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What’s Coming Next? (And What to Do About It?)

A quick note: obviously, the stock market’s recent/current volatility is not the most important thing happening in the world right now. Yet of all the events going on, it’s the one I feel qualified to write about, so that’s what I’m doing, in the hope you find it helpful. Stay safe, everybody.

In terms of percentage gained/lost, last Thursday (3/12) was the 5th-worst day in stock market history. (Of the four days that were worse, three were part of the 1929 crash.)

The following day, Friday, was the 9th-best day in stock market history.

If you had your money out of the market before Thursday, you looked like a market-timing genius by Thursday evening. But if you took your money out near the end of Thursday or early Friday, you have just the opposite result: you were hit by the historically-bad day and missed the historically-good day.

Jumping in and out of the market, especially during super volatile times like this, is a high stakes game.

And it’s not an easy game to win.

When I think back to early Friday morning (and as I write this, it’s Friday evening, so that wasn’t very long ago), the things on my mind were whether my wife’s workplace would soon be implementing mandatory work-from-home, whether local schools would be closing, and things of that nature. I definitely wasn’t sitting there thinking, “maybe today will be one of the best days in stock market history.” Frankly, if anything, I would have bet on a further decline.

Let’s Try an Experiment

Below are three charts, made using the Morningstar website. Each one shows the performance of the Vanguard 500 Index Fund over a particular 1-month period. The specific dates are intentionally omitted.

Unspecified Decline #1:

Unspecified Decline #2:

Unspecified Decline #3:

In each case, the fund has fallen by a considerable amount over the month in question. Again, I’ve cropped the dates from the charts intentionally. But I promise that in each case, investors were scared.

Want to guess what happened next?

[Spoilers below.]

It depends.

Our first chart was from 9/18/1987 – 10/19/1987. The huge single-day drop at the end is “Black Monday” — the worst day in U.S. stock market history. Here’s what happens when we zoom out and show the results through the end of the following year. (You can click the image to see it full-size.)

By the end of the 1-month period in the original image, the market had finished falling. The 28% decline was the extent of it. The market’s return over the next next year was positive.

Our second chart was from 9/10/2008 – 10/10/2008 (i.e., early stages of the global financial crisis). Here’s what happens when we zoom out and show the next few months of returns.

Point being, the 27% decline in the original image turned out to be only about half of the total decline this time. The market still had much farther to fall.

But, at least for me, when I look at the first two undated 1-month charts above, there’s no way I would have known which one marks the beginning of a recovery and which one marks the halfway point of a larger decline.

So what’s the third undated chart? The third chart is the fund’s 1-month return as of today.

And I have no idea what comes next.

So I’m doing what I do when I don’t know what comes next (which is all the time) — just sticking with my same, simple/boring all-in-one fund, continuing to invest steadily, and continuing to pay attention to all the other important aspects of financial planning (tax planning, insurance, monitoring spending, etc.).

What to Do (With Your Portfolio) about a Likely Pandemic

As of the end of Friday the stock market was down about 13% from its peak earlier this month.

The World Health Organization has declared has declared COVID-19 a “Public Health Emergency of International Concern.” The CDC says that “current global circumstances suggest it is likely that this virus will cause a pandemic.”

These are scary times.

Because some people have asked: no, we have not made any changes to our asset allocation. It’s still 100% Vanguard LifeStrategy Growth (which is 80% stock, 20% bond).

That’s the point of strategic asset allocation, after all: to find an allocation that you’re comfortable with, even in scary times.

And this, right now, is why we spend so much time talking about risk tolerance. It’s important to know how well you tolerate risk. So take a moment to ask yourself: how well are you tolerating this risk? Right now, when you’re actually seeing and feeling some risk, is precisely the time to make that assessment.

Assessing your risk tolerance at a time when the markets are shooting upward is a recipe for disaster. When markets are shooting upward it’s easy to look at data about historical market declines and say, “yeah, I’d be OK with that.” It’s another thing entirely to actually see that your portfolio has declined by more in the last week than you’ve earned at your job in the last year — and to know that the upcoming week could be just as bad.

