personal finance  |  june 9, 2020

Maintaining Perspective in Unsettled Markets

How to stay confident in your long-term investment strategy.

 

Key Points

  • Equities are the main driver of long-term growth.

  • The appropriate asset allocation can help you maximize growth potential without exposing your portfolio to inappropriate, unnecessary levels of risk.

  • Sticking with your plan can help you maintain control through periods of uncertainty.

Judith Ward, CFP®

Senior Financial Planner

The longest-running bull market in U.S. history came to an end in February 2020. The bear that finally brought the bull to its knees rattled even the most veteran investors with its rapid declines and historic levels of volatility.1 And while it is impossible to predict the long-term impact the coronavirus pandemic will have on the economy and the stock market, history may offer some insight.

Recent bear markets have been caused by a variety of reasons, including extreme overvaluations, recessions, and even structural problems in financial markets. “While market fluctuations may feel unsettling, we recommend not letting short-term swings distract from your long-term strategy,” says Judith Ward, CFP®, a senior financial planner with T. Rowe Price. As investors decide how to respond, there are a few key things to keep in mind. Chief among them is that equities play an important role in a long-term plan.

Harness the Power of Equities

Although the stock market has experienced two major downturns since 2000, it bounced back each time and eventually reached higher levels. “Equities Drive Growth” demonstrates how the market has fluctuated over the past 25 years. Although stocks saw some drastic dips, they also rallied periodically for strong gains, and over a long-term time horizon, they’ve provided a higher return potential when compared with bonds or cash. A balanced 60/40 allocation of stocks and bonds would have returned nearly double the gains of bonds only, with less volatility than an all-stock portfolio.

Equities Drive Growth

Tracking the growth of $10,000 over 25 years shows greater growth potential for stocks when compared with bonds or cash. A balanced portfolio of 60% stocks and 40% bonds over time has typically returned comparable gains to an all-stock portfolio but with less volatility.

The chart tracks the growth of $10,000 over 25 years (1995-2020) shows greater growth potential for stocks when compared with bonds or cash. A balanced portfolio of 60% stocks and 40% bonds over time has typically returned comparable gains to an all-stock portfolio. Stocks are tracking at $83,406, Bonds at $38,028, Cash at $17,847, and 60%/40% at $65,482.

Equity is represented by the S&P 500 Index. Bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Cash is represented by the 3-month U.S. Treasury bill. Source for Bloomberg Barclays Index data: Bloomberg Index Services Ltd. Copyright © 2020, Bloomberg Index Services Ltd. Used with permission. Past performance cannot guarantee future results. It is not possible to invest directly in an index. Charts are shown for illustrative purposes.

Let History Be Your Guide

To better understand how stocks have performed over longer time periods, consider historical performance. Past performance cannot guarantee future results; however, if we examine the S&P 500 Index from the beginning of 1926 to December 31, 2019:

  • There have been 85 rolling 10-year periods since 1926. The S&P 500 produced gains in 81 of them and losses in four—meaning the market increased in 95% of 10-year time frames.

  • Stocks produced positive returns in every rolling 15-calendar year period since 1926.

  • During the 65 rolling 30-year periods since 1926, the stock market’s worst performance was an annualized return of 8.5%.

These historical returns illustrate how stocks have shown resilience and growth potential over the long term. That said, there also are important reasons to hold bonds. If you have short- or intermediate-term goals, you can help address the risk of near-term stock market losses by having bonds in your portfolio. Bonds typically offer greater return potential than cash and greater stability than stocks, which is important for investors with nearer-term financial goals. (See “Asset Class Returns by Holding Period.”)

Asset Class Returns by Holding Period

Although stocks have the greatest variability over shorter-term holding periods, they provide the highest average returns over longer periods as compared with bonds and cash.

Based on an observation period of 1945 to 2020, this bar chart profiles stocks, bonds, and cash with return % versus 1 year, 5 years, 10 years, and 20 years rolling periods. It also provides a percentage of total observations of the rolling periods for stocks (Negative 21% for 1-year, 7% for 5 years, 3% for 10 years, and 0% for 20-year), bonds (Negative 11% 1-year, 0% for 5-, 10-, and 20-year ), and cash (Negative 0% for 1, 5, 10, and 20 years). Although stocks have the greatest variability over shorter term holding periods, they provide the highest average returns over longer periods as compared with bonds and cash.

Equity is represented by the S&P 500 Index. Bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Cash is represented by the 3-month U.S. Treasury bill. Source for Bloomberg Barclays Index data: Bloomberg Index Services Ltd. Copyright © 2020, Bloomberg Index Services Ltd. Used with permission. Past performance cannot guarantee future results. It is not possible to invest directly in an index. Charts are shown for illustrative purposes.

