Investing During Uncertain Times

Over the course of a lifetime, the average investor will experience many events that create uncertainty and volatility in their investment portfolios. Looking back just two decades since the turn of the century, investors have experienced the effects of the Dotcom Bubble, the Great Recession, and recently COVID-19.

Currently there are factors leading to additional uncertainty regarding the future including substantial levels of inflation, rising interest rates, and the unrest between Russia and Ukraine. For many families, this uncertainty leads to the question of how to protect the wealth they’ve built and continue to add to it in the years ahead.

Certainty Versus Security

When investors believe the future is uncertain, the natural desire is to find a way avoid the uncertainty. Often the temptation is to sell what are typically considered “risky” assets such as stocks and hold cash until the uncertainty passes.

This approach is based on the assumption that certainty provides security. When the future is uncertain, the feeling of financial security is gone. By selling the assets that create the uncertainty and holding cash, the individual often feels as though they’ve regained control.

To explore this further, let’s start by considering the definitions of certainty and security. Paraphrasing the Merriam Webster dictionary, certainty and security can be defined as follows:

• Certainty: Something that is fixed or settled. Something that is dependable, reliable, and inevitable.
• Security: Something that is free from danger. Something that affords safety and is free from the risk of loss.

While these terms sound very similar, they are different. For example, if an investor has a $1,000,000 portfolio, and they receive an offer to exchange their $1,000,000 portfolio today for a guaranteed check of $250,000 in 40 years, we would say that it may be certain, but it represents a certain loss of 75%. It definitely does not provide security for the investor and their family.

The purpose of this example is to demonstrate that people’s natural desire for security cannot be filled simply by looking for certainty. While very few individuals would accept the offer to sell their current portfolio in exchange for a guaranteed loss, many individuals effectively do exactly that by selling equities at the bottom of a down market, holding cash during inflationary periods, or simply abandoning their investment plan whenever they feel there is uncertainty in the market.

Key Takeaway:

Certainty does not equal security.

Common Responses By Concerned Investors

To understand the real-life consequences of abandoning a well thought out investment plan, let’s consider three common reactions by concerned investors:

1. Selling equities and going to cash.
2. Selling equities and buying gold.
3. Going back and forth between cash and equities in an attempt to time the market.

Selling Equities and Going to Cash:

The most common way that investors avoid uncertainty is to sell their equity investments and hold cash or short-term fixed income investments instead. The problem with this approach is that cash and short-term fixed income currently pay very low interest rates. In the inflationary environment we are in, holding cash or short-term fixed income will result in certain loss of purchasing power over time.

U.S. Inflation Since 1980: Inflation represents the general increase in the price level over time. For example, the price of burger at McDonalds today costs more than it did 40 years ago. This isn’t surprising to most individuals given they experience it every day – especially lately with the most recent annual inflation numbers exceeding 8%.

The following chart shows historical inflation in the United States since 1980 using the Consumer Price Index data for All Urban Consumers (CPI-U) from the Bureau of Labor Statistics:

Inflation isn’t always a bad thing. In the United States, the Federal Reserve has set a target of annual average inflation of 2% with the expectation that this will assist in maintaining an economic system with full employment and price stability. However the inflation we are currently experiencing of over 8% demonstrates the difficulty of maintaining a specific level of inflation at any given time.

Since inflation increases the cost of living, the purchasing power of a dollar declines over time. Using the inflation rates above, $1.00 in 1980 has declined in value to only $0.28 today. In other words, $1.00 today would buy the same amount as $0.28 in 1980.

This means the inflation adjusted value of $1.00 has declined by 72% since 1980.

While an individual who had $1,000,000 dollars in 1980 could have held it all in cash and would still have $1,000,000 dollars today, that individual would have suffered a 72% loss in purchasing power.

The Cost of Cash:

While selling assets that typically are considered risky and holding cash provides the certainty that many investors believe they want, the impacts of inflation demonstrate that holding cash comes with a significant cost which is the loss of purchasing power over time.

Often that loss of purchasing power is so significant that it undermines the security of an individual’s financial future ultimately negating the very goal the investor was attempting to protect.

