Decision 2020: Your Vote and Your Money
Welcome to Decision 2020: Your Vote and Your Money. This special series will examine the outlook for November’s elections, the potential impacts on markets and taxes, and steps you can take now to election-proof your finances. Make sure to check back often so that you don’t miss any of this special series, in which we’ll cover topics including:
- Who Will Win the Race for the White House?
- Will the Next Congress be Red or Blue?
- Do Elections Even Matter for Markets?
- Are Your Taxes Heading Higher?
- Can You Build an Election-Proof Portfolio?
How to Build an Election-Proof Portfolio
Welcome to Part Five of this special series Decision 2020: Your Vote and Your Money. In the first installment, we examined the race for the White House, as well as where the candidates stand on some important economic issues. Part Two focused on the legislature and took a closer look at the outlook for the House and Senate races, while Part Three evaluated the historical record to see if elections even matter to markets. In Part Four we examined the critical question of whether your taxes are headed higher and laid out some steps to potentially reduce your future tax burden.
Now in Part Five, we’ll look at some ways you can election-proof your portfolio.
Before we start though, remember that elections aren’t necessarily bad for markets. In fact, in the 23 presidential election years since 1926, there have only been four times when the S&P 500 declined. In the 19 other election years, the S&P posted a positive performance.
With that nugget of information out of the way, let’s turn our attention to how you might want to invest ahead of, and after, this election.
Market leadership changes as often as politicians
The world has changed quite a bit in 2020, what with COVID-19 and shelter-in-place and the economic slowdown. Now we are facing an election, with the potential for additional changes there.
But one thing has remained consistent: For a large part of the year, a small subset of stocks has driven the markets higher. In fact, these same stocks have been among the best performers for several years now.
S&P 500 Leaders (As of May 18, 2020)
The Super 6 Explain Most of the Return Gap
S&P 500 Market Value, 2015=100
These market leaders fall into the “growth stock” category. Because of that, growth stocks have outperformed value stocks recently. This phenomenon is not unprecedented, but the data clearly shows that value stocks outperform growth stocks over longer periods of time. Going forward, if you subscribe to the belief that markets tend to revert to their mean, then this could be a good time to evaluate your allocation to value stocks.
As you can see in the chart below, five stocks (Apple, Microsoft, Amazon, Alphabet, and Facebook) make up almost a quarter of the S&P 500, and more than 40% of the NASDAQ. Therefore, investors in these indexes have a large concentration in a small handful of stocks. Since those five stocks fall into the “growth” category, those same investors also have a concentration towards growth stocks, at the expense of value stocks.
Of course, there is no guarantee that the performance of value stocks will improve, but the historical probabilities do seem to argue for that. So, it could make sense to evaluate your current exposure to value and growth stocks and adjust accordingly if you find that you are out of balance.
You should also consider that, while the market’s current leaders are great companies with excellent future prospects, that does not mean that future success is guaranteed. Look at how the market’s leading companies have evolved over time.
As you can see, there have been a number of companies that were among the ten largest in the United States that then fell from their perches. Some even went bankrupt. I want to emphasize that the chart above isn’t intended as a commentary on any of the current market leaders. Rather, the idea is to remind you that future success is never guaranteed. Successful companies got that way by disrupting industries and changing the way people do business. Similarly, new companies could come along and do the same.
Additionally, when a company has done well, there is a lot of good news already baked into the stock price. That means that to continue to excel, a company cannot just do “good.” Instead, it needs to beat expectations and do “great.” With companies that have been as successful as say, Apple or Amazon, that is a very high hurdle to clear.
Not every country is having an election
If you haven’t already done so, now might be a good time to consider global diversification. For starters, the chart below shows that more than 40% of the stocks in the world come from outside the United States. This means that if you are only investing in the United States you’re missing out on a large portion of the world’s markets, including such well-known companies as Toyota, Nestlé, and Unilever. And as an added bonus, most of those companies are domiciled in countries that aren’t having an election!
