It was a brutal start for stock investors in 2020. February and March saw some of the worst one-day point drops in the Dow’s history. April may be just as volatile. As bad as it is, there are lessons we can learn from the recent stock market downturn that can help us in the future.
These lessons, or themes as I call them, have popped up before in past bear markets. Investors are wise to learn from their mistakes. Here are five lessons, or themes, I’ve learned from my 20 years of managing clients through past stock market crashes:
1. Asset allocation does work
I find many investors don’t spend enough time getting the right mix of stocks to bonds. We call this asset allocation. That is a mistake. All the major equity markets were down for the first quarter, but U.S. Treasury bonds held up. Lesson learned, spend time on your asset allocation. Make sure your mix of stocks and bonds is appropriate for how much risk or downside you can stomach. There are several online risk calculators that can help. My firm uses stress testing software to see how a client’s portfolio behaved in past crashes.
2. Diversification can work too
So far gold did well when the stock market didn’t. We saw this in 2008-09 as well. That may not always be the case, but gold does have a history of shining at the right times. True, gold does have its disadvantages, namely it doesn’t pay dividends and there are costs to owning it directly. The point is diversification — owning different assets that hopefully perform differently — can smooth out the overall return over time. The table below shows how a diversified portfolio performed over the years. Notice the diversified portfolio (in the white boxes below) is never the best nor the worst performer: Its performance has always fallen somewhere in the middle.
Figure 1
3. Not all bonds are created equal
Many investors — and portfolio managers — stretched for higher yields and bought riskier bonds. Riskier bonds didn’t behave like bonds on the way down, however, but more like equities. In times of extreme market duress and panic selling — risk off , as we call it in the industry — the only bond that has held up is the U.S. Treasury. My advice: Make sure your bonds are bonds and not equities.
4. Hedging strategies can help
Owning some downside protection is appreciated in market panics. Institutional investors know this. That is why many of them hedge their positions. One type of hedging involves holding stocks — we call this being “long the market” — and “shorting” a small percentage of the market. Shorting hopes to profit when the market falls. Hedging is costly, involves risk and often limits your upside. It is not for everyone. However, most long-short equity strategies did hold up during the downturn. For this reason, I may recommend a small percentage of a client’s account be invested in retail long-short equity mutual funds.
5. Guarantees are appreciated in market downturns
In times of great uncertainty, when panic overtakes us all, and the toilet paper is missing from the shopping aisles, it is reassuring to have some guarantees in life. Recently when the Dow lost almost 13% in one day, I was grateful my whole life insurance has a guaranteed account, that is peace of mind.
I am also grateful my clients owned annuities with guarantees. Some annuities provide guaranteed income, while others a guaranteed return. Either way, guarantees are nice to have in times of extreme market panic.
Final thoughts
There are many lessons learned from the recent stock market sell-off. These five have helped me get through past bear markets. While I can’t guarantee what the next bear market will look like, there is a good chance these five themes will pop up again. It’s like that old adage, fool me once.