Another thing to take note of here is that almost nobody was talking about coronavirus even just a few months ago. Whatever the big scary thing is that sends the markets tumbling, almost nobody sees it coming. It’s always new. It’s always a surprise to most of us. It’s always scary. That’s the point.

Pick a portfolio with which you are comfortable even now.

To be clear, I don’t know if or how far the market will continue to drop. I have no idea what the next week, month, or year have in store for us.

And frankly, nobody does.

The guesses are all over the map as far as how bad the outbreak will be. And even if we knew how bad it would be in terms of human suffering, it would still be a major challenge to get a ballpark figure for what the cost would be in terms of “how much less profitable will companies be going forward, relative to how profitable they would have been if not for the virus?” Because that’s ultimately what the change in valuation comes down to.

On the whole though, businesses will keep earning money. Stocks will be profitable, eventually.

So to summarize:

  1. Market declines are scary, and a significant part of that scariness is due to the fact that they’re usually linked to some largely-unforeseen, scary real-world event.
  2. A market decline is the only time to assess your risk tolerance. Now that you are actually seeing and feeling some risk, how well are you tolerating it?
  3. You want to pick an allocation with which you are comfortable, even during the bad times. And then stick with that allocation! Don’t adjust to a higher stock allocation later, or you’ll again be caught with “too much” risk during the next downturn.
  4. Nobody ever knows what’s coming next for financial markets.
  5. Stocks will be profitable, eventually.

We didn’t make any portfolio changes. What we have done in our household is what the experts are recommending: stock up on nonperishable food, toiletries, and our over-the-counter medications. (It’s an easy action to take because there’s no downside — it’s all stuff we’ll use eventually anyway.)

Risk Adjusted Returns: What’s the Point?

A reader writes in, asking:

“I don’t understand the point of ‘risk adjusted’ returns. All I’m concerned with is actual returns. If a change to my portfolio ‘improves’ my risk adjusted return but does not improve the actual return, it doesn’t seem like I actually benefit from it.”

I’m sure you would agree that any change to your portfolio that results in an increase to expected return without an increase in risk is an obvious “win.”

Similarly, any change to your portfolio that reduces risk without decreasing expected return is also a “win.” What may not be obvious is that, in such a case, you have the option of happily accepting that lower level of risk, or, if you prefer, you could do something else that brings your risk level back up to what it was before (e.g., shift your stock allocation slightly upward), but now with a higher level of expected return.

In other words, those two things — an increase in expected return without an increase in risk, or a decrease in risk without a decrease in expected return — are somewhat interchangeable. A decrease in risk can easily be exchanged for an increase in expected return.

More broadly, the concept of risk-adjusted return is asking: once we have determined approximately how much risk is acceptable for this portfolio, how can we get the highest expected return for that level of risk?

Everybody Has a Risk Limit

Over the years I have come across several young, risk tolerant investors who have told me that they do not care about risk at all. All they are concerned with is return (or expected return).

That’s nonsense.

Every investor has a limit to the risk they can accept.

Even if your portfolio is 100% stocks right now, you are still forgoing higher-risk, higher-expected return options. For instance, instead of just 100% stocks, why not 100% small-cap value stocks? And why stop at 100%? You could borrow money to invest (i.e., invest on margin). You could short a bond ETF (e.g., have an effective allocation of 110% stocks, -10% bonds). If you haven’t done such things and choose not to do such things, you too have a limit to the risk you will accept.

Sometimes the limit is a financial limit (you cannot afford to take on more risk), and sometimes the limit is a psychological limit (you cannot tolerate more risk). But you definitely have a limit.


While the concept of risk-adjusted return is useful for understanding portfolio construction discussions, applying it in real life comes with important caveats.

Firstly, there are many ways to measure risk. Standard deviation of returns is the most popular measure historically. But looking only at the standard deviation of a distribution gives you an incomplete picture. For instance, as Larry Swedroe often mentions, it is helpful to also consider skewness (i.e., how asymmetrical is the distribution of returns) and kurtosis (i.e., how far is the distribution from a normal distribution — how fat are the tails).

And for a retirement stage portfolio (as opposed to an accumulation stage portfolio), we’re concerned with an entirely different set of risk metrics (e.g., probability of portfolio depletion, size of portfolio shortfall, etc.).

