security at a predetermined price. When prices fall below the predetermined strike price, investors can prevent additional losses by exercising their options and selling or “putting” their shares.
Although this type of downside protection can work very well, it can be extremely expensive and its success also varies based on timing. Additionally as the pricing of options varies with market conditions, often the time in which you seek insurance is also the time in which it is very expensive. Ultimately the opportunity cost in this strategy comes in the form of reduced returns in order to pay for the insurance.
Diversify your Assets in Accordance with Time Horizon and Risk Tolerance
At APCM, we recognize the value in focusing on asset allocation as it is the primary driver of returns. There are a variety of factors that determine an appropriate asset allocation, but the two most important are time horizon and risk tolerance. With a thorough understanding of these factors and armed with reasonable market expectations, an investor can be confident in their investment strategy. By planning in advance and selecting an appropriate asset allocation it is possible to accept market volatility without worrying about falling short on your investment goals. The opportunity costs of only planning for bad outcomes by hoarding cash, timing the market, or constantly buying insurance are too high. In the long-run it’s simply better to stick with the plan.
Brandy Niclai, CFA®