Correlation: Positive One

A diversified portfolio is always recommended. Balancing your accounts between stocks, bonds, and cash will allow it to grow with less risk than a concentrated portfolio.

A key metric to determine how well diversified your investments are is the correlation coefficient. It ranges from positive one to negative one. If two investments have a correlation of positive one, they’ll move in lock step. They will move in opposite directions with a correlation of negative one – one will zig, the other will zag. For example, large cap stocks and mid cap stocks have a high correlation of .97. These two asset classes will rise and fall as if they’re one.  Real estate investments and small-cap value stocks have a negative correlation of .25, so they’ll often move in opposite directions.

If we apply this metric to food, then swordfish, mahi-mahi, and tilapia are highly correlated.  Swordfish and brussel sprouts are negatively correlated.

Stocks and bonds have low, or negative, correlations and this is one of the reasons your risk will be reduced when you add bonds to your portfolio. In a rising market, investors get frustrated with a high allocation to bonds because it puts a lid on returns. However, when stocks fall, bonds help cushion the blow.

October has been horrible for stocks, bonds, and almost every other publicly traded asset class. During times of duress investors panic and sell their holdings and this causes investments to have a short-term correlation of one, meaning everything is moving in the same direction. When every asset class is in negative territory, emotion overrides logic. During a down draft, investors don’t care about negatively correlated assets, balanced portfolios, or diversified investments because they only want to sell, regardless of long-term consequences.

What can you do if your portfolio is going down and the “safe” investments are failing to stop the slide? Here are a few suggestions.

Review. Have your goals changed in the last thirty days? The recent fall in stocks has been a disruption in the long-term trend of the stock market, but it’s unlikely it will have a lasting impact on your goals. If you’re not sure your investments are aligned to your goals, then a financial plan can help you quantify them.

Rebalance. During times of market turmoil your original asset allocation has probably moved from its original mooring.  If you purchased an equal amount of stocks and bonds ten years ago, your allocation today is approximately 70% stocks, 30% bonds. The stock market has risen dramatically over the past ten years, and, as a result, your portfolio is now too aggressive based on your original asset allocation of 50% stocks, 50% bonds. Rebalancing your accounts annually will keep your risk level intact.

Purchase. Buying investments when everyone is selling is difficult, but it has proved profitable during the past 200 years or so, so I’m not sure why this time will be any different. Adding money to your investments when they are down makes financial and economic sense. If you automate your investing, it will remove some of the emotion from buying when others are selling.

Nothing. Patience is a virtue and a smart investment strategy. Doing nothing is hard, but it could pay dividends in the future. From March 1, 2009 through October 29, 2018, the Dow Jones has risen 221%. During this run, the Dow had negative monthly returns about a third of the time. It was down almost 8% in May 2012. It had 26 different months where it lost between 1% and 6%. If you panicked during these down months, you would’ve missed the long-term trend of the market for the past nine years.

Disconnect. A walk in the mountains or a stroll on the beach will clear your head. It will also take you away from CNBC and the other media outlets who declare every day a state of emergency. It doesn’t matter if the market is rising or falling, because, according to the “experts”, there’s always something lurking. Distancing yourself from the noise will give you perspective about your investments and your goals.

Give. It’s hard to worry about money when you’re giving it away to help others. Giving will reduce your dependence on money. Ron Blue said giving breaks the power of money. Paul Allen, the co-founder of Microsoft, recently died with an estate worth more than $26 billion. Over his life he gave away billions of dollars to several groups and organizations. His estate is expected to give away another $13 billion to charities when it settles.[1] His giving didn’t hinder his wealth accumulation, in fact, it probably enhanced it.

Over time correlations work and diversified portfolios produce solid gains. Time has benefited stock holders for generations, especially those who have had the courage to buy during market mayhem. Trying to time the market is impossible. Rather than trying to figure out if the market will rise or fall from one day to the next, focus on your goals and how your resources can benefit others.

He who observes the wind will not sow, and he who regards the clouds will not reap. ~ Ecclesiastes 11:4

10/30/2018

Bill Parrott is the President and CEO of Parrott Wealth Management located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog.

 

 

[1] https://www.heraldnet.com/business/paul-allens-26-billion-estate-will-take-years-to-unravel/, by Simone Foxman and Noah Buhayar / Bloomberg, 10/28/2018

Lord of the Flies.

Lord of the Flies by William Golding is a classic book and one of my favorite reads.  The story is about a group of boys stranded on a deserted island who try to establish a civilized society with the help of the conch.   It doesn’t take long before their community falls apart and panic and chaos take over with the boys splitting into separate factions.  The boys are eventually rescued but not before Piggy dies and the island is set ablaze.

After Hurricane Harvey rolled through Texas, panic and chaos set in as people thought our state was running out of gas.   In Austin, the stations ran out of gas as people filled up cars and other containers hoping to avoid a coming crisis.  A picture posted on social media showed one gentleman filling up two 30-gallon trash cans with gas, an illegal and hazardous activity.  Despite assurance from the Texas Railroad Commissioner, Ryan Sitton, Austinites and other Texas residents are draining gas pumps dry.  He said we have nothing to fear but did add, “This is a case of a self-fulfilling prophecy.”

In a panic, individuals stop thinking, lose control, and make decision with long term consequences.   This happens often when the stock market falls.  During a stock market correction, investors panic and act irrationally.

Here a few tips to help you when the stock market falls again:

  • Don’t Panic. I can’t repeat this often enough, don’t panic!  The stock market may stay depressed for days or months but it will eventually recover.
  • Remain Calm. The panic and chaos will eventually subside and order will be restored.
  • Carry On. A market correction is a great time to revisit your financial plan to make sure you’re still on the right path to financial freedom.  The downtime will give you a chance to focus on what’s most important to you and your family.
  • Buy Bonds. A well-diversified portfolio should include an allocation to bonds.   During a market rout, U.S. Government bonds perform well as investors seek shelter.  When the stock market dropped 37% in 2008, long-term Government bonds rose 26%.[1]
  • Seek Opportunities. During a market meltdown, you’ll always find a bargain.  If the price of Apple stock price falls 50%, they’ll continue to sell iPhones, ear-buds and chargers.  In the 2008 correction, Apple dropped 57%.  In 2009, it climbed 147%!  A $10,000 investment in Apple Stock in January of 2008 is now worth $64,425 generating an average annual return of 21.24%.[2]
  • Give. During a correction or calamity there will always be people in need.  Can you use a portion of your wealth to help others?

Hurricane Harvey was a terrible storm and my heart aches for the lives lost and the destruction that occurred, however, I’m hopeful we’ll eventually reap a harvest of peace.

Let us not become weary in doing good, for at the proper time we will reap a harvest if we do not give up. ~ Galatians 6:9.

Bill Parrott is the President and CEO of Parrott Wealth Management, LLC.  For more information on financial planning and investment management, please visit www.parrottwealth.com.

Note:  Your returns may differ than those posted in this blog.  Past performance is not a guarantee of future performance.

September 2, 2017

[1] Dimensional Fund Advisors Matrix Book 2017.

[2] Morningstar Office Hypothetical Tool, 1/1/2008 – 8/31/2017.