This is part of an ongoing series of Weekly Commentary articles published by Johnson Financial Group.
This week's issue is written by Jason Herried, SVP, Director of Equity Strategies.
October proved to be a ghastly month for investors as U.S. stocks declined over 7% and international stocks declined over 8%, reminding investors that owning stocks comes with volatility. The October decline was the worst month for U.S. stocks since September, 2011, and for international stocks since May, 2012. The 11% peak to trough decline during October was the second correction for stocks in 2018, and some investors are worried that the bull market might be on its last legs.
Investor concerns include rising interest rates, peak growth and trade tensions with China. In short, our view is that interest rates are likely to increase a bit further, but we are nearing the cycle peak. Economic and earnings growth are set to slow, but growing nonetheless, and recession indicators remain relatively low. With respect to trade, it seems that tensions may stay the same or perhaps escalate as we head into 2019, although a late November meeting between President Trump and President Xi Jinping may result in progress.
Taking a broader perspective, however, investors can use a correction as an opportunity to reaffirm their risk tolerance and time horizon because panic and an overly aggressive portfolio are the two main paths to permanent losses in stocks. To put portfolio risk into perspective, take a few minutes to study the drawdown chart below. It measures the peak to trough decline of an all‐stock portfolio (blue) compared to a balanced portfolio (red).
The first thing a drawdown chart tells us is how deep the respective portfolios can be expected to decline during a pullback, correction or bear market. Pullbacks represent declines of 5% to 10% and typically occur three to five times per year. A correction is associated with a decline between 10% and 20%. Corrections can be expected about once every year or two outside of bear markets. Finally, bear markets, commonly defined as a decline of 20% or more, are rare and have only occurred a handful of times over the past 30 years.
As we all know, a balanced portfolio declines less than an all‐stock portfolio during a stock market decline, thanks to the stability of the bond portion of the portfolio. During pullbacks, the difference might be just a percent or two, but during a correction or bear market, the return differential is substantial. During most corrections and bear markets, the balanced portfolio suffers about half the decline of an all‐stock portfolio.
The second thing the chart demonstrates is the time it takes to recover from a drawdown. What we see is that during a pullback or correction, a balanced portfolio and an all‐stock portfolio typically recover within a few months. However, during a bear market, the balanced portfolio recovers in about three years, compared to about five years for an all‐stock portfolio.
In managing client portfolios, we consider each client’s risk tolerance and time horizon in portfolio construction. We desire to build a portfolio that will allow clients to sleep during turbulent nights like those in October. While stocks offer the best return over the long run, bonds offer diversification during large declines and provide income and stability to meet cash flow needs when stock prices are depressed.
Pullbacks and corrections, and large rallies for that matter, offer opportunities to rebalance portfolios. Portfolio management means being opportunistic by putting cash to work during declines and managing risk by taking profits and raising cash for distributions after large rallies. For clients with a changing time horizon or risk tolerance, like those nearing retirement, we also look to confirm investment objectives and typically look for a good time to reduce the risk level of the portfolio based on a discussion of the changing needs.
Ultimately we do not know whether this correction will turn into something more sinister or simply be forgotten. However, it is a reminder that a portfolio review is more than just a look at performance. Instead, it should focus on the future and the appropriate risk for each client’s portfolio given their specific circumstances.
This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank, Johnson Wealth Inc. and Johnson Insurance Services LLC. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE