With any crisis in life, there are always lessons to be learned from the experience, especially during such an unprecedented time as what we are living through right now. Between what I've read in the news the past few weeks along with the countless conversations and discussions with clients, family and friends, I've seen a common theme emerge concerning what the COVID-19 crisis has been revealing to many regarding their financial state of affairs.
Lesson #1: Diversification isn't just an overused financial term
Unless you are living under a rock, you have likely heard the term "diversification" used by a variety of financial experts. Unfortunately, it's not until the stock market takes a hit like it has recently that people begin to truly understand what diversification actually means, especially if and when they realize they actually weren't diversified to the extent that they thought and now their investments are down 30%.
Financial institutions may tell you that you are diversified when in fact what they likely mean is that your investments within the stock market are diversified among a varying list of companies and industries (such as in a mutual fund). This is different than the kind of diversification I am talking about. When I talk about diversification I am referring to the process of investing in a variety of opportunities, especially those that are not correlated with the stock market. When the stock market suffers great losses, then that means mutual funds, individual stocks and bonds are all affected. If you only have all of your investments in those three areas then you are at risk for losing money as many have experienced these past few weeks.
As the saying goes, "Don't put all your eggs in one basket". I almost always advise our clients to invest a portion of their money in other areas outside of the stock market such as real estate related investment funds, private equity, private debt, and energy just to name a few. These alternative investments aren't impacted in the same manner that the stock market is and although they have their own risks or periods of decline, clients could be in a better position if they invest their money in both alternative investments along with the stock market. A discussion with your advisor will help determine which alternative investments are suitable for you based on your situation.
Lesson #2: Your risk tolerance level may be lower than you think
Most people have a general idea of how conservative or risky they are comfortable being when it comes to their investments. However, what I've found in speaking with clients over the last few weeks is that even some who previously considered themselves on the riskier side of conservative, are finding that perhaps they prefer to be more conservative than even they realized. Of course, what we are experiencing is not a typical situation and can cause even the most confident investors to question their investment strategy and risk level. And yet it's also a reminder that historically we have been faced with unexpected circumstances every decade or two that have caused severe market corrections (i.e. the Great Recession in 2008 causing the worst market conditions since the 1930s and the terrorist attacks of 2001 just to name a few). The bottom line is that there are going to always be extenuating circumstances that occur so you want to ensure your risk level is adjusted properly based on those assumptions.
A very efficient and effective way to determine your risk tolerance level is through a software program that can calculate it more precisely. The program I use assigns a potential range of returns within a six-month period based on the historical performance of a specific asset (both the upside and downside). It then calculates a risk score to an account and to an entire portfolio. The software rationale assumes most people get nervous during volatile markets and begin wanting to make changes to their investments within 6 months, regardless of their original long-term plans. Although the results are not the only measure that should be used when analyzing risk level and how a client's portfolio is positioned, it's an extremely helpful tool.
Lesson #3: Investments are for the long-term
Every financial professional will tell you that past performance is no guarantee of future results. While this is absolutely true, historically speaking, investments in the stock market generally have a higher return over time than fixed-income investments. The downside to these higher returns is that stocks can also be more volatile over short periods and may lose substantial value. That is what we are seeing now. But it’s important to remember that one fundamental thing has not changed. You have to remain invested for the long term in order to earn the higher returns available in the stock market.
Many people try to “time the market” only to end up frustrated that as soon as they sell, the market finally goes back up. Occasionally someone may get lucky but most of the time, the stock market, just like life, is unpredictable enough that timing the market is just risky business. I cannot stress enough the importance of a long-term perspective when it comes to your investment strategy.
Lesson #4: Sometimes selling at a loss is better than waiting for a bounce back
Even though I almost always recommend sticking with your long-term strategy, there are still times when selling at a loss may be better than waiting for the market to “bounce back” so that you can recoup your losses.
For example, if selling at a loss provides an opportunity to reinvest in something that has a greater likelihood of bouncing back at a higher rate of return, then it may be worth the loss to obtain the greater gain. Of course, this requires a lot of personal analysis with your advisor to determine if it makes sense. But the lesson here is to be flexible because even though it might be hard to sell at a loss, it could prove more beneficial in the long run.
Lesson #5: Fees are worth it if it can protect your money
I occasionally have clients that are fixated on the fees associated with their investments. Although many people do not like the idea of fees, it’s important to understand the value associated with those fees. For example, one client preferred to keep her money in her company 401K rather than move it to a managed services account such as Frontier Asset Management. Managed services accounts do have fees associated with them, however, one of the services they provide is that they are constantly managing and adjusting their portfolios to ensure the best rate of return. As a result, when the stock market takes a big decline a managed service account could be less impacted than a 401K plan. In the case of my client, the amount she would have paid in fees over the last year would have been significantly less than the amount her account went down when the market dropped.
There are times when I may suggest to a potential client that they would be better off managing their own funds through an online account that has minimal fees, especially if the fees associated with working with an advisor outweigh the benefit. However, the larger your account, the more necessary an advisor becomes, especially if you want access to alternative investments which are not obtainable on your own through an online service.
For almost every hardship we face in life, there are lessons to be learned and skills to be developed. Don't let this season pass you by without learning from the experience. Sometime in the next 10-15 years, if history continues to repeat itself, we will likely face another financially crippling event so learn from this one in order to be better prepared for the next one. Use this season to refine your investment strategy, adjust your risk level and plan for the long-term.