The Playbook for Down-Markets

S&P 500 Total Return (as of 8/5/24):

We’ve seen the S&P 500 decline as much as -8.5% off recent highs, and yet…

• Record All-Time Highs in 2024: 42

• YTD Total Return: 9.61%

• 12-Month Total Return: 16.64%

• 3-Year Annualized Return (Aug ’21-Aug ’24): 7.39%

• 5-Year Annualized Return (Aug ’19-Aug ’24): 13.93%

• 10-Year Annualized Return (Aug ’14-Aug ’24): 12.48%

Imagine if, in 2019, I told you that we were on the cusp of a global pandemic that would result in tens of millions losing their jobs, a bout of inflation not seen in decades, and a policy response involving interest rate hikes so significant that they would lead to bank failures across the U.S. Add to that several geopolitical events (Russia-Ukraine; Israel-Hamas) and our own recent electoral chaos. Now, imagine me telling you that this same environment would produce annualized returns for the S&P 500 over the next five years well above long-term averages, registering nearly 14% per year.

As much as I’d like to celebrate this past performance and preach the stereotypical “stay the course” during the current decline, I find such an approach lacking in the lasting perspective needed to calm nerves during downturns. It can also lead many to make impulsive decisions if things get worse.

Instead, I want to share how we approach these inevitable declines both proactively and reactively for our clients. We’ll call it our Playbook for Down Markets.

Proactive Planning Makes These Events Far Less Scary:

1) Understanding Volatility is the Cost of Admission to Generate Returns: Although recent returns for the stock market have been outstanding, those who have captured these returns have had to endure declines of -20% in 2018, -34% in 2020, -25% in 2022, and -10% in 2023. Each event was scary and felt like it was the beginning of something much worse. (perhaps no different than today) Yet, allowing any of those declines to scare you out of the market (or keep you from investing in it) likely would have meant far worse outcomes for your portfolio.

We often use the chart below to illustrate how normal volatility is for the stock market. The grey bars show calendar-year returns for the S&P 500 over the last 40+ years, while the red dots highlight top-to-bottom losses experienced within each year. The takeaway: Larger intra-year declines happen quite regularly (on average a decline of -14.2% per year), sometimes in the context of an otherwise great year.

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2) Ensure You Have Enough Stable Income and Safe Asset Exposure to Ride Out a Prolonged Market Decline: The stock market is a long-term investment vehicle, and you should invest accordingly. What typically hurts investors the most is selling stocks during a market decline. To avoid this, ensure you have adequate outside income and/or safe asset exposure (such as high-quality bonds and cash) that you can rely on during a downturn. How much is enough? It depends on your risk tolerance, but a good starting point is to calculate any cash needs you may have from your portfolio over the next five years. That amount should be allocated to safer assets within your overall portfolio and used in the event of an extended market decline.

*Buying that house in the next 5 years? The down payment should not be in the market.

*Need to distribute $100k from your portfolio over the next 5 years? You should have at least $500k of safe asset exposure as part of that portfolio.

3) Stress-Testing your Current Portfolio:  While confirming that you have adequate safe assets and income sources to ride out a market decline is a good start, you also need to be emotionally prepared for the potential dollar losses that can occur during much larger downturns. As many investors have seen their portfolios grow to new heights in recent years, even modest market pullbacks can result in dollar losses they never imagined possible. You should understand how your current portfolio would have performed during periods of stress, such as the financial crisis, the early 2000s, and even the more typical annual declines that can occur in any given year. It’s a matter of when, not if, similar losses will impact your portfolio. Having a realistic understanding of what these losses might look like ahead of time can allow you to properly align your portfolio with your risk tolerance and improve your chances of sticking with the strategy as the declines occur.

We walk every client through these scenarios using tools like the one below. This takes a client’s current strategy and portfolio values and simulates historical market environments, providing a gut check on whether they can ride out the potential dollar losses.

4) Diversification: During periods of strong market performance, diversification can sometimes seem like a drag on returns. It’s tempting to question whether diversification is the right strategy when you see others achieving far greater results through more speculative or concentrated approaches, such as crypto ventures, meme stocks, or the latest tech craze. However, the reality is that many of these so-called “investments” are more akin to a roulette table than an asset belonging to an investment portfolio. Even for those with more sound economic and financial underpinnings, it’s rare for any single investment’s outperformance to persist over long time horizons.