Secondly, portfolio changes that clearly achieve either of the goals that we’re discussing here (that is, a reduction in risk without a reduction in expected return or an increase in expected return without an increase in risk) are rare. And you want to have a high degree of skepticism when somebody suggests that they have a way for you to do so, other than simply “diversify” and “reduce costs.”

Doing Nothing About a Market Decline

A reader writes in, asking:

“The performance in my Roth IRA has been all over the place lately. I recently had a day where literally all four of my funds went down. What do you do differently during periods when nothing is performing well?”

I’ve gotten a few questions like this lately. And you can see the same thing happening on the Bogleheads forum too. For anybody who started investing in March of 2009 or later, they’ve never really experienced a bear market. So little bumps like we’ve seen lately are new and scary.

And to be clear, what we’ve experienced in the last few months is just a little bit of bumpiness. Vanguard Total Stock Market Index Fund is down about 5% over the last 3 months. But it’s still up, year-to-date. Compared to the 2008-2009 decline during which the market fell by more than 50% (or the 2000-2002 decline during which it fell by very nearly 50%), what we’ve seen in the last few months is nothing.

Nothing at all.

And as it happens, that’s also the answer to the reader’s question about what we’re doing differently with our portfolio as a result of the recent bumpiness: nothing.

My wife and I are just contributing to our accounts and buying the same LifeStrategy fund as always.

If you have an appropriately diversified portfolio that is suitable for your risk tolerance, there are only a few things to do during a market decline:

  1. Rebalance, if your plan calls for such. (Quick note on definitions: rebalancing is not changing your targeted allocation. It’s moving your current allocation back to your targeted allocation. It is not a change in plan, but rather an implementation of the already-existing plan. Rebalancing generally means buying more of whatever has been performing the worst recently.)
  2. Tax-loss harvest if you have holdings in taxable accounts.
  3. Cut spending, if you’re retired and spending from your portfolio and your retirement plan calls for such.

That’s it. Obsessively checking your portfolio to see whether it’s up or down from yesterday doesn’t help. And trying to predict whether it will be up or down tomorrow doesn’t help either.

In our case, we use an all-in-one fund that is automatically rebalanced, so there’s no need to worry about that. And essentially all of our holdings are in retirement accounts (we have high contribution limits, due to self-employment income), so there’s no need to worry about tax-loss harvesting. There’s no need to do anything at all.

Don’t Forget About Disability Insurance

A fundamental principle of financial planning is that insurance comes first. If you don’t have the proper insurance, you can do everything else exactly right — save a large percentage of your income, invest that savings wisely, engage in excellent tax planning, etc. — and still end up financially ruined if you find yourself on the unlucky side of a large uninsured risk.

Of course, you don’t need every type of insurance. For example, if there is nobody else who is financially dependent upon you — as would be the case for many people with no children — you most likely have no need for life insurance.

But if you have a job, there’s a good chance you are dependent upon the income from that job — and therefore have a significant need for disability insurance.

A 2014 “actuarial note” from the SSA estimated that, for a person who reached age 20 in 2013, there is only a 6.5% chance of dying prior to full retirement age but a 27% chance of becoming disabled prior to full retirement age.

And the above estimate uses the SSA’s definition of disabled, which states that you must be unable “to do any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months.” There are plenty of people who incur injury or illness that meaningfully reduces their income yet who do not qualify for Social Security disability benefits.

In addition to being difficult to qualify for, Social Security disability isn’t particularly generous in terms of amount paid. You can get an estimate of what your Social Security disability benefits would be (if you became disabled right now) by signing into your online account. The average monthly Social Security disability benefit is $1,172. That’s a heck of a lot better than nothing, but even with other forms of government assistance, we’re talking about a serious financial struggle in most cases.

So how many people actually have private disability insurance? Last year an article by Stuart Heckman in the Journal of Financial Planning looked at the 2013 Survey of Consumer Finances from the Federal Reserve Board to answer that question (and many other related questions). Heckman found that only 30% of households had private disability insurance (i.e., insurance beyond that provided by Social Security). Interestingly, he also found that people who use a financial planner are not significantly more likely to own disability insurance.

