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The Art of Preserving Capital When the Market is Sinking

The past year has been one of greater market volatility and downturns due to increased interest rates, looming trade wars, and prospects of recession.  Downturns are a normal and expected part of the market cycle.  While we have been experiencing a boom in market values for the better part of the past ten years, we are now heading into a period where investors tend to focus on Preservation of Capital.

Preservation of capital is an investment policy concept intended to protect portfolio values.  Basically, investors want to maintain what they currently have.  But how do you do it when everything in the market seems to be going down? 

First and foremost, we encourage investors to stick with The Plan they crafted for their portfolios before the market downturn began.  The plan may not have changed, but your emotional response to the market environment likely has.  Preservation of Capital was always a part of the plan, but you may not have been focusing on it when markets were going up. 

Now that it’s a more immediate concern, let’s go over the basic concepts of protecting portfolios across the broad market to which most investors are exposed.

  • What part do Bonds play in portfolios during market downturns?  How do you know when and how to add or increase them?
  • How should you handle your current Stocks?  What is the difference between trimming and fleeing?
  • How does passive vs active stock investment impact portfolios during market downturns?  The cost of investing becomes increasingly important when prices are sliding, but cheap index funds may not be the answer.
  • What is the difference between growth and value stocks?If the market isn’t “growing,” what stocks should you be buying?
  • How do currency values impact global stocks?

Bonds and the Flight to Safety

In times of market stress, investors often engage in what is called a “flight to safety,” as they leave funds in cash, invest in Treasury bills or bonds, and other high quality fixed income, like investment grade corporates or general obligation municipals.  Rather than an “all or nothing” reaction to market downturns, we encourage investors to focus on the long-term plan that you made before the market downturn began.  That plan should have always included at least some focus on Preservation of Capital.In general, the part of the plan focused on Preservation of Capital at least determined the percentage of a portfolio that should be allocated to bonds. 

Allocations to fixed income vary greatly depending on the client’s objectives, time horizon, and appetite for risk.Preservation of capital in times of market stress, like rising interest rates, also means being cautious about extending into yield chasing in junk bonds, high duration bonds, or other riskier parts of the bond market.   Quality and safety become much more important.  The fundamental consideration In bond investing is return OF principal, as opposed to return ON principal.  Getting your money back when a bond matures is much more important than just getting a larger coupon or interest payment.

We will work with you to determine how much of your portfolio you actually need to keep in bonds, even during a market downturn, and what types of bonds you should be buying to preserve your capital.

Stocks and Knowing When to Trim vs Flee

Investors with larger allocations to equities also face preservation of capital issues.  Market timing is one dangerous approach, but the decision to get out of equities leaves open the question of when to get back in?  If investor allocations include an all-weather approach (aka The Plan!), then more dramatic moves in and out of equities, with the timing risks that entails, are more easily avoided.

Because of this, preservation of capital in longer term equity portfolios begins with a reconsideration of whether your diversification is sound and matched to your risk tolerance.  Weak markets can be a useful wake up call in determining whether investors can achieve a long-term steady approach without undue panic or emotional investment mistakes, which are quite common.

Re-balancing, taking profits, or trimming equity investments that have done well in years past can minimize steep losses as market leaders on the upside become market leaders in the downside.  As financial advisors, we use analysis of up capture and down capture ratios in evaluating how mutual fund investments are likely to perform in stock downturns.Good managers look to create portfolios that perform well in both up and down markets.  Excellent choices in hiring active managers can make a great difference in protecting capital in challenging  times.

Index Funds vs Active Management during Market Downturns

To recap, index funds are passive investments that are sold cheap to investors.  Passive simply means that a company’s stock or a bond will be included in a fund along with other similar stocks based entirely on whether or not it meets the quantitative criteria (is it the right size, the right industry, etc).  It says nothing of a company’s qualitative value (is it well run, does the future market have a place for this company, is management experienced, etc).  Actively managed funds, on the other hand, are groups of handpicked stocks and bonds after a considerable amount of research into the details of each company.