As counter intuitive as it may seem, historically the best way to build, grow, and protect wealth over time has been to buy and hold productive assets for the long-term and avoid holding unnecessary amounts of cash.

Key Takeaway:

Holding cash results in losses of purchasing power over time.

Selling Equities and Buying Gold:

The second natural instinct for many investors is to sell their equity investments and purchase an asset that is marketed as a store of value or a safe haven – the most typical example is gold.

Since inflationary pressures make it very difficult to hold cash for long periods of time, many investors choose to purchase gold during uncertain and inflationary times. Gold has often been thought of and marketed as a good inflation hedge that is often non-correlated with the rest of the market.

If we consider the performance of gold since 1980, we will see that its value has increased over time. The following chart shows the average price of gold from 1980 through 2021. As the graph shows, the value of 1 oz of gold has increased by about three times from just over $600/oz in 1980 to just over $1,800/oz in 2021.

Since the value of gold has increased by over three times since 1980, it is important to compare that growth to inflation over the same time period to determine whether it has protected investors’ purchasing power over time.

As this graph shows, $1 that is compounded at the annual inflation rate each year from 1980 through 2021 would increase in value to $3.63. If that same dollar was invested in gold, it would have grown to $3.27. So over that time period gold nearly kept pace with inflation.

However, if you look more closely at the graph, the returns of gold deviate significantly from inflation during long time periods on the graph. From 1980 – 2000 the value of gold did not increase despite consistent inflation. Conversely from 2000 to 2010, the value of gold increased much more rapidly than inflation.

The results of this data clarify that gold has some ability to maintain its inflation adjusted value over time; however, the returns of gold over this entire period have underperformed inflation and have not always been correlated with inflation over shorter time frames (20 years or less).

Accordingly, gold appears to be a marginal investment with limited ability to protect against inflation over time.

Key Takeaway:

Since 1980, gold has been a marginal investment that has provided a moderate amount of inflation protection.

Timing the Market:

The third response many investors have to uncertainty is to try to time the market. Timing the market occurs when an investor attempts to sell their investments while the general market level is high and then hold cash until the market corrects with the goal of buying back in again before the market rebounds.

Market timing seems like a simple strategy because the only choices are when to sell and when to buy back in. However in practice, knowing when to buy and sell are two of the most difficult questions to answer. Market timers must be right twice in order to profitably time the market since they need to sell at the correct time and buy back in at the correct time.

Markets are complex systems impacted by innumerable factors, and no one is able to correctly predict the short-term movements of the market consistently over time.

Market timing has been the subject of significant research. In a paper published in 2016, Wim Antoons and the Brandes Institute focused specifically on market timing and concluded that investors are overconfident in their ability to make market timing calls. In nearly every case market timing approaches underperform buy and hold strategies.

Specifically, the study referenced their review of 68 market timing experts. Forty-two of the 68 were accurate less than 50% of the time and not one was able to make money from their market timing calls after factoring in transaction costs (Antoons, 2016, p9).

While timing the market seems simple, in practice its results are similar to going to the casino and gambling. It works just enough to keep an individual coming back, but the odds are unfavorable and over time it is a losing game that can have devastating impacts on long-term results.

Key Takeaway:

Timing the market sounds enticing simple, but in practice it is impossible to consistently implement effectively.

What Then?

If the natural instinct of many investors to go to cash, buy gold, or time the market are not effective solutions to achieving long-term financial security, what is the best approach? History has shown that the best approach is to have a well-diversified portfolio of productive assets and let the market do its work over time.

In many cases the uncertainty itself is what allows for higher long-term investment returns in the first place. For example, if the outcome of an investment is uncertain, investors will require higher expected returns in exchange for making the investment.

Accordingly, when there are significant amounts of uncertainty regarding the future of the market, it is precisely at those times that the future return of the market is likely to be higher.

The simple fact that uncertainty itself is a primary driver of long-term returns is what we consider the “upside of uncertainty”. The uncertainty itself gives investors the ability to purchase assets at a cheaper price specifically because the outcomes cannot be precisely known.

