In the last few weeks, capital markets have seen considerable fluctuations, causing many investors to face increased stress and uncertainty.

This weekend we have seen Iran attack Israel. Middle East tensions are considerably higher today than even a week ago. Oil prices are spiking up and gold is at an all-time high. There is no shortage of bad news at the moment and global capital markets are feeling the stress.

Will this too pass or is there something more permanent?

For the DIY investor, especially those nearing or already in retirement, these shifts can seem particularly daunting. However, with a proactive approach and a research-based framework, it's possible to navigate these rocky periods effectively.

This note will guide you through understanding the nature of market changes, evaluating your investment strategy, managing emotional reactions, and maintaining a balanced perspective on investing.

Ultimately, you'll be better equipped to face market volatility and stress without compromising your financial security.

Understanding Market Conditions

When capital markets become volatile, the first question that might come to mind is whether these changes signify a fundamental shift or are merely temporary disturbances.

To discern this, it's crucial to understand the factors driving the market's behavior.

• For instance, fundamental changes may stem from shifts in economic policies, significant technological advancements, or major geopolitical events.

• In contrast, temporary fluctuations often result from short-term uncertainties or emotional reactions from the market participants.

Fundamental changes imply a shift in the underlying economic or financial environment that could have a prolonged impact on market performance.

A prime example would be the 2008 financial crisis, where excessive risk-taking by banks and a bursting housing bubble led to a global economic downturn. This fundamental change required a reassessment of investment strategies due to long-lasting effects on the market.

In contrast, the sharp declines and recoveries in stock markets during the early days of the COVID-19 pandemic were largely driven by temporary panic and subsequent reassurance through government interventions. Market corrections, often defined as short-term drops of 10% to 20% from recent peaks, are generally driven by transient factors.

For example, in 2018, the U.S. stock market experienced a rapid 10% drop due to fears of increased interest rates and trade tensions with China. However, it recovered quickly as tensions eased and economic indicators remained strong, showcasing a typical temporary correction.

The current volatility spike in global capital markets feels more transient than permanent. Inflation may not return to the pre-pandemic levels anytime soon but remains under control and within historical norms. The Middle East has been in conflict for decades. Global financial markets are always experiencing stress somewhere but the fundamental drivers of growth and profitability remain on track.

Re-Assessing Your Investment Strategy

As a DIY investor, one of the most critical steps in navigating market turbulence is to ensure that your asset allocation aligns with your risk tolerance and retirement goals. This alignment is essential for maintaining financial security and achieving long-term objectives, especially in a volatile market.

As markets evolve, so too should your investment strategy.

For those nearing retirement, it’s generally advisable to have a more conservative asset mix to mitigate risk. However, this needs regular reassessment to ensure it aligns with current market conditions and personal financial goals.

Understanding Risk Tolerance and Investment Goals

Your risk tolerance is likely to change as you approach retirement. What once seemed like an acceptable risk in exchange for higher returns may no longer suit your current situation.

For instance, a younger investor might opt for a high percentage of equities in their portfolio, but as retirement nears, the focus often shifts towards more stable investments like bonds or dividend-paying stocks.

At a time of market stress, it’s always a good practice to go back to basics:

Take a detailed look at your current portfolio distribution across various asset classes—stocks, bonds, alternatives, and cash.

For example, if your ideal asset mix was 60% equities and 40% bonds a few years ago, significant market gains might have shifted this ratio, inadvertently increasing your exposure to equities and thus, risk. It’s probably time to make some adjustments!

Adjustment Strategies

If your assessment shows a drift from your target allocation, consider rebalancing your portfolio.

Rebalancing usually involves selling off overperforming assets and buying underperforming ones to return to your original asset distribution. This might sound counterintuitive but remember, rebalancing helps in buying low and selling high, a fundamental investment principle.

Alternatively, you may need a total portfolio makeover. Maybe you let your portfolio become way over-dependant on one asset class, and the recent spike in market volatility has reminded you to scale back and lower your overall portfolio risk. You may find that updating your strategic asset allocation is required.

I advise that you review your strategic or target asset allocation at least annually, considering any changes in your personal life, financial goals, and the broader economic environment. This assessment helps align your investments with your current risk tolerance and retirement timeline.

Rebalancing Your Portfolio (if necessary)

Rebalancing is a fundamental practice for any investor, particularly those in retirement or nearing it, to ensure their investment strategy remains aligned with their risk tolerance and financial goals despite market fluctuations.