My overall point here is just to provide a basic reminder: don’t forget to consider disability insurance. Do you have it? If not, should you?

If you do end up shopping for disability insurance, you should know that there’s a lot of variation from one policy to another. This Bogleheads wiki article provides a brief explanation of the most important considerations.

“Total Market” Investing and Multi-Factor Models

A reader writes in, asking:

“I would like to ask you about factor investing. For background, I am a plain vanilla investor. I use the Vanguard Market-cap weighted Total World Stock fund. As simple as it gets!

However I have been reading literature about the case for factor investing. There seems to be a broad consensus that multi-factor models explain returns much better than the CAPM. [Mike’s note: the Capital Asset Pricing Model is an older model in finance that states that a portfolio’s expected return is a function of how sensitive the portfolio is to market risk. More recently, various multi-factor models have said that a portfolio’s expected return also depends on other things, such as how much of the portfolio is allocated to small-cap stocks (as opposed to large-cap stocks) or to value stocks (as opposed to growth stocks).]

I have heard many recommending tilting to small and value stocks.

Do I need to be concerned about my plain vanilla strategy? Am I potentially missing out on much superior returns over the long run?”

It’s true that there is, roughly, a consensus that multi-factor models explain returns better than CAPM. That isn’t an argument for or against a “total market” portfolio though.

To back up a step, a one-factor model such as CAPM tells us that stocks are riskier than bonds and should therefore usually have higher returns. But that’s not an argument for an all-stock portfolio (or any other particular stock/bond allocation). It all depends on your own personal balance of desire for return and willingness to take stock market risk.

Similarly, in multi-factor models, value stocks and small-cap stocks are generally considered to have higher risk and higher expected return than their counterparts. But that’s not an argument for any particular value/growth allocation or small/mid/large allocation. Again it all depends on your personal balance of desire for return and willingness to take risk.

In my experience, it’s usually the salespeople (e.g., certain advisors or purveyors of mutual funds) who argue that a given allocation is better, while the academics are much more neutral on the matter. For instance, Eugene Fama (one of the two people originally behind multi-factor research) was super clear in a video interview on Dimensional Fund Advisors’ website. The video disappeared when they restructured their site a few years back, but here’s the relevant quote:

Interviewer: Some people cite your research showing that value and small firms have higher average returns over time and they assume that you would recommend most investors have a big helping of small and value stocks in their portfolios. Is that a fair representation of your views?

Fama: Um, no. (Laughs) Basically this is a risk story the way we tell it, so there is no optimal portfolio. The way I like to talk about it when I give presentations for DFA or other people is, in every asset pricing model, the market portfolio is always an efficient portfolio. It’s always a relevant portfolio for an investor to hold. And investors can decide to tilt away from that based on their personal tastes.

But that’s what it amounts to. You can decide to tilt toward more value or smaller size based on your tastes for these dimensions of risk. But you needn’t do it. You could also decide to go the other way. You could look at the premiums and say, no, I think I like the growth stocks better. Then, as long as you get a diversified portfolio of them, I can’t argue with that either.

So there’s a whole multi-dimensional continuum here of efficient portfolios that anybody can decide to buy that I can’t quarrel with. And I have no recommendations about it because I think it’s totally a matter of taste. If you eat oranges and I eat apples I can’t really quarrel very much with that.

As far as still-available interviews with Eugene Fama, here are two:

In the first video, Fama talks about the origin of the 3-factor model. While he doesn’t explicitly get around to portfolio construction in this interview, he does state very clearly that his view is that the higher returns are the result of higher risk. (Around 5:26 is where the conversation leads to this point.)

The second video is longer and covers a lot of topics. The video’s publisher explicitly requests that it not be quoted, so I won’t quote it. Instead, I’ll just point out that around 28:45, Fama says things very similar to the interview that I quoted above. And at 35:28 he says something very clear about holding a market portfolio and whether he thinks it’s a good choice or not.

In my view, overweighting small-cap stocks or value stocks in your portfolio is a perfectly reasonable thing to do. But on occasion you’ll encounter people who indicate that doing so is the smart way to invest and only an uninformed investor would say otherwise. But that’s clearly not true.

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