Index funds can suffer in negative markets because they are capitalization weighted. Cap-weighting means that larger companies are a larger part of the group versus all companies in the group being weighted equally.  So in hot upswings, the stocks that are steaming upward gain greater weights as the index is re-balanced.  However, those leaders during upswings may also be the ones to fall first in the downswing, dragging the entire index down with them.  (A perfect example is the fall of Enron in 2001.)

This somewhat hidden downside of index funds can be addressed by the use of fundamental indices, which weight their holdings by other factors than the market value of securities.  Fundamental indices commonly use dividend weighting or actual cash paid out to investors, or other such actual dollar fundamental measures instead of market values.  These fundamental indices can provide more downside protection in negative markets.

Quality also becomes a key to preservation of capital in equity markets.  The internal diversification of subsidiary holdings in equities like Berkshire Hathaway are an example.  Warren Buffet buys companies with a long-term focus, allocates additional capital to them to allow sound management to improve their company, and holds with a long-term objective.  Contrast that with General Electric, a long, highly-regarded blue chip company, whose quality has evaporated due to a stale corporate culture that responded slowly to market changes while encountering accounting problems in how it reported earnings amid the uncertainty of key changes in its CEO.  Its transition from being perceived as high quality to lower led to substantial losses for those who paid too much for it in the recent strong markets.

Growth vs Value Stocks

Growth versus value becomes another important consideration in weaker markets.  Growth companies are those that offer investors the possibility of capital appreciation.  They are, as the name suggest, growing!  Value companies are those that are not necessarily growing, perhaps because they already have a mature business model with a healthy market share.  For this reason, they tend to trade at a lower price than growth stocks, but they may offer investors steady growth with possible dividends.

Growth stocks and the funds that hold them have led recent market gains.  During market declines, value stocks become more attractive.  Why?  Well, when markets are suffering, consumers will likely continue to consume essentials like energy, healthcare, hygiene products, food, etc.  They may be less likely to buy electronics, vacations, cars.It stands to reason that companies that produce “wants” versus “needs” will suffer.  That is not to say that all growth companies will do poorly during market downturns.  That is where active management comes in.

On the other hand, it does not mean that all value stocks will weather a downturn well either. Some value managers have recently suffered what are known as “value traps” as lower stock values reflect real problems in company operations or prospects.  But as value investors adjust to high quality companies with good potential, good value managers can add protection in weak markets and do better than growth stocks.

Global Exposure in a Global Economy

International markets have suffered because of our strong U.S. dollar, which increased nearly 10% last year against other currencies.That 10% got subtracted from European and other global companies when their values were reported back in dollars in your mutual fund statement.  So if a company lost 5% in value in European markets, it lost 15% on your mutual fund statement when returned to you in dollars.   Currencies tend to revert to the mean over longer terms, so this effect can both work against you or for you.  Lately it’s been against you.   So we are looking more closely at ways to hedge currency risk in our client portfolios.One exchange traded fund we like uses a dynamic approach by adding to hedging when market conditions favor that but reducing hedging otherwise.   This provides a way to maintain investment in under-valued international stocks without carrying the added risk of currency fluctuations.

In Closing

At Propel, we will continue to evaluate and make adjustments to client portfolios consistent with your objectives and risk tolerances.  Don’t hesitate to call with your questions  or concerns.

Remember that long time horizons also favor continuing to regularly add to your portfolios to take advantage of the “sale prices” weak markets provide.   In the long term, buying stocks on sale in market weakness will help you achieve your long-term objectives as markets recover.  Sound fundamentals  call for reinvesting earnings  for the long term and compounding your gains going forward.  Even if you are nearing retirement, remember that 65-year-old you might need cash now, but 80-year-old you needs cash later.  The Plan may include stocks that are currently falling in price, but their recovery could fuel your income needs later.

- David Vaught, CFA