These lessons often become painfully clear during a market decline, which can erase far more wealth than was created on the way up. This is why we strongly advocate for broad diversification—both across and within different types of investments. For an asset to be included in the portfolios we manage, it must have a solid economic rationale and a proven track record spanning multiple decades. This level of diversification helps us reduce the range of potential outcomes, achieve smoother and more consistent results, and create opportunities for rebalancing across different market environments.

5) Defining Risk Beyond Volatility: While market volatility can be painful in the short term, a more permanent and catastrophic risk is losing purchasing power and/or outliving your assets. This is why we start every client relationship with long-term projections of their income and net worth. These projections allow us to quantify the required rate of return necessary to avoid outliving their portfolio. This creates a much better definition of investment success beyond simply maximizing returns, beating a market index, or targeting an arbitrary portfolio value.

As we develop these long-term projections, we also tend to use conservative expectations for future portfolio returns. This provides an additional layer of cushion for poor market performance and/or unanticipated events in one’s financial plan.

6) Long Time Horizons and Discipline Solve Most Performance Issues: I often share the story of my dad’s experience with the stock market. He was a disciplined saver for most of his working career, but also a very conservative investor with those savings. (investing his entire portfolio in bonds) That is until October of 2007. He met with the advisor for his 401k and took their guidance to shift his portfolio to nearly 60% stocks. The timing, perhaps the worst imaginable. Within a couple of weeks, the market peaked, eventually losing more than half its value during the financial crisis.

Fortunately, he didn’t need the money until more than a decade later and didn’t panic sell during the decline. The results of such an ill-timed portfolio adjustment as of today: the S&P 500 has racked up a return of just over 10% per year. A portfolio of all high-quality bonds over this same time frame, just under 3%.

Yes, there was plenty of second-guessing and concerns over the short term as the losses mounted, but without a doubt, carrying discipline and a long-term perspective with the markets changed the trajectory of his retirement timeline and income potential.

Reactive Steps during a Market Decline:

Designing your portfolio and setting realistic expectations in anticipation of market declines can put you in a position to take advantage of them as they occur. Here are a few actions you should consider as you navigate a volatile market environment.

1) Portfolio Rebalancing; Strategic Asset Class Sales for Distributions: Buy low, sell high. This simple formula for investment success can be easily forgotten about, particularly in the backdrop of volatile markets. By embracing diversification (as noted above), you increase the chances of having more opportunities to rebalance as various asset classes within your portfolio drift in and out of favor.

If you need to make withdrawals from your portfolio during this time, utilizing your safe asset reserve may be necessary. You’ll also want to thoroughly review the rest of your portfolio to determine if there are other assets better suited for sale to fund the distribution.

2) Tax-loss harvesting: Regularly review your taxable portfolio balances for holdings that can be sold at a loss. These losses can offset current or future-year capital gains, and up to $3,000 of excess losses can be used to offset your non-investment income per year. If you do sell an investment at a loss, you’ll need to be sure not to repurchase that same security within 30 days to avoid wash-sale rules.

3) Roth IRA Conversions: While your marginal tax rates in any given year should be the primary factor driving the decision to convert pre-tax balances to Roth, a market decline does provide you an opportunity to convert a greater proportion of those pre-tax balances. As always, consult your own financial and tax professional to determine how this may apply in your specific circumstances.

4) Portfolio Transitioning: If you have balances in taxable investment portfolios, down markets can present an opportunity to shift to lower-cost, more tax-efficient options that align better with your overall investment strategy.

5) Investing Cash: If you have excess cash beyond what is needed for short-term spending, down markets present a great opportunity to put it to work. This can be done either through a one-time lump sum, or by starting a dollar-cost-averaging program.

6) Ignore the Headlines, Prognosticators, and Salespeople: When things get shaky, it's natural to seek certainty in an uncertain world. The media, its pundits, and outside salespeople will be there in droves, offering predictions and products pretending to provide such certainty. As compelling as their stories and product pitches might sound in the moment, you’ll often find their long term track record far from your best interest.

Address the items discussed in this blog, turn off the television, turn down the invitation for the free steak dinner, and enjoy living life with less stress about the daily noise of the financial markets.

Custom Wealth Planners is a Registered Investment Adviser offering services in Iowa and in other jurisdictions where exempt from registration. All views, expressions, and opinions included on this site are for informational purposes only, and should not be relied upon for specific investment, tax, or legal advice. Please consult your own advisor, tax, and legal professionals for how information discussed on this site may apply to your own circumstances.