The Upside of Uncertainty:

While productive assets like equities or publicly traded real estate are subject to the price fluctuations and volatility that create the uncertainty that many investors dislike, they have allowed many long-term investors to build wealth and create security for their family.

Note: We define productive assets as assets that produce income and cash flow and include equities such as US and international large cap, mid cap, and small cap companies and real estate. For purposes of this article, we will focus on US large cap equities to demonstrate the value of holding productive assets over time.

The fact that these assets are traded daily on the stock market create the perspective that their value can change significantly in short periods of time and leads to the belief that their values cannot be counted on in the future. However, historically the truth has been that these assets have provided significant value over time by generating profits and being able to adapt to new market conditions.

For example, in inflationary periods, companies can raise their selling prices if the costs of their inputs increase. Owners of real estate similarly can increase rents. Both of these actions protect the profits of the companies and real estate and ultimately provide more flexibility to navigate changing market conditions than cash or fixed income investments.

Although the price on any given day for a specific company or real estate asset may fluctuate, over time these assets have created substantial wealth for those who choose to patiently hold them long-term.

To provide perspective, consider the value of $1 in 1980 invested in the S&P 500. The value of that dollar at the end of 2021 would be worth $133. Since a dollar today is only worth 28% of what a 1980 dollar was worth, an investor in the S&P 500 would still have accumulated $37 of 1980 equivalent dollars!

Not only does this significantly exceed inflation, but it has allowed patient investors to build substantial wealth over time. None of the natural inclinations of many investors such as going to cash, investing heavily in gold, or timing the market have achieved anywhere near the success of patient investors who create a sound strategy and stick with it over time.

Ultimately as counter-intuitive as it may seems, holding productive assets that many deem as “risky” or “uncertain” is the key to protecting wealth and providing the security each individual desires.

Key Takeaway:

Despite the volatility of the stock market, patient investors have reaped significant long-term returns.

How to Manage Uncertainty:

While holding a well-diversified portfolio of productive assets is the key to creating the security necessary to protect for the future, it is also important to acknowledge that the value of these assets at any given point in time can fluctuate.

Given this issue, it is important to create a plan that can balance the need for growth to match and outpace inflation while also creating a level of stability to meet an individual’s income needs during times of volatility.

The key is to create a customized approach for each individual considering the amount of annual income the individual will need from their portfolio. If an individual is retired and is receiving Social Security and a pension, they may not need to draw anything on the portfolio. Others may rely entirely on their portfolio to provide the income they need to live.

In either case, it is important for each individual to have enough of their portfolio allocated to stable assets to cover two to five years of income. Stable assets can include cash, but more typically would be comprised of short-term treasury bonds and other fixed income investments.

This creates a stable source of funds that will allow each investor to maintain necessary retirement distributions during market downturns without requiring the investor to sell productive assets while their prices are depressed.

The important point to note is that the allocation to stable assets should be determined ahead of time and should not be changed as a result of emotional responses to market fluctuations.

Ideally the allocation to stable assets should be limited to only the amount necessary to weather a market downturn or to allow an investor to maintain their conviction to stick with their investment plan during periods of volatility.

The rest of the portfolio should be allocated to productive assets that are expected to generate significant returns over time that outpace inflation.

Key Takeaway:

The volatility and uncertainty that comes with investing in the market can be managed with a rational investment plan.

Conclusion:

Financial security is a top priority for Americans – especially those nearing retirement. When investors become concerned about the uncertainty of the economy and stock market, the natural human reaction is to look for certainty with the belief that certainty will provide security.

However, certainty and security are not synonymous, and especially during inflationary times, choosing certainty results in losses of purchasing power that decrease financial security.

Historically, those who have committed to a long-term strategy of investing in productive assets and have managed the accompanying uncertainty with a well constructed investment plan have successfully built wealth and created long-term security for themselves and their families.

If you are interested in learning more about creating an investment plan to protect and grow your wealth for the future and provide financial security for your family, we would love to connect to see if what we do is right for you.

 

References:

1. Wim Antoons (2016). Market Timing: Opportunities and Risks (Number 2016-06). The Brandes Institute. https://www.brandes.com/docs/default-source/brandes-institute/2016/market-timing-opportunities-and-risks-whitepaper