October 2, 2020 | Stock Market
Today, let’s talk about market drops and how we can position ourselves to respond during periods of market volatility and stress.
We do not know (nor does anyone know!) when the next drop will come, how long it will last, or how severe it may be. However, just like the proverbial “death and taxes,” we can be confident that we will experience another drop at some point in the future.
Over the past few months, our investment committee, led by LifeGuide partner Zak Lutz, has been hard at work refining our strategy for addressing periods of extreme market volatility like we experienced earlier this year. The result of their work is the next generation of our Buy the Dip Progression (BDP) and Sell the Recovery Progression (SRP) strategies.
We’ve got Zak here to share more with you. (Note that the video below was produced for the August 2020 edition of Guidepost, our monthly client newsletter.)
A quick note at the top: Unless you are a self-proclaimed, die-hard financial nerd (and we know most of you would not identify as such!), we’ll save the background theory and research and instead share some of the overarching principles behind these strategies. If you are interested in the theory and research, just contact us and we’d be happy to give you a deeper dive!
At its core, our BDP and SRP strategies are built on the primary assumption that stocks will continue to go up over the long term even though they experience periods of decline. If stock prices will presumably trend up over the long term, it does not make sense to attempt to predictably time the top.
It does, however, make sense to systematically anticipate the bottom.
So, if we believe that the stock market will continue to increase over the long term, then we must also believe that stock prices ultimately have a floor during periods of decline. Therefore, should the market dip like we saw this past March, our BDP/ SRP strategies aim to temporarily increase stock allocation in steps at predetermined market levels on the way down (i.e. “buy the dip”). We do this expecting stocks will eventually recover and continue their upward trend over the long term.
Buying at discounted levels gives us the opportunity to sell back these over-weighted stock positions on the way up (i.e. “sell the recovery”), hopefully at a profit.
One way to visualize the dynamics of a market drop is to imagine a life preserver floating on water. As you push the life preserver down under the water, the force pushing back up against your hand increases the farther down you push until, eventually, the life preserver pops back up to the surface. In a similar way, as stock prices fall, an increasingly powerful upward pressure is exerted on them as markets drop to lower levels.
In practical terms, this means that diversified stock funds get less risky the lower they’re bought.
(Note: These principles apply on a macro, not micro, level. The above analogy does not necessarily hold true in the case of picking specific stocks or sectors as individual companies and sectors can go bankrupt or be permanently impacted.)
Many forces apply “upward pressure” on the market during times of stress to create price floors. These forces have caused stocks to recover over reasonable periods of time, such as:
Treasury bond funds (the bond positions in many of our portfolios) typically go up during times of market stress as investors “run to safety.” This can magnify the effect of the BDP/SRP strategy by selling bonds when they are higher to be able to buy into stocks when they are lower.
In other words, the farther down stock prices drop, the better the risk/return equation of buying additional stocks by selling bonds or investing available cash becomes.
After we Buy the Dip, we prepare to “Sell the Recovery.” Once the market recovers and stocks return to a more normal risk/return profile, the forces listed above subside and there is no longer the increased upward pressure on stocks. Therefore, it is prudent to buy back into our targeted level of bonds to increase the level of stability in our portfolio.
Just as emotions can cause us to make unwise decisions as the markets decline, they can also work against us after the markets have recovered. Greed can set in and we can convince ourselves that “now isn’t the right time to sell.” Therefore, it’s important to establish predetermined selling thresholds to help us make strategic, prudent decisions.
In summary, our Sell the Recovery Progression aims to:
We believe that having a comprehensive Financial Life Plan and corresponding principled investment strategy are foundational to achieving financial success.
This is especially true in times of market volatility when emotions can run high and fear can prevent us from making wise decisions that enable us to take advantage of opportunities and avoid pitfalls. Consistent with LifeGuide’s third investment principle, these strategies are contrarian in nature. That is, they run counter to the natural inclination to “abandon ship” during market drops and hop back on board as the market rises. Yet our research has convinced us that periods of large market drops provide rare, contrarian opportunities for long-term investors.
As with any investing strategy, our BDP/ SRP strategies are not without risk of loss. However, these strategies represent some of our best thinking with our team putting in many hours of research and analysis.
As part of our comprehensive services here at LifeGuide, we develop a specific investment strategy to support your goals and values as identified in your personal LifePlan. Don’t hesitate to reach out to your advisor if you would like to explore if implementing a BDP/SRP strategy is right for you.
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