Stocks got slammed Wednesday on Fed-easing fears. Time to run to fixed income, right? Oh, that's right. Bonds also fell on concerns that the Fed would slow its monthly $85 billion buying spree of Treasuries and mortgage-backed securities.
Time to stash the cash under the mattress? Or just zero in on high-beta small-caps and trade, trade, trade? No, not so fast.
First, one day of heavy-volume downside trade is nothing to panic about. That's exactly what I've been saying for years, even when I was coaching traders (yes, even those who liked volatile small-caps).
Second, throughout any kind of market cycle -- and one day does not a cycle make -- it's crucial to have portfolio construction that incorporates elements from both the bond and stock sides of the market.
A couple of notes on that: Clients often come in with an existing portfolio that they call "conservative." When I scan the holdings (usually expense-laden mutual funds, with some single stocks sometimes sprinkled in), it's not unusual to find a portfolio consisting mostly of stocks. Sometimes, it's all stocks. The previous advisor somehow believed that widely traded large-caps were "conservative." He or she also convinced the client of that. But that's wrong.
They're stocks, so they carry equity market risk. Sure, Johnson & Johnson (JNJ), with a beta of 0.53 and a dividend yield of 3%, is generally more sedate than a small-cap growth name such Lumber Liquidators (LL), which has a beta of 1.43 and no dividend. But stocks can trend lower in tandem, which can pose a particular risk for investors in or nearing retirement.
Traders, and those selling a particular trading system, will cling to the notion that they can sell at the right time. But we know that doesn't work. If any of these trading systems were 100% successful, everybody would be using them, and succeeding. (Of course, that would necessitate other systems to win from the other side of the trade, but it's a moot point.)
I meet plenty of people who rely on one system or another to monitor their portfolios, and they try tweaking and fine-tuning to optimize various ratios they don't really understand. Sharpe and Sortino ratios. Risk and return? Phooey. Jack up those returns, risk be damned!
But that has zero to do with a financial plan for offsetting future obligations (also known as "your non-working years.") It's closer to betting your nest egg on "lucky No. 7" on the roulette wheel at Circus Circus.
Instead, think about portfolio construction. Not "asset allocation," which is the process of spreading assets across various regions and asset types. Portfolio construction is concerned with designing the correct balance of assets for a particular investor's objective.
By having a portion of money in stocks, bonds and cash, investors can, over time, mitigate downside risk while achieving growth in the portfolio. But this is why I started out with a warning about days like today, when asset classes are more correlated. Traders tend to panic, and want to make shifts. Investors with a plan realize that slow-and-steady is the way to win the race. And by "winning," I mean attaining security in your golden years, and not having to eat cat food while you trade in and out of nano-caps.