Well, that was a bit unnerving. Last week the stock market took a pretty good dive and investors were shaken alert. The drop, as measured by the Dow Jones Industrial Average, was about 1,300 points or 5%. That qualifies as an official “pull back.” The market quickly stabilized and closed Friday with a modest gain.
Why, you might be asking, did it happen? The short answer is rising interest rates. The Federal Reserve has been systematically raising interest rates over the past two years. The most recent quarter-point increase in the discount rate in September finally pushed the yields on several benchmark US government bonds to levels that left investors questioning the riskiness of stocks. The thinking goes like this. If I can invest in an essentially risk-free US government bond that will yield 3% or more, why would I invest in risky stocks that have dividend yields that are virtually the same?
At Springwater, we’re not particularly concerned about this recent bout of market volatility. We see an investing environment that is still quite compelling. Interest rates, while higher than they’ve been in a number of years, are still at historically low levels. Unemployment has not been this low since the 1960s. The Tax Cuts and Jobs Act of 2017 has fueled business investment and increased household consumption. The economy is growing at a strong pace. Inflation remains muted, with the Labor Department reporting in September that costs, excluding food and energy, were up an annualized 1.8% over the past quarter. The US dollar remains relatively strong, boosting American purchasing power overseas.
So, while we remain alert for a major market correction, we don’t necessarily see a big storm on the horizon. However, we do think this is a good time for investors to make sure that their asset allocation is appropriate. We would suggest that there are three perspective you should apply to this assessment.
First, what is your ability to take risk? This is largely a function of your investment time horizon. Why? Because, if your horizon is short (less than 5 years), you should invest asset classes that are not tied to the stock market (like cash, money market funds, and short-term bonds). If the stock market drops, it can take more than 5 years for stock prices to recover. If your investment horizon is intermediate (say, 5-10 years), you could consider bonds and well-established stocks that should experience a complete market cycle (peak to trough to recovery) within 5-10 years. If your time horizon is long (10 or more years), you can appropriately invest in riskier stocks that experience market cycles that are longer and deeper.
By the way, we can relate this to our discussion of investing “buckets” from a few weeks ago. The short-term funds, intermediate-term funds and long-term funds all go into different buckets. These buckets are, in turn, invested in horizon-appropriate asset classes. All of the buckets, combined together, make a properly diversified portfolio.
The second perspective on asset allocation corresponds to your willingness to accept risk as an investor. Think of this as your emotional disposition toward investment risk. It is possible to measure this and at Springwater we use a third-party psychometric tool to do so. We can determine the degree to which an investor will be comfortable investing in the stock market. We might learn, for example, that you would be comfortable with a portfolio that has a 60% exposure to the stock market. If we put you in a portfolio with 60% or less allocated to the stock market, we would expect you to be comfortable throughout the swings of a market cycle. However, if you were invested in a more aggressive portfolio, a market downturn would leave you feeling very uncomfortable. We would point out that an investor’s tolerance for investment risk is not directly correlated to gender, age, education, etc.
The third perspective on asset allocation is related to your economic “need” to take investment risk. Some people are in the rather envious position of having more money than they can reasonably spend over the rest of their lives. These people do not “need” to take any investment risk. They can put their money in the bank, their mattress, or an underground vault, where they will earn little or nothing and it will not affect their long-term financial security. Most people, however, need to grow their investments in order to meet their financial goals. Sound financial planning and modeling will reveal the extent to which you need to invest in the stock market.
So, asset allocation is driven by your time horizon, risk tolerance and economic need.