This is a field manual of sorts.
COVID-19 is here. now how do you invest in the wake of the 2020 Crash?
I’ve looked at hundreds of investment portfolios, and I’ve gone through the materials most advisors have used to create them (speaking generally of course). Occasionally, I’ll see an account statement or a portfolio model that stands out, but most of the time, they all look about the same. While I take a different approach than most, I feel the need to share some important information that will help your portfolio recover. If you’re already a client of mine, this won’t apply, but if you’re in the 90% of people with the same general allocation… Go get your statements… Listen up.
Take Out the Trash
One of the biggest mistakes financial advisors make is assuming that the quality of your investments doesn’t matter as long as the portfolio as a whole seems ok. We can get into how Modern Portfolio Theory and the Efficient Market Hypothesis became twisted around since their development in the 1950’s & 60’s, but that would take a book (if you have questions, We would be happy to talk with you). Financial Advisors have been taught that the only risk that matters is the volatility of your portfolio. There are other, more severe, risks to which you’ve probably been exposed—all in the name of diversification.[1]
Look at your statement: You’ll likely find several investments with the terms: “high yield,” or “high income.” (on occasion, they will label these as income “opportunities”). These are called “junk bonds,” officially. They are “below investment grade” loans made to governments, corporations, and municipalities with particularly poor credit. They pay a high interest rate because they have more significant default risks. In good times, it’s an unwise financial decision to lend money to someone who can’t pay it back. Why do we do this in our investment portfolios? (FYI, because their price moves differently that “stocks” is a dumb answer.) You don’t need these to be diversified, and the times of crisis, in which bonds might help stabilize your portfolio, will certainly increase the risks that your borrowers won’t make their loan payments. If they don’t, you lose 100% instead of the 10, 20, of 30% you were trying to avoid.
Highlight these on your statements, sell them, and NEVER buy them back.
Walk Tall
By “walking tall,” I mean get rid of your “short” funds. These are investments that make money when the stock market declines. These are generally a gamble and are among the rare investments that have unlimited losses when the market goes up in value. It’s well established fact that the stock market increases over time, so these are poor long-term investments. If you have them, they served you well in the recent drop, but as we approach the end of the decline, you’ll want to trade them out.
Bring It Home
The impact of the COVID-19 outbreak will hit developing nations much harder that it will the United States (and a few other countries with highly developed economies). Most people own “emerging markets” mutual funds, ETFs, or even index funds. These are higher “risk” investments (read: more volatile), and actually have much higher risks (political risks, stability of the business themselves, Currency & Trade risks, etc.). Advisors keep these in your portfolio to be open to the opportunity that could arise if one country experiences rapid economic growth. Most people, however have a few funds that just own other funds focused on every country around the globe. These have been hard hit in the midst of COVID-19, and they will continue to lose value longer then that United States, and won’t recover quickly.
I’ve always believed with conviction, that if you have a significantly high probability of losing money on a given investment, it’s best not to own it. Like Junk Bonds, these don’t add much of anything to your diversification and they certainly won’t help your portfolio in the coming months, perhaps years. It’s time to move to investments primarily based in the United States.
Take a Focused Approach to Risk Management
Most people have a number of “index” funds in their portfolio. An “index” is just a fancy way of making an average. Indexes include a defined set of investments, usually weighted by size. They became commonplace in the 1960s when William Sharpe decided that they would be an effective way to measure covariance (at the time, measuring covariance of individual investments would have been impossible to consistently do by hand). They were never intended to be an investment, but became a staple in the 1990s and early 2000s. As quickly as they became popular, it became clear that indexes were anything but efficient and simple adjustments could almost ensure superior results. There are dozens of approaches, but they all perform a similar function: eliminate the investments that are clearly below average. Owning the index creates reasonably good returns, especially when times are good, but exposes your portfolio to the below-average investments you would probably never choose to own. For example, the Russel 3000 contains approximately 90% of publicly traded US companies. Owning the Russel 3000, you’ll undoubtedly own a number of small, poorly-run companies that will struggle to recover from the impact of COVID-19.
Instead of owning indexes, focus your portfolio around high-quality investments that have been resilient for many years, and have done well though other difficult times. Most of these will be mature, dividend-paying companies with long track-records of increasing their payouts. I would encourage you to work with your advisor to determine appropriate investments.
Shift Your Bond Allocation into Stocks
While staying within the bounds of your investment policy, you should reallocate from your expensive investments to those that you can buy for a bargain. At present, interest rates are almost impossibly low, which means the price of fixed income investments has risen, or at least has declined less than stock investments during the recent crash.
Let’s say you are invested in a portfolio that is 60% equity (stock), and 40% fixed income. If stocks stand to gain 40% in their recovery and bonds stay about the same (or decline as a result of rising interest rates), it is the perfect time to capture more of the recovery by shifting some or all of you fixed income investments into equity. By doing so, you would add a significant amount to the total return of your portfolio.
In doing so, it is important that you maintain the diversification of your portfolio. This means identifying investments that don’t move in similar fashion to one another. We’ve generally, and wrongly, assumed that bonds diversify stocks. Often times, they do. They also frequently don’t. Consider the following example: You own 100 shares of stock in the fictitious company CRP. They also owe you money because you own CRP bonds. If CRP loses revenue, the stock value declines. CRP will also have a harder time paying its debt, so your bond will lose value as well. Owning a stock and a bond make sense when the two have low “covariance” (their price movements are unrelated). This is a question of how closely related their price movements are, not whether it is a stock or a bond.
What About Now?
At the time of my writing, it appears that the S&P 500 is near the end of its decline. Its price dropped about 35%, factoring in an economic decline for the quarter of apocalyptic proportions. We would have to see a 80% slowdown in corporate profits over the next 4 months to justify the drop. While the reaction to COVID-19 has been extreme, it will not cause this level of catastrophe. Investments could continue to lose value, but are already at historic bargains. Now is the perfect time to begin preparing yourself to take advantage of the recovery.
We strongly advise working with a qualified investment
professional when evaluating your investment decisions. A CoCreate Financial advisor is prepared to
help you make the right adjustments to your portfolio in times of crisis and
have solutions designed specifically to make the most out of the COVID-19
recovery.
[1] Note: Diversification should have never been translated into “owning everything.” Being diversified means owning enough investments whose prices fluctuate independently (low “covariance”) of one another in such a way that the short term price changes in a single security will have a minimal effect on the overall value of the portfolio.
Investing involves risk in any market conditions. Your investments cannot be guaranteed and may lose value. The recommendations made above should always be considered in consultation with a qualified professional and account for your individual circumstances. These recommendations are given generally and should not be interpreted as individual investment advice.