How To Weather The Next Economic Downturn

moneyMy Comments: It’s again a question of WHEN and not IF. Despite the fact that most clients understand intellectually that markets go up and down, whenever there is a drawdown, emotion tends to overwhelm intellect. And it happens to me too.

For the past few months the markets have trended down. All the while, volatility, driven by both a slowdown in China and the uncertainty regarding interest rates and whether the Fed is going to finally make a move, creates an uncertain future for most of us.

The chart featured here suggests we are in for at least several more months of drawdown before a discernable upturn can be identified. Whether you can weather this economic downturn remains to be seen. While the comments reference institutional investors, there are parallels for you and I here as well.

Ben Carlson October 28, 2015

My colleague Josh Brown had an excellent piece in the most recent Fortune Magazine that asked a simple, yet loaded question:  Are You Ready for the Next Bear Market?

As we’ve seen from the seemingly never-ending market crash predictions over the past few years, no one really knows when the next bear market will hit. But we do know that bear markets are a natural outcome when you mix an uncertain future with human emotions that tend to take things to the extremes on the greed and fear spectrum.

Here are ten of the worst bear markets since 1926:

drawdownsI’m a huge proponent of thinking and acting for the long-term to be successful as an investor. But to be able to take advantage of the long-term you have to be able to make it through the short  to intermediate term.

As you can see from this chart, the time it takes to round-trip from some of the worst drawdowns, which can last for a number of years. On average, it has taken the stock market roughly 4-5 years to recover back to the prior peak. In my experience, these periods are where the majority of mistakes are made by investors.

One of my biggest realizations from working in in the institutional money management business during the financial crisis is that far too many organizations were unprepared for a severe market disruption. They didn’t understand what they owned.

It turned out that many of their portfolios were operationally inefficient. They didn’t have sufficient liquidity to survive or even take advantage of opportunities from the brutal bear market.

And the worst part is many organizations were forced to cut back their spending distributions from their portfolios. Many charitable organizations had to lay people off because of it.

One of the things I’m most excited about in my new role with Ritholtz Wealth Management is that I get to help institutions create investment plans that will give them a high probability for success during these situations. That means not only achieving their long-term goals, but also surviving severe market disruptions without compromising the organization’s mission.

Financial markets are a complex adaptive system, so the automatic response by the majority of institutional investors is a complex investment structure. These complex portfolios basically work until they don’t. And when they don’t work it’s usually at the most inopportune times.
With private securities, fund lock-ups and gates on investor redemptions there is no diversification benefit because you can’t rebalance to take advantage of market volatility. You become a forced seller elsewhere in your portfolio, which is a position you never want to find yourself as an investor.

My experience has been that the best risk controls an institution can implement to survive these serious market disruptions exist within a straightforward, transparent and sufficiently liquid portfolio. So what’s an investor to do with the knowledge that a bear market will hit some day, but we don’t know when?

In the words of Howard Marks, “You can’t predict. You can prepare.”

Advertisements