U.S. Stocks as a % of World Markets
Global Equity Markets: Weights in MSCI All Country World Index
Additionally, international stocks have underperformed US stocks over the last decade. While that might on the surface seem like a reason to avoid them, the reality is that underperformance might indicate an opportunity to buy stocks in markets that are more reasonably priced than the United States.
Furthermore, fluctuations in the value of the U.S. dollar are a key driver of international stock returns for US-based investors. No one has a crystal ball as to what those future moves might look like, but over the past fifty years, the dollar has tended to move in a series of long trends.
Recently, the trend has been up, in part because interest rates in the United States have been much higher than those abroad. However, U.S. rates have fallen sharply over the past several months due to the COVID-19 pandemic. This could potentially mean we are moving towards an environment when the dollar will once again enter a weakening trend against other currencies. If this were to occur, it would provide investors in global stocks an additional boost to their returns.
With regards to COVID-19, some foreign countries may prove more adept at limiting the spread of the disease, which could lead to stronger performance for their markets.
One final point to make when it comes to global investing is that economic growth in emerging markets continues to be stronger than in developed markets. You can see in the chart below that despite periodic crises and economic collapses, this has been the case for two decades. Back before the financial crisis, this superior economic growth was rewarded as stock markets in many emerging countries soared. Market participants and other observers referred to a “secular growth story” in emerging markets (EM.)
Emerging Markets Secular Growth Story
Emerging Markets: Emerging Markets and Developed Markets Growth
Flash forward a dozen years and stock market performance in emerging markets has largely lagged the U.S. and other developed countries (though EM performance has picked up in the last six months.) Yet the secular growth story largely remains intact. As such, it might make sense to diversify into an asset class with superior growth prospects at attractive valuations.
What pattern do you see?
Look at the multi-colored chart below, which examines the years 2000-2019. The chart stack ranks various asset classes by performance, with the year’s best performer at the top and the worst performer at the bottom.
Reversion to the Mean
What pattern do you see?
If your response is that you don’t see a pattern, you are correct. On a year-by-year basis, different types of investments perform relatively better or worse, and no single asset class leads the way year after year. In fact, there are a number of times when an asset class went from first to worst or from bottom to top. For instance, the Barclays Aggregate Bond Index was the worst performer in 2007, but the best in 2008. Similarly, the MSCI Emerging Markets Stock Index was the worst performer in 2008 and then the best in 2009.
At the end of the day, the last thing you want is to have a concentration in what has recently done best, right before its performance reverses. You also don’t want to underweight recent laggers, right before their returns jump.
Rebalancing can prevent either of those scenarios from occurring. Best of all, a systematic rebalancing process takes emotions out of the equation, so that you don’t have to decide to buy more stocks when the news is grim, and markets are collapsing. You just do it automatically, because that is your process. And study after study has shown that the more automated you can make your finances, and the more you can remove emotions from the equation, the greater your likelihood for success.
With that in mind, if you don’t already have a disciplined rebalancing process in place, here are some more reasons that this might be an ideal time to set one up.
Have a disciplined rebalancing process
The foundation of your finances is your cash flow, which is why it is so important to map out your future income, expenses, taxes, and the like. Once you’ve completed this exercise, you’ll be able to determine your required rate of return, which is the return your portfolio needs to generate for you to meet your financial goals. In turn, this required rate will suggest various portfolio mixes that might help you meet your goals. You’ll then select an appropriate mix and invest your portfolio accordingly. Of course, at that point, everything will immediately go off track, as some of your investments go up and others go down, with the result that your portfolio is no longer in balance.
That is why, once you’ve determined your appropriate risk exposure and asset allocation, it is important to implement a systematic rebalancing process to help you stay on course. For instance, let’s assume that you’ve set your optimal portfolio mix as sixty percent in stocks and forty percent in bonds. In that case, you would have needed to sell some bonds and buy some stocks during the COVID-19 market collapse last spring. That is because the value of stocks fell sharply, while the value of the bonds remained relatively stable. So, if you didn’t sell some of the bonds and buy some stocks, your exposure to stocks would have declined as a percentage of your overall portfolio.
