Riding the Rollercoaster Without Losing Your Mind: How to Prepare for the Next Market Downturn

By Nick Fisher, Portfolio Manager and Rick Thomas, Business Advisor

If you have been following the financial headlines of late you may have noticed a consistent theme around the ills of over stimulated markets. Every day we go deeper into this historic market run up the warnings become more pronounced. Even to the seasoned investor, the current state defies conventional logic. After unprecedented zero interest rate policy, US Household net worth is up nearly 30% higher than before the great recession and debt levels are higher. Déjà vu all over again? Only time will tell, however it has provoked an interesting discussion amongst us internally over what happens when the market does cycle downward.

While we are not very good at predicting when a correction will happen, we can be certain that it will. We know that many asset prices will at some point be drastically cheaper. Therefore, the more interesting conversation is, what investor behavior will drive decisions when it does? Even for the best prepared, dealing with the emotions of cyclical volatility can overwhelm the most rational minds. As was illustrated in Michael Lewis’ The Big Short, it took extraordinary resolve and patience to profit from the financial meltdown (Note: Lewis recounts the actions of a hedge fund manager who is a former neurologist diagnosed with Asperger’s Syndrome). For the rest of us who don’t benefit from this hyper-rational ability and brilliance, we are left to deal with the emotions and fear of volatility. Only in adequately preparing ourselves for an eventual downturn can we feel secure when it happens.

Only in adequately preparing ourselves for an eventual downturn can we feel secure when it happens.

Leveraging conversations we have with many of our clients in how to prepare their businesses and investment portfolios for an eventual downturn, following are guidelines in how to fortify your interests for the eventual market correction:

Grounding Yourself

Start with memorializing your financial goals. Often our greatest anxieties come from not knowing what the objective is. Whether it is between you and your spouse, significant other or family member, have a conversation (or several!) around what your goals are and why they are important. Now, write them down! It is not enough to just talk about it. Memorializing your goals will focus your energy in achieving them and bring clarity to the subsequent conversations with your advisor.

Continuing with the writing theme, write down your greatest fears. As simple as this sounds, many avoid this because they somehow believe articulating the fear will somehow make it come true. In truth, the opposite is usually the case , but until we see the words on paper or on the screen in front of us, we don’t truly see them for what they are – just fears. In most cases, the fears our clients share with us have something to do with the loss of security. When we explore and probe the basis for these fears, they are almost always manifested from past experiences, not present ones. Once out in the open, the work then becomes aligning the lifestyle and habits around the goals, along with an investment strategy that accounts for those risks. In taking these steps, combatting the rollercoaster of emotions during a downturn becomes much more achievable and begins to alleviate the anxiety of the unknown.

Own up to past habits and mistakes that don’t serve you anymore. Let’s be honest…we all make mistakes, whether in investing, in life or otherwise. The question is, are we willing to own them and know when to make a change? The definition of insanity is continuing to do the same thing repeatedly and expecting a different result, and in investing the adage holds true as well. Many investors were casualties of the great recession; unable to recognize that their initial successes were due much less to clever investing than to a hyper inflated market. For many others, the opposite was true. Fearing the worst at every turn, they stuffed their mattresses full of cash waiting for the bottom to drop out. Unfortunately for this group, they missed out on one of the longest running bull markets in the last half-century. In either scenario and for all that lay in between, our belief is that pragmatism prevails with a diversified and balanced approach. Unfortunately, that can only be appreciated when the sins of ignorance and denial have been atoned through owning the mistakes and choosing to change core behaviors. Admittedly, this is not an easy thing to do but very necessary nonetheless.

Our belief is that pragmatism prevails with a diversified and balanced approach. Unfortunately, that can only be appreciated when the sins of ignorance and denial have been atoned through owning the mistakes and choosing to change core behaviors.

Be wary of headlines. We cannot fully analyze our investing behaviors and biases without first understanding what we are feeding them. A daily diet of headlines from the average news organizations are likely to only tell us what we fear to be true. News organizations exist by selling news, even when there is no news to sell. Relying solely on the large news organizations to shape and form our opinions and outlook is foolish. Instead, make a short list of the people you know to be thoughtful thinkers and ask them who their resources are, who do they follow? (or ask us and we would be happy to provide a robust list) Begin to build a bench of information sources that are diverse and have stood the test of time. Your mind will benefit from the healthy diet of reason and sound intellect and ultimately help pacify the emotions of uncertainty and fear in a downward market.