Rebalancing is the process of realigning the weightings of a portfolio of assets to maintain a desired level of asset allocation and risk. This often involves buying or selling assets periodically to achieve the desired asset balance.

Over time, the actual allocation of assets in your portfolio can drift away from your target allocation due to differing returns from various asset classes. For instance, if the equity portion of your portfolio has experienced significant growth, it might now constitute a larger share of your investments than intended, exposing you to greater risk than you might be comfortable with at this stage in your life.

Steps to Effective Rebalancing

Assessment: Regularly review your portfolio to identify which assets have deviated from your target allocation. I suggest you do this every quarter.

Decision: Determine the extent of the deviation and decide whether it's substantial enough to warrant rebalancing. This decision might depend on factors such as current market conditions, the cost of trading, and tax implications. A 5% deviation from the target especially in volatile asset classes such as equities should trigger an adjustment.

The frequency of rebalancing is also crucial. Some investors review their portfolios annually, while others may do so quarterly or in response to significant market movements. Choose a frequency that fits your investment style and the level of volatility you can handle.

Execution: Adjust your holdings to realign with your target asset allocation. This could involve selling off excess stocks and buying more bonds or other less volatile assets. I usually suggest doing all the trades simultaneously and not waiting for the perfect time.

Maintaining Discipline: Rebalancing requires discipline; it's not always easy to sell assets that are performing well or buy more of those that aren't.

However, the primary goal of rebalancing is not to maximize returns but to maintain the level of risk you are comfortable with.

By implementing a systematic approach to rebalancing, you maintain control over your investment strategy, ensuring that it continues to reflect your financial goals and risk tolerance as market conditions change.

Managing Your Emotions

During turbulent market periods, it's natural to feel stressed or fearful about your investments.

However, allowing emotions to dictate your investment decisions can lead to poor outcomes. Recognize signs of emotional investing, such as feeling compelled to sell off investments during a downturn to prevent further losses, or conversely, investing heavily in a rising market out of fear of missing out.

For investors, particularly those nearing or already in retirement, managing emotions can be as crucial as managing investments.

Understanding Emotional Triggers

Investors often react emotionally to market downturns; fear of loss can provoke a sell-off at market lows, which is counterproductive to long-term investment goals. Recognizing these emotional triggers is the first step toward controlling them.

Some common emotional pitfalls include:

• Panic Selling: Reacting to a sharp decline in the market by selling assets in a panic, fearing further losses.

• Overconfidence: During market highs, feeling overly confident can lead investors to take on more risk than their strategy permits.

• Confirmation Bias: Seeking information that supports one's preconceived notions about an investment, while ignoring contradictory evidence.

Counteract your Emotional Tendencies

Set Clear Investment Goals: Having clear, written objectives for your investments can serve as a reminder of your long-term plans and help resist impulsive decisions.

Create an Investment Policy Statement (IPS): This document outlines your investment strategy, including asset allocation and what to do in various market conditions, which can guide actions during emotional times. Don’t overcomplicate this. Just jot down your main goals and action steps on a piece of paper.

Regular Reviews with a trusted advisor or mastermind: Eliciting a “second opinion” can provide an objective perspective, helping to mitigate emotional biases and reaffirm your strategy.

Embracing Risk and Uncertainty

Investing inherently involves risks and the value of investments will always fluctuate over time. It's important to accept that market ups and downs are part of the investing landscape, particularly in the short term.

As a retiree or soon-to-be retiree, understanding the concept of "paper losses" - losses that are not realized until an asset is sold below its purchase price — can help maintain perspective during market dips.

Use the same perspective when it comes to “paper gains”. Just because your brokerage report or 401k statement has a certain value does not mean that when you need to access that money it will be there.

Adopting a realistic view of investment risks and acknowledging that portfolio values are accurate only at any given moment will help in making more measured and informed decisions.

Markets are always in motion and fluctuate between optimism and pessimism. In the long term, the fundamentals win out, but in the short term investor sentiment and transitory forces can hold sway over market prices.

Understanding and accepting that markets go through cycles of highs and lows can help temper emotional responses. It’s important to remember that markets have historically recovered over time, which can provide some comfort during downturns.

Investing inherently involves risk, and no investment is without potential loss. However, understanding and accepting this risk is key to managing it effectively.

For instance, equities offer higher potential returns but come with higher volatility, whereas bonds typically provide lower returns with less risk. Balancing these in your portfolio according to your risk tolerance is fundamental.

