My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Summer 2022

Below are some strategies for coping with market downturns. Before getting to that though, it is fundamental to have an appropriate portfolio before the downturn occurs. That means not only properly diversified, but also one with a risk level that you will be comfortable with when the inevitable downturns come.

One very popular strategy is to simply don’t look at your portfolio. Most people, when they look at their portfolios, are happy when the value has increased and are unhappy when it has decreased. The magnitude of the change seems less important than the direction in determining how they feel. Therefore, to maximize happiness, most people should probably look at their portfolios less often. Here’s why:

From the beginning of 1988 (I don’t have daily total return data prior to 1988) through 6/28/22, the U.S. stock market (using the S&P 500 total return index still) has had an average annual return of about 10.5%. In other words, ignoring transaction costs and taxes, $10,000 invested at the end of 1987 in U.S. stocks with dividends reinvested would have grown to about $315,000 today. If you looked at your portfolio daily during this period you would have been unhappy about half the time, while if you looked annually, you would have been happy about 4 out of 5 times. Here are numbers:

Frequency of Looking	Happy	Sad
Daily	54%	46%
Weekly	58%	42%
Monthly	66%	34%
Annually	79%	21%

Ideally you could be both happy and informed, but in this case, there is a trade-off; knowing the current value of your portfolio frequently is likely to make you less happy.

Another key strategy is to have a significant margin of safety. In other words, spending significantly below your resources (relative to income pre-retirement, and relative to portfolio size post-retirement) gives comfort that in virtually all situations that you will be just fine. We probably don’t need to spend as much as we do. I’m going to make some book recommendations below so here I’ll mention Walden; Or, Life in the Woods (1854) by Thoreau or The Quest of the Simple Life (1907) by William Dawson for perspective on how much we need.

You can also rebalance your portfolio. (We take care of this for you if you are a client.) This means trimming portfolio holdings that have been doing better and purchasing more of relative losers. This is important in good times as well, and is difficult for people to do in both scenarios.

You might also add to your portfolio when the market is down. We wouldn’t recommend holding cash waiting for a downturn, but if you find you have excess cash it’s always a good time to invest (because expected returns on investments are always higher than cash, though realized returns may turn out not to be).

If you have holdings in a taxable (i.e., non-retirement) account you may also be able to tax-loss harvest. (Again, we take care of this for you if you are a client.) This means selling positions that have losses to reduce your taxes. There are nuances to this (e.g., wash sale rules) but it can be a good opportunity.

It can also be helpful to maintain a long-term perspective and be aware of market history – plus ça change, plus c’est la même chose! This is harder if you aren’t a financial professional as the time investment is probably unreasonable for an individual, but I would recommend you read The Rational Optimist (2010) for a much-needed counterpoint to the fear and panic that seem to feature in our society.

Finally, and this may be the very best recommendation, you could read books such as Man’s Search for Meaning by Viktor Frankl. It is difficult (and perhaps impossible) to read a first-hand account of the Holocaust and simultaneously worry about your portfolio size!

How should an asset allocation change over time? Most folks (financial professionals included) believe that the longer your time horizon the more risk you can take. That, as stated, is clearly wrong. Let me explain by way of an example. Assume an individual is 35 years old and inherits $1,000,000. He or she will not save any additional funds and at age 65 will annuitize for retirement whatever that sum has grown to. We will ignore taxes or other complications. Now, suppose that over the next 30 years, one year will have a positive 100% return (i.e. the portfolio doubles), one year will have a negative 50% return (i.e. the portfolio halves), and the remaining 28 years will each have a return of 6%. To maximize the ending value, what sequence of those returns would be best?

I have been asking that question of financial professionals in classes for about a decade now (I don’t remember specifically when I started, but it’s been a while). Almost never do I get the correct answer. Some just have no idea and guess, but most say you want the bad return first (when the portfolio is smallest), the 28 returns of 6% next, and the best return at the end (when the portfolio is largest). I then chide them (with a smile) for failing third grade math. It’s in the third grade that I think most students learn the commutive properties of addition and multiplication. Our problem may be stated mathematically as:

($1,000,000) x (2) x (0.5) x (1.06^28) = $5,111,687

The parenthesis are just there for readability. The point is that the answer doesn’t change if you rearrange the order of the terms (the items in parenthesis)! A x B x C = C x B x A! It also doesn’t matter what the returns are – any 30 returns will give the same ending value as the same 30 returns that simply occurred in a different order.