Sound Strategy

Have a strategy that accounts for both upside and downside. One of the more glaring omissions we notice in portfolio construction is the absence of balance and diversity. This does not mean that an investor should have exposure to the whole universe of equities and fixed income, nor does it have anything to do with the quantity of investments in a portfolio. The greatest investors realize that in any decision multiple outcomes are possible and therefore an investor must consider the probabilities of all outcomes. Remember, some outcomes are not only undesirable, but there may be an outcome or two that are unacceptable. It’s like the 6 foot man who drowned crossing the 5 foot deep river on average. We employ a strategy that balances the best-case scenario outcomes, with the worst-case scenario outcomes. In this way, we can ensure a portion of the portfolio will perform, regardless of the outcome.

From a performance perspective, if an investor’s goal is to be in the top 5% of investor performance during a given year, it very well may be achieved, however, it almost guarantees that in a bad year that investor will be in the bottom 5%. We prefer to shoot for above average performance and consistency so we avoid the bottom of the barrel in difficult performance years. Remember, an investor must be up 100% after being down 50%, just to break even. While highflying offenses are exciting to watch, it is defense that wins championships.

See downturns as opportunities. Beyond the flashy headlines on 24 hour news networks, the real news during down cycles is the level of activity from patient investors. Berkshire Hathaway, Koch Industries, Fairfax Financial, Markel, Wesco Financial, and many others all made significant acquisitions during the last recession. Why? No one was prepared to invest and for the few that were, the price was right. It required that they had the balance sheet and cash on hand to take advantage of the down cycle. Everyone can see a bargain when it happens, but not everyone can do something about it. Temperament is much more important than intelligence. Activity is often the enemy, and when an investor is unable to find bargains, they should have the temperament to go fishing or golfing instead. No amount of intelligence or effort can make an investment with too high a price a good purchase. Only those patient investors who maintain liquidity when opportunities become too expensive, will truly benefit in leveraging downturns into successful investment performance.

Dig the well before you are thirsty…- Chinese proverb

Putting it Together

Planning and investing can be thought of as a complex system. It can’t be done with math alone, nor should it be done in a vacuum as human behavior and emotions have far reaching impacts. Only through the company of wise counsel and sound rationale can a portfolio be constructed in a manner that adequately plans for risk. For an advisor, one must be a systems engineer of sorts, factoring in all of the system influences of randomness and emotion that can impact our decision-making abilities. Paramount to this is an integrated approach whereby the likely potential failures of the system are recognized and planned for in advance. This begins, first and foremost, with regular communication with your advisor as the foundation of risk management. Unfortunately, many people operate on the principal that no news is good news only to find out after the fact that the portfolio may not have been prepared for the downturn. A simple conversation on a quarterly basis focusing on the following questions will ensure your portfolio is prepared (or highlight you do not have the right advisor!):

Past: How has the portfolio anticipated the risks and opportunities in the market? What mistakes have been made and what have we learned? This conversation must happen over a full market cycle, as all other results are most likely influenced by “randomness” as Nicholas Taleb so wisely pointed out in his book, Fooled by Randomness. Every investor makes mistakes and the best advisors have no problem highlighting and discussing their mistakes.

Future: What risks and opportunities does the advisor anticipate going forward? What major outcomes does the advisor see relative to the portfolio? This will likely translate into generalizations of asset class returns, but more importantly what the range of potential outcomes in the form of returns look like over the short-term and long-term; how the portfolio is constructed to deal with the possible outcomes both on the upside and downside; how the advisor expects to act in each scenario. Remember, given life circumstances and market conditions it is perfectly acceptable to emphasize a more defensive or offensive approach.

Current: Is your portfolio still aligned with your current financial goals and objectives? Often we find goals change and the objective/s of the portfolio have not been adjusted to maintain alignment. A good advisor will continue to ask questions about what the goals are and if anything has changed.

If you find yourself unsatisfied with the answers, it may be that there is a lack of alignment with your advisor, be it values, style or philosophy. While most investors are first concerned with performance when choosing an advisor and while we agree that performance is an important metric, true long-term performance is an outcome of good risk management. Your ability to communicate with an advisor is critical. We also believe the only way to successfully implement planning and investment strategy is through the fiduciary relationship that is implicit with a fee only investment advisor.

As most have hopefully learned coming out of the last correction, down cycles can be painful when one is not adequately prepared for what often is the opportunity of a lifetime. Now is the time to anticipate and prepare for the next one, not in a run-for-the-hills fashion, but in a rational save-for-a-rainy-day approach. Partnering with your advisor on this will in the least ensure you are not losing your mind from the emotional rollercoaster of boomsday, to doomsday predictions and headlines. When the market correction does hit, you may just be prepared to take advantage of the buying opportunities and be in the rare company of successful investors that truly build wealth over the long haul.