P is for Prudence

​During the second half of 2017, I spent a lot of time with clients walking through annual market reviews. I would like to share some of the insights that have come out of those meetings. There are two broad areas of focus: investment implications and personal finance implications (or, as I like to think of it, regular old life implications). 

​Investment Implications
 
The market data I shared with clients this year brings us to one inescapable conclusion: US markets are very highly valued based on historical measures. For example, take this chart from Advisor Perspectives, which illustrates the CAPE (Cyclically Adjusted PE – a measure of how expensive the markets are based on 10 yr average earnings):

Based on this metric, valuations have only been higher during the tech bubble and just before the great depression. When talking about this type of market data, it is important to keep in mind that these types of metrics are very poor timing indicators. However, they do have a decent record of foreshadowing 10 year stock market returns. And the historical data indicates that our expectations should be lower for the next decade for US stocks. Perhaps in the 3-5% annual return range, vs. the 10% return we have historically experience from US stocks. (see here for more info on CAPE and returns).
 
Given that we cannot use these metrics to predict the next market crash, what is it good for? Here is a sampling of the types of things discussed with clients:

• If expected returns are subdued, should we save more?
• If US markets are expensive, can we tilt towards International markets that are cheaper?
• Given the low returns, and the historical tendency for these types of valuations to be resolved with a market drop of some sort, should we change our allocation to make it more conservative?
• Would this be a good time to take some chips off the table? Many people have private investments in things like rental real estate or venture capital. Given the historically high value of these types of financial assets, it might be good to consider selling while the market is strong. This would be particularly applicable to any highly speculative assets you may have (bitcoin anyone?).

 
These are not binary options – despite what the financial press would have you think. You do not need move to 100% cash when market risk is elevated. You can simply “tilt” a little more conservative based on current market conditions. A correctly constructed diversified portfolio is designed to take advantage of market volatility.
 
Given the long bull market, we should not be surprised by the next downturn. After almost 9 years of very solid US returns, we should be prepared for a correction. Anything can happen, and the market could well continue to advance from here, but history would guide us not to be surprised by a correction in the near future. It is important to re-think our tolerance to withstand a drop.
 
Let’s take a hypothetical example of an investor who was 30 in 2008, she was lucky enough to have accumulated $100,000 in her IRA at that point in time. The prospect of a 50% loss on her investment would have meant $50,000. She may well have been able to “re-save” that amount in just a few years. Fast forward to today, and if she has $500,000 due to diligent saving and good investment returns, her 50% loss represents a much larger absolute amount - $250,000 - which could take many years to “re-save”. She could understandably have a much different view of risk even if very little of her situation has changed in the intervening years.
 
Personal Finance Implications
 
Although investing strategy is important, most of my conversations with clients focused on topics outside of investing. Market drops don’t have a tendency to happen in isolation, they are usually accompanied by recession or some other major event. As a result, your preparation outside your investment accounts is often more important than your investment strategy. Here’s just a sample of the type of issues addressed by clients:

• If market returns may be lower, would funds be better used to pay off debt? Not only do you get a guaranteed return equivalent to the interest you were paying, but you also get increased financial flexibility now that you have lower monthly debt payments. (Here is a recent post on paying down your mortgage).
• Would it be advisable to increase the amount of emergency funds we have on hand? This is particularly important for those that might be subject to layoffs in an economic slowdown.
• Should I bolster my career? Additional certifications, or valuable work related experience could make your job much more secure if there is any downturn.

 
Again, these aren’t binary decisions. You don’t need to pay off your mortgage in total, or sell the cabin you inherited from Grandma. But to the extent that you can, you may want to manage your finances as prudently as possible. Making sure you are financially and emotionally prepared for a more volatile future would be a good exercise as we enter the new year.