Evaluate Your Plan

Your portfolio allocation should always reflect your investment horizon—the time remaining until you begin to withdraw the money and the amount of time it will take to spend it—as well as your risk tolerance. The appropriate allocation for your portfolio can help maximize your growth potential without exposing you to inappropriate levels of market risk. In general, the longer your time horizon, the more you should hold in stock funds or other growth-oriented investments. (See “Finding the Right Mix.”)

Over time, your allocation can get out of sync with your risk tolerance. Regular rebalancing can help keep your portfolio aligned with your goals and time horizon, which can leave you better prepared to weather a market downturn like the one that began in February.

Finding the Right Mix

As you get closer to retirement, your portfolio may move gradually from more aggressive (more stocks) to more conservative (less stocks). Consider the T. Rowe Price age-based asset allocation models.

The chart shows T. Rowe Price age-based asset allocation models (age: 20s/30s, 40s, 50s, 60s, and 70+). For 20s/30s stocks = 90-100% and bonds = 0-10%; age 40s stocks = 80-100% and bonds = 0-20%; age 50s stocks = 65-85% and bonds = 15-35%; age 60s stocks = 45-65%, bonds = 30-50%, and cash = 0-10%; age 70+ stocks = 30-50%, bonds = 40-60%, and cash = 0-20%).

Within Stocks: 60% U.S. Large-Cap, 25% Developed International, 10% U.S. Small-Cap, 5% Emerging Markets
Within Bonds: 70% U.S. Investment Grade, 10% High Yield, 10% International, 10% Emerging Markets
Within Cash: 100% Money Market Securities, Certificates of Deposit, Bank Accounts, and/or Short-Term Bonds

These allocations are age-based only and do not take risk tolerance into account. Our asset allocation models are designed to meet the needs of a hypothetical investor with an assumed retirement age of 65 and a withdrawal horizon of 30 years. The model asset allocations are based on analysis that seeks to balance long-term return potential with anticipated short-term volatility. The model reflects our view of appropriate levels of trade-off between potential return and short-term volatility for investors of certain ages or time frames. The longer the time frame for investing, the higher the allocation is to stocks (and the higher the volatility) versus bonds or cash.

Limitations
While the asset allocation models have been designed with reasonable assumptions and methods, the tool provides models based on the needs of hypothetical investors only and has certain limitations:
The models do not take into account individual circumstances or preferences, and the model displayed for your investment goal and/or age may not align with your accumulation time frame, withdrawal horizon, or view of the appropriate levels of trade-off between potential return and short-term volatility.
Investing consistent with a model allocation does not protect against losses or guarantee future results.
Please be sure to take other assets, income, and investments into consideration when reviewing results that do not incorporate that information. Other T. Rowe Price educational tools or advice services use different assumptions and methods and may yield different outcomes.

If you have a:

Longer time horizon and appropriate asset mix: Your retirement is many decades away, and it’s likely that even a dramatic decline in stocks won’t have an immediate impact on your lifestyle. If you have managed your allocation carefully, you are likely in a good position to weather the downturn.

Shorter time horizon and appropriate asset mix: You may be nearing retirement, or are already retired, and are rightfully concerned. T. Rowe Price suggests holding 45% to 65% of your portfolio in stocks at retirement, as well as maintaining a one- to two-year reserve of cash. Bonds and cash holdings can help buffer against stock volatility. In fact, if your allocation is well aligned, you may notice that your overall portfolio value has not declined as much as the broader market because of your allocation choices. If the market decline lasts for an extended period, use your cash reserve to cover your spending needs to avoid selling stocks at the bottom.

Mismatched time horizon and asset mix: If you had too much equity exposure for your time horizon or risk tolerance going into the bear market, you may be feeling concerned. Remember that your portfolio has likely benefited from robust gains over the past several years, which may have positioned it to sustain you despite recent losses. Even so, try to avoid acting out of fear, as selling now will only lock in those losses. Instead, plan on reevaluating your asset allocation once the volatility subsides. Meanwhile, look for ways to cut discretionary spending, and, if you are in retirement, adopt a more conservative withdrawal plan.

Rebalance When Possible

In the wake of a long bull market, your portfolio may have held more stocks than your risk tolerance might justify. “When markets are performing well, investors tend to ride them higher,” says Ward. “But when there is a sharp decline, that approach can lead to significant losses. Rebalancing is a way to help maintain a level of risk that investors find more comfortable.”

The recent declines in equity values may have pushed your allocations out of alignment. Rebalancing can help correct them. In general, if an asset class has strayed from its target by a certain amount (three to five percentage points, for example), consider rebalancing once the current volatility has subsided. You could also plan to rebalance your investments once a year to make sure your target allocation stays on course. Note that rebalancing does not protect against loss in a declining market.

As you rebalance, keep in mind the diversification of your portfolio to help manage business and sector risk. Business risk refers to the possibility that a particular company will encounter difficulties, leading to a stock price decline. Sector risk is the chance that negative factors could affect a particular industry or segment of the financial markets.

You can help reduce these risks without giving up return potential by not only spreading your investments among different market sectors, but also diversifying among a variety of stocks within those sectors. In the stock market, aim to diversify between domestic and international stocks. Diversify your bond exposure between international and domestic securities—and bonds with different credit qualities and maturities. Diversification cannot assure a profit or protect against loss in a declining market.

Stay Invested

While it may be challenging to stick with your plan, doing so means you’ll be well positioned to reap potential long-term gains as the market recovers. (See “The High Cost of Cashing Out.”) To illustrate the benefit of staying invested through all types of markets, let’s consider two hypothetical investors—the first adheres to an investment strategy despite market fluctuations, and the second becomes anxious during volatile markets and jumps in and out.

The High Cost of Cashing Out

Compare the performance of two hypothetical investors. Investor 1 sticks to an investment strategy despite market fluctuations, while Investor 2 jumps in and out based on anxiety about the volatility.

The bar chart shows a comparison between two investors - a steady one and an anxious one - during various market fluctuations like Tech Bubble Crash in 1Q2001, Global Financial Crisis in 4Q2008, Flash Crash in 2Q2010, U.S. Credit Downgrade in 3Q2011, 2018 4Q Sell-Off in 4Q2018, and Coronavirus Sell-Off in 1Q2020.

The “anxious” investor style is assumed to be invested in 3-month Treasury bills as a cash equivalent. The $2,000 contributed each quarter in this example assumes minimal interest earned. The anxious investor style also assumes that cash is invested in Treasury bills during those periods when not invested in the stock market. The performance of stocks shown is that of the S&P 500 Stock Index, which measures the performance of large-capitalization companies that represent a broad spectrum of the U.S. economy. Charts are for illustrative purposes only. Investors cannot invest directly in an index. Past performance cannot guarantee future results.
Sources: T. Rowe Price and S&P. See Additional Disclosures.

Both investors contributed $2,000 each quarter to their investment accounts. The steady investor kept their money and ongoing contributions invested, riding out the stock market’s ups and downs. The anxious investor moved their account balance and contributions to cash when stocks dropped 10% or more in a quarter and only jumped back into equities after a fourth consecutive quarter of positive returns. This behavior was repeated throughout several market cycles.

While both investors saw their portfolio balances decline during downturns, they continued to contribute to their accounts. The steady investor took advantage of lower stock prices through ongoing contributions and was rewarded as the market recovered. Ultimately, the anxious investor’s account value was less than half of the steady long-term investor’s account at the end of the period.

Stay Flexible

Making small adjustments over time, rather than impulsively selling, may be a more prudent way to keep your retirement on track. In the meantime, reevaluate your spending and income sources, and hold off on discretionary spending. If you are not yet retired, consider remaining flexible on the timing of your retirement as you monitor the market. This down market is an opportunity to buy shares at lower prices, so if you’re able, consider boosting your contributions to take advantage of the bargains.

“We might not know when or how long this downturn may persist,” says Ward. “But having a plan in place and being willing to make small adjustments can help you maintain control through these periods of uncertainty.”

1As measured by Cboe Volatility Index (VIX). High point on March 16, 2020.

Additional Disclosures

The “S&P 500 Index” is a product of S&P Dow Jones Indices LLC, a division of S&P Global, or its affiliates (“SPDJI”), and has been licensed for use by T. Rowe Price. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC, a division of S&P Global (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). T. Rowe Price’s product is not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, or their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product nor do they have any liability for any errors, omissions, or interruptions of the S&P 500 Index.

Important Information

This material is provided for general and educational purposes only and is not intended to provide legal, tax, or investment advice. This material does not provide fiduciary recommendations concerning investments; it is not individualized to the needs of any specific benefit plan or retirement investor, nor is it intended to serve as the primary basis for investment decision-making.

The views contained herein are those of the authors as of May 2020 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

All investments involve risk. All charts and tables are shown for illustrative purposes only.

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