That would mean that you’d no longer be positioned to meet your goals. Even worse, that reduction in your stock allocation would have occurred just when you might otherwise most want to hold stocks for the long run, i.e. when they have fallen in value and are therefore less expensive.
It’s easy to focus on the benefits of buying beaten-down stocks before they rebound. But it is equally important that you trim stock exposure during good times, to avoid taking on too much risk.
Ultimately, rebalancing is the single best way to:
- Maintain a consistent risk profile
- Achieve your required rate of return
- Avoid overconcentration in a single stock or sector
- Buy low and sell high in a disciplined manner
Bad news often equals good returns
It is entirely possible that the election and its aftermath might prompt a wave of market volatility. But even if it doesn’t, the fact of the matter is that the economy is still weak, and the world is trying to overcome the coronavirus pandemic. As such, you are likely to see plenty of negative headlines in the months to come.
That is why this is a good time to remember that, when it comes to investing, bad news often equals good results. In fact, as the chart below shows since 1948 the S&P 500 has performed the best when:
- Unemployment was the highest
- Economic growth was the weakest
- Corporate profits were the worst
Bad News Equals Good Results
Conversely, since 1948 the S&P 500 has performed the worst when:
- Unemployment was the lowest
- Economic growth was the strongest
- Corporate profits were the best
If you want a recent example of this principle in action, you need not look any further than the spring of 2020. Markets bottomed at the peak of the COVID-19 pandemic when shelter-in-place restrictions were rampant, and there was little to no visibility into the future prospects of corporate America. At the same time, unemployment was hitting record levels as millions of workers lost their jobs, and economic growth was in a freefall. And yet stocks staged a historic rally despite that backdrop.
So again, as a reminder, just because the news is full of negative headlines and everyone “knows things are going to be bad,” doesn’t mean financial markets can’t do well.
That seems like an especially important principle to remember, especially in the midst of a tumultuous election, societal upheaval, a global pandemic, and severe economic slowdown.
Reevaluate your risk tolerance
How have you been sleeping lately? Are worries about the election and its impact on your finances causing you stress? Has the stock market volatility kept you up at night, or are you all good, knowing that you hold stocks for the long run, and they have always come back in past? The answers to those questions will help you identify whether you are taking an appropriate amount of risk in your portfolio.
Many people overestimate their risk tolerance, and when markets drop, these people get extremely uncomfortable. At best, they lose some sleep. At worst, they panic and abandon the market, usually just before the bottom. With that in mind, if you are unduly stressed about the events of 2020, it might be worth considering taking a little bit less risk in your portfolio. This doesn’t mean abandoning the markets and going to cash. It means incremental changes, such as moving from 70% in stocks to 60% or something like that.
On the flip side, some of you may be entirely comfortable with this year’s roller-coaster ride in the markets. If that is the case, and depending on your goals and time horizon, you might have the capacity to take on more risk in your portfolio. Of course, if you are on track to meet your goals, you don’t have to take on more risk unless you want to. Again, these moves should be incremental, as perhaps you move from 60% in stocks to 70% or something along those lines.
I want to emphasize that you should seldom change your long-term strategic asset allocation unless your life situation changes (retirement, illness, job loss, etc.) But if the prospect of further volatility is pushing you to the point of panic, or if you sense a golden opportunity, you might use this time to reevaluate whether you’re currently invested in the optimal asset mix and if not, then you can make measured changes to your allocation.
And finally, Ignore The Hype
The media’s job is to attract viewers and then keep them tuned in. The easiest way to do this is by playing on people’s emotions, and the media knows this, which is why sensationalist headlines and excitable anchors are so common. And 2020 has certainly given the media ample fodder:
- The coronavirus pandemic!
- Social unrest!!
- And now an election!!!
The bottom line is that yes, there is an election coming up. And yes, it is important for a number of reasons. But at the end of the day, if you have a reasonable financial plan in place and have a properly diversified portfolio designed to meet your goals, the election should be something of a non-event from an investment perspective. But of course, you won’t know that if you tune in to the financial news:
The election is nearly upon us now. With that in mind, this special Decision 2020 series will conclude with an election summary and question and answer installment once the outcome is known.
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