Lessons in Diversification

Greetings All,

There is no beating around the bush…financial markets have had a tough start to the year, particularly over the last few weeks.

Now, we've dealt with slow market cycles before. The wounds of the 2022 market pullback may have healed for the general population, but there are still some scars left over. During that year, markets fell by more than 20% over a period of about ten to twelve months. It was a slow bleed. 

In comparison, the current market pullback is much more rapid. Over the past three to four months, we have sat down a handful of times to write one of these, only for something new to be released. During a client call in early February, we were having a conversation about the newly implemented tariffs on Mexico and Canada. By the time we were off the call, the Mexican tariffs had been punted thirty days. Later that afternoon, the tariffs on Canadian imports were also pushed out.

Things in the world are happening fast. Policy decisions are being made that will impact our day-to-day lives. In a world where information is available and exchanged with the click of a button, this can make things incredibly uncomfortable. 

All of this has led to markets around the globe pulling back, with the sharpest pullback happening here in the US. When markets closed on Monday, broad US markets were down about 15%. 

Although this is painful, it's not all that abnormal. The average intra-year drawdown for markets is 14%. Comparatively, we had more severe market declines in 2015, 2018, 2020, and 2022 and made it through them all. This includes Covid, recessions, high inflation, the Fed abruptly hiking rates, etc. 

Yes, this is different and not "normal," but the reality is that every downturn is different and not "normal." Simply put, that is why they happen. Over a trillion dollars exchange hands daily in financial markets, constantly pricing in all new information in real time. If impending disaster were a certainty, markets would reflect that.

The current political environment certainly heightens both the triggers of fear and excitement. We have as many clients terrified at the moment as we do extremely optimistic. Globally, buyers and sellers are on the opposite side of every trade. 

The simple fact is the market does not care if we like or dislike what's going on, which is also why we do not invest based on emotion or politics. Markets and the companies that comprise them are resilient. Those of you who work in corporate America certainly know that your companies are not just rolling over. Many of you are working overtime on solutions to solve the new uncertainties of the day. Companies (and markets) are living and breathing things, and they will work tirelessly to continue to grow and thrive in whatever environment exists. Market swings are inevitable, but you are investing in the collective intelligence and resilience of the millions of men and women grinding away to make things work out. 

Additionally, the vast majority of this drop is being led by the seven largest tech companies in the world. Six of these companies (Amazon, Apple, Facebook, Nvidia, Tesla, and Google) are all down over 20%. The lone holdout, Microsoft, is still down close to 15%. 

These companies, which have been the darlings of the investment world for the better part of two years, are coming back to earth. Unfortunately, this has resulted in the broader market being pulled down with them. Folks who just own US companies or, more specifically, tech companies are hurting much more than the group that diversifies. 

Diversification has been our identity for as long as our firm has existed. Every portfolio that we manage owns US stocks, as well as a healthy number of foreign companies. Until late last week, foreign holdings were up over 10% on the year. Even after a couple of sharply negative days, these investments are basically flat. Flat might not sound great, but it's still a double-digit lead on US markets.

The other layer that has shown its purpose this year is the bond side of the portfolio. In a year where markets are down, these bonds continue to hold their value and spin-off interest payments of 4-5%. Those interest payments won't make you rich in the long term, but they will keep you from getting completely crushed during these volatile periods.

All in all, the portfolios we manage are down in the mid-single digits. No one ever wants to see things move backwards, but this drop is certainly not a rout, and does not impact anyone's specific financial plan. These reduced drop-offs are much easier to come back from. For example, a 5% decrease only requires a 5.25% return to get back to even. A 15% decrease requires an 18% return to get back to even. A 20% decrease requires a 25% return to get back to even. It's much easier to achieve 5.25% than it is to achieve 18% or 25%. Diversification is working.

Over the past few days, we've had a handful of clients who have reached out on how to approach this rocky period, many of whom were surprised to learn of the limited damage to their portfolio. Some of these conversations are talking through the implications of jumping ship and going to all cash, which we are strongly opposed to. On the flip side, we are also talking people out of emptying cash reserves and tapping into lines of credit to purchase stocks while they're low. Reactions to market swings come in many different forms!

When it comes down to it, everything happening today is part of the investment and financial planning process. When we run our long-term modeling, there are market iterations far worse than this being accounted for. Outside of a significant lifestyle shift, our confidence in these models is the same today as it was at the start of the year.

For the clients living off their assets, rest assured that plenty of cash and bonds are available to meet withdrawal needs. As mentioned before, bonds have provided an impressive, albeit not unexpected, level of stability to start the year. These assets are not exposed to the market fluctuations that you are seeing on the news. If markets remain low for an extended period of time, we will use these bonds to meet your spending needs and not be forced to sell stocks at reduced prices.

For the clients who want to buy while markets are low, it is a pretty good time to do so. However, cash and bonds still play an important role in every financial plan, so new additions should be added proportionately to your allocation, not just a full dump into stocks. Anything earmarked for emergencies and expenses in the coming year should not be exposed to stock markets. 

For the clients who just want a general idea of what moves are being made, please know that we are very actively paying attention to things. Rebalancing is happening as needed. If there are beneficial tax opportunities, we are taking advantage of them. 

The final thing we want you to know is we are fully invested in the philosophy in the same manner you are. Every dollar we have saved follows the same philosophy that our clients have. This includes the family and friends who have given us the opportunity to work with them. We are here not only for you but with you.

The philosophy that we implement has worked for the better part of a century. It's survived world wars, depressions, pandemics, inflation, and everything else our country has endured. We have survived, and we will survive. 

Hang in there.