Here we are three weeks or so into the meltdown of the US and global stock markets. What’s an investor to do after watching years of gains evaporate and, like a time machine, return to levels where we were three years ago? Perhaps we should take a lesson from “The Gambler” in the Kenny Rogers song. It all comes down to you need to know when to hold them and know when to fold them. And know when to walk away and know when to run.
The doom and gloom of the headlines is hard to escape. Sticking your head in the sand isn’t going to help. But should you fold and run? I still don’t think so. As long as you have a strategy in place and have bought solid businesses, you can weather the storm.
Confessions of a Portfolio Strategist
Trying to come up with a globally diversified, tax-efficient portfolio can be challenging in the best of times. With a bull market that is melting down almost daily, it is even more of a challenge. So, how should you prepare an investment portfolio that gets you to your goals and avoids getting wiped out?
MarketFlex Portfolio Design
When I’m designing a client’s portfolio I’ll mix things up. I like to use a solid core holding and other elements designed to add to the returns or dividends or that help buffer the downside.
Generally, I like to use Vanguard Wellington (VWELX) as a core position. While closed to many, I’m fortunate to have access to this fund through one of my custodian platforms.
Then I have added satellite positions around this to add some potential upside and to add more protection on the downside.
Through these satellite positions, I can add more bonds or more alternative income-oriented investments like individual dividend-paying stocks or real estate. Depending on what research I dig up from one of the many newsletter services I read, I may want to add more in one area or another. So, I’ll use other specific portfolios of ETFs and high-yield Closed-End Funds that I’ve created.
Since most investors tend to be overly concentrated in large-cap stocks, I like to add diversification to the size of stocks. In this case I often add small- and mid-cap low-cost US index ETFs and specific stocks.
And because what goes up may very likely go down, I like to include ways to hedge against a downturn. While there are different ways to do this, I’ve used ETFs that focus on “covered call” options strategies. Other ways include using gold or “managed futures” or even tactical money managers.
Morningstar Research and Downside Capture
Given uncertainty in all things, it’s never a bad thing to play defense. Even Warren Buffet, the “Oracle of Omaha,” had built up cash over the last two years. While “cash” doesn’t generate a lot of return and, up until now, has been considered to be “trash,” it’s been a smart holding in hindsight.
Another thing to consider is the defensive value of quality dividend-paying stocks. Research has shown that in a downturn, quality stocks with a history of increasing dividends have generally held up better than the rest of the market.
This is why I use a selection of a dozen to two dozen individual stocks that have increased dividends every year for at least 25 years and in some cases 50 years. Why? Well, if a company has been able to stay in business that long and been able to support the cash outflow needed to pay out to its stockholders, it’s got a strong business model. If it’s been around that long it’s gotten through a lot of adverse market events. I also use a couple of ETFs focused on the same strategy as well.
Morningstar recently did some research to find a list of stocks that have held up well during this recent crisis. Their screening focused on those in Defensive Super Sectors that are relatively immune to economic cycles: healthcare, utilities, consumer defensive areas. All trade at Morningstar’s 4- and 5- star levels and exhibit high predictability of cash flows.
I’m happy to report that of their list of thirty-one stocks, the MarketFlex portfolios I’ve prepared include seven of their names. These holdings range from drug manufacturers to tobacco and include packaged goods, healthcare, and pharmacy stores. And though some of my other specific holdings didn’t make this specific list, the others are in similar defensive super sectors and include many household names.
To see the entire list, visit Morningstar here.
Separately, another analyst has filtered to find the top ten Dividend Aristocrats, companies with a ten year history of increasing dividends, to buy or hold in this market. In this case, the filter used are A-rated companies with a 6%+ dividend. In this case, the MarketFlex portfolios are holding five of these 10. These companies were good last year, last month, and yesterday. They’re just as good today but on sale.
For more on this analysis, visit Advisor Perspectives here.
Cash: How Much to Hold
Until this month, holding lots of cash drew lots of comments from clients. Keeping cash on the sidelines is one way to “keep your powder dry.” When we find ourselves in times like these, we can find lots of good companies at bargain prices. Look, companies like Coca-Cola, AT&T, Johnson & Johnson were good before this crisis and they’ll be here after it ends. Now, we have an opportunity to buy them and their consistent dividend cash flow at a lower price.
All that being said, how much cash should you hold. If you’re a long-term investor, I think that 1% to 5% is more than enough in your investment accounts. As part of your broader financial plan, you should target your emergency reserves to be between three months and one year of your fixed expenses depending on your risk profile, whether you’re self-employed, or if you’re married.
If you’re retired, then I’ll recommend that you hold a cash position of six months to two years of fixed expenses or at least that portion not covered by other guaranteed income sources (i.e. pensions, Social Security). This way you’re less inclined to panic and sell everything during these kinds of crises.
Will You Lose Money?
Will you lose money? Yes. Odds are you will.
Is it hard not to go all into cash? You bet. But I’ve been around long enough to have been on the other side and missed timing when to jump back in to ride the market up.
Could I use some sort of “market timing” signal service or a third-party manager? Sure. I have tested them out in the past but haven’t been convinced that a “bucket strategy” with a globally diversified allocation works better.
Could I “short” the market and win on bets that the index or individual stocks will go down? Yup. But there is a cost to doing that as well. More often than not, “shorting the market” as a whole has been a losing proposition.
How have the MarketFlex Portfolios handled the storm? I’d love to say that no one has seen a decline. But let’s be real. Everything is getting hammered. But analysis shows that these portfolios have held up well given the circumstances. While broad market indices have gone down, these have done OK as measured by standard metrics like standard deviation, downside capture ratios, and risk.
The key metric that matters is personal: Can a client still be able to fund goals like retirement? And most of my time these past weeks has been updating client plans to show that is still the case for many.
Hold On – Investing Is Simple But Not Easy
Capitalism will survive this. Good companies will still be here tomorrow. Selling after a downmarket rarely, if ever, works in the long run.
In the words of Allan Roth of WealthLogic, “Investing is simple but not easy. Down markets really separate speculators from investors.”
So, in the end, I find the best way that I can help my clients is to be vigilant, hold an amount of cash needed for their situation, and diversify with a focus on dividends.
Will this insulate everyone from loss? As we have been reminded by the speed and severity of this “correction” in just three weeks, no. When it rains, we all get wet. The question is how to minimize being drowned.
