Market corrections are where returns are made so don’t head for the sidelines

Goals-based investing and tactical asset management, or having the willingness to go on offence or defence when others are doing the opposite, are showing their merit in this year’s volatile markets.

But there are still those who are trying to time the stock market bottom perfectly, and they run the risk of getting it wrong due to some tight groupings of the largest up days. As a result, those going to cash could end up missing out on these best days, which can be detrimental to their portfolio’s returns.

J.P. Morgan Asset Management did a good analysis of this over a 20-year period from January 2002 to December 2022 and found that if you missed just the 20 best market days, your annual rate of return was cut in half to a paltry 2.63 per cent from the 5.33 per cent you would have earned if you had only missed the 10 best days. That’s also much worse than the 9.52-per-cent return if you had stayed fully invested. If you missed the 30 best days, your return would have been barely positive, at just 0.43 per cent.

We know that it is almost impossible to statistically miss out on all the best days over such a long period, but the point is to show investors that missing out on just a few of them will impact their returns, especially since these days tend to group together during periods of extreme volatility.

Market corrections are where returns are made, so it is important to be careful when the doom-and-gloomers warn of the next great economic collapse and then sit on the sidelines with an all-or-nothing approach.

Another problem occurs when stocks and bonds move down together, something that hadn’t happened in decades until this year. Many have been touting this as the end of the classic 60/40 portfolio, including myself when I point out how poorly this strategy has done this year.

But it is important to remember that risk management can come in many forms and there are many tools one can use beyond just fixed income. For example, we decided to reduce our duration risk in both stocks and bonds just as central bankers were starting to hike rates, and added inflation protection via low-duration assets.

We didn’t get it right with inflation-protected Treasuries and gold, but our energy positions sure helped offset a portion of our broader market exposure. Keeping bonds to our allowable minimums along with an overweight in U.S. dollar floating bonds also helped, as did high-coupon-paying structured notes.

Now that bonds have experienced their worst year on record, we have slowly been adding positions, starting with investment-grade corporates. Long-duration equities such as the technology sector have also been hit quite hard and so we’re buying some of the mega-caps and even the broader S&P 500, which is top heavy with these companies.

This doesn’t mean markets will not worsen in the near term, because the bottoms are a process and impossible to time perfectly, but history has shown it pays to be a bit of a contrarian following large moves.

The bottom line is that volatile times like these are when it is important to have a game plan and not capitulate to emotional biases such as loss aversion.

Start by sitting down with your money manager and asking them what they are specifically doing for your portfolio(s) besides waiting it out. This includes reviewing how you are positioned to best capture the upside when the market recovers while managing against some of the near-term risks.