Focusing On What’s Important

Finally, remember that wealth isn't solely your financial assets. Your NET WEALTH includes, for starters, your health, relationships, and personal achievements.

Re-evaluate what truly matters to you, especially during times of financial stress. This broader perspective can significantly shift your approach to managing true wealth, focusing more on achieving a fulfilling and balanced life rather than merely accumulating assets.

Reflect on your personal and financial goals regularly. Are they still aligned with what you value most? This ongoing introspection can guide your investment decisions and strategies, ensuring they contribute positively to your overall life plans.

Navigating the unpredictable waters of the capital markets as a DIY investor requires a blend of strategic planning, emotional control, and an acceptance of the inherent uncertainties of investing.

By distinguishing between temporary corrections and fundamental market changes, regularly assessing and adjusting your asset allocation, effectively rebalancing your portfolio, managing your emotional responses, and embracing the broader realities of investing, you can maintain a steady course toward your financial goals

The Big Picture:

• Equities keep outperforming bonds. The dominance of US large-cap equities has been a key driver of the outperformance over the last decade.

• The big losers last week were US Small Cap Equity investors.

• Cash was the only asset class with a positive return last week.

• The investment environment has gone from risk-on to risk-neutral over the last couple of weeks.  

• Extreme investor complacency had to come to an end. It always does yet aggressive asset allocation strategies are still way ahead of less risky allocations.

Asset Class Risk Characteristics:

Economy:

• Inflation is the key issue in the US economy. Consumer price inflation is currently running at 3.5%. This represents a slight increase from the February rate of 3.2% and is above the U.S. Federal Reserve's target of 2%​. Unfortunately, the CPI is also trending higher, not lower.

• Shelter costs are the main contributor to rising prices. This category continues to be a significant driver of overall CPI, with a 5.7% increase over the past year.

• Transportation Services are also significantly going up. Prices in this category have increased by 10.7% rise over the past year.

• Another category with larger-than-average price increases is Food Away from Home. The cost of dining has risen 4.2% over the past year.

• Oil prices have been trending up contributing to inflationary pressures. Year-to-date crude is up almost 20%. Higher oil prices make the Fed’s job much harder and depress consumer sentiment.

• OPEC has implemented production cuts which are significantly tightening global oil supplies.

• Ongoing geopolitical conflicts in the Middle East, have recently affected oil transportation routes requiring oil tankers to take longer routes increasing transportation costs.

• As the global economy recovers from the impacts of the COVID-19 pandemic, oil demand is increasing. This resurgence in demand, particularly from countries like China, is pushing prices up as markets adjust to higher consumption levels.

• Higher oil prices spell trouble for the US economy but we haven’t yet reached panic levels. Higher oil prices will keep CPI inflation higher than the Fed wants.

Equities:

• The S&P 500 lost 1.5% last week with Growth stocks outperforming Value strategies. Higher interest rates on Treasuries and geopolitical concerns were the main culprits.

• The Russell 2000, our measure of small-cap stocks in the US, has continued to underperform. Last week the index lost 2.9% and year-to-date it is down 0.8%.

• Despite improving sentiment the Russell 2000 continues to disappoint investors looking for a place to diversify away from large-cap stocks.

• Japanese markets ended the week positively, with the Nikkei 225 and TOPIX indices gaining due to a depreciating yen.

• UK stocks also showed resilience, with the FTSE 100 surpassing the 8,000 mark, buoyed by gains in oil and mining companies.

• In the last month, Emerging Market Equities have performed best among the key equity-focused asset categories. Chinese stocks comprising 1/3 of the MSCI EM Index have led the way.

Bonds:

• The yields on U.S. Treasury notes, particularly the 10-year and 2-year yields jumped up last week as inflationary expectations kept getting revised up. The 10-year yield rose by 20 basis points, reaching a new year-to-date high of 4.40%. The 2-year yields also moved up by 13 basis points.

• The bond market movements are in part reactions to robust economic data, including a strong labor market report.

• This economic strength has led to speculation about the Federal Reserve's interest rate policies, with mixed signals about potential rate cuts later in the year. The probability of a rate cut in June is now only 20%.

• Year to date the performance of short-maturity bonds has trounced the return of long-maturity bond strategies. The iShares 20+ Year Treasury Bond ETF (TLT) is down 7.7% for the year.

Signal Versus Noise

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• Asset Allocation Performance - Portfolio Implications

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