In other words, if our investor can’t afford the risk of a 50% loss the year before retirement, he or she also cannot logically afford to take such a risk at age 35 either – it’s the same risk! In the absence of cash flows, the time horizon is utterly irrelevant to the asset allocation decision.

Nonetheless, it seems intuitively correct to change the asset allocation over time to a more conservative one. And I think that is right, but it is for a different reason than commonly assumed. Few people have a lump sum as used in the example above. They are actually converting their human capital to financial capital over time. So we don’t have two buckets (stocks and bonds) but three (stocks, bonds, and human capital). A young person’s human capital (the present value of future wages) will significantly dwarf their financial capital in the early years. Assume for simplicity that human capital was equivalent to bonds (more on this below). Further assume that to reduce risk we want half our assets to be kept safe. But we don’t have human capital in cash and can’t implement this allocation in practice. Rationally, a 35 year old should borrow against future earnings to reallocate human capital to stocks. There are significant constraints to doing so however. What we can do is “borrow” by reducing the bond position much lower than we would if there were no human capital in play. Selling bonds is equivalent to borrowing. We can take the proceeds and invest in stocks to improve our allocation. So, because of borrowing constraints our hypothetical investor should perhaps be 100% stocks in their financial portfolio at young ages and this is not risky because of the enormous allocation to human capital that still exists. (Of course it’s still prudent in most cases to have an emergency fund – or perhaps a HELOC, a wealthy parent, or something similar.)

This assumes that human capital is bond-like. It probably depends on the career, but research indicates that human capital is generally more bond-like than stock-like. Traditional stock brokers and big-ticket luxury goods workers are correlated in their wages with stocks somewhat (but perhaps not ultra-luxury goods which may be uncorrelated or small dollar luxuries which may be negatively correlated), securities attorneys (who litigate) are negatively correlated with a lag (and I think high-quality advisors are too) but most folks are relatively uncorrelated in the short run (though in extreme cases such as the great depression equity markets and human capital may suddenly become highly correlated). In the long run if the economy grows 4% per year both pay and stocks will do much better than if the economy grows 2% per year. In addition, things like Social Security are more sustainable if the economy has been growing at a faster rate. So there may be very valid reasons not to lever up to extreme levels to buy stocks even when young, but overweighting stocks seems very prudent.

In short, time horizon doesn’t matter to your asset allocation, but your human capital certainly does.

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Spring 2022

There is no way to value Bitcoin or other cryptocurrencies (since there are no cash flows from it) so we are in the realm of uncertainty, not risk. Gambling has known odds (more or less, depending on what you are betting on) and a negative expected return (house gets a cut). Investing has estimable odds (again, more or less) with a positive expected return for bearing risk. Bitcoin has no assessable odds at all, just guesses (and hype and wishes). That’s not to say it won’t skyrocket (sometimes gambles pay off), there’s just no way to know or even estimate any odds or values.

Interestingly, there is still no significant use case for it still (blockchain technology, perhaps; cryptocurrencies, not really) which I find telling given the enthusiasm and efforts to do so. It’s like tulips (1636-1637) or Beanie Babies (late 1990’s) – you are betting that someone else later will pay more for it despite the intrinsic value being roughly zero, aka the greater fool theory. There are a lot of fools out there so a buyer might make money. It’s essentially a pyramid scheme (without the cash flows) – as long as the pool of buyers increases it works. There are a lot of people who don’t own it yet, so it could go on, but there are a lot of people who don’t own most things in the world and that doesn’t automatically make them good investments.

The supply of dollars increases at about 3% per year. Bitcoin at about 1.8%. So there is a little scarcity difference, but not a material one. Cash is enormously more useful. Yet you don’t see people suggesting that squirreling away $100 bills in your sock drawer is a good way to get rich. The objection to that argument would be that there is fear that central bankers could debase the dollar. That’s fair, but the supply of Confederate dollars has been fixed for about 150 years and it isn’t skyrocketing in value despite having historical value and few people owning them. The global gold supply also increases at roughly the same rate as dollars or bitcoin (precise numbers are harder to get), and it’s useful (jewelry, electronics, dentistry, etc.), yet the expected return is the inflation rate.

Buying a little bit (very little) to avoid FOMO, indulge YOLO, or whatever is fine, but realize that it’s much closer to gambling than investing. It’s also interesting to me that we only get questions about it when it has hit a new high, never at the lows. People are mostly just buying the momentum rather than anything fundamental – because there isn’t anything fundamental. Again, there are no cash flows to value, ever.

I did a somewhat related blog post about five years ago comparing gambling, investing, and insurance. You can find that here if you are interested.