Trump’s Trade War

Hey! How’s it going? In my previous post on President Trump’s Trade War, and its potential to impact your wallet and retirement, I mentioned a future post where I would outline prudent risk mitigation measures an investor might take. Given the fact that the main front of the Trump Trade War kicked off for reals with China on 06 July 2018, it seemed appropriate to pen further articles now. I’ve seen nothing in the intervening days to change my gloomy outlook. In fact, I may have underestimated how bad this situation might get.

I’m getting ahead of myself though. For those of you who missed the first Trump Trade War article, you can find it here. In it, I outlined what I thought was a significant misunderstanding of macroeconomics and strategy (or is that strategery?) within the Trump administration. I showed how the steps they’ve taken on tariffs, free-trade, taxes, and immigration seemed specifically designed to make the next recession worse. I also opined that the administration’s actions may be hastening the onset of the next recession through inflationary pressures. While I bemoaned the idea of a three front trade war, two of which are against some of our closest allies and trading partners; I didn’t necessarily dismiss the need for action on China. Only the method.

Intent

That said, I’m going to avoid wonkishly poking further holes in the big boss’s awful economic and trade policies. Instead, I want to concentrate on the prudent measures readers can take to minimize the impact of those policies on their investment portfolios. As I discussed in my previous Trade War article, as the U.S. economy goes, so goes the U.S. stock market more often than not. Thus, anyone planning on using their investments for retirement revenue needs to ensure their portfolio doesn’t suffer irreparable damage during this turbulent economic time. Even those who plan to live entirely on a pension should take note since pension funds invest in the market as well.

But before we get to the heart of this article, I have a few caveats …

Caveats

First off, I’m not a professional. Nor, have I taken your personal situation into account. So please don’t misconstrue anything I lay out in this, or any following articles, as personalized financial advice. Consider the options I describe as starting points for research if you’re a DIY investor, or a conversation with your investment professional if you’re not a DIY investor.

Second, I don’t possess any insider knowledge or keen insight into market movements — at least no more than the next person. Thus, I don’t know when the next market downturn is coming. As I pointed out in my previous Trade War article, statistically the U.S. is overdue a Bear Market and recession. However, I don’t know if the next downturn will start tomorrow or two years from now. The only prediction I’ve made is that the Trump administration’s current economic policies will make overcoming the next recession that much harder.

More Caveats

Thirdly, I remind you that statistics show that more than 90% of professional active investment managers can’t consistently beat their benchmarks over any significant length of time. Those that do beat the market, can’t beat it long or consistently enough for their success to be distinguished from luck! In case you don’t believe me, check out the chapter on the subject in Nate Silver’s book “The Signal and the Noise“. I reviewed it in one of my earliest posts. My history with actively trading stocks certainly fits the above mold. In fact, if I ever attempt to provide an individual stock tip via this forum you should do exactly the opposite of what I say.

The above paragraph is a long-winded way of saying that there’s only so much a person can do; especially if you’re an investment novice — which is what I still consider myself. Thus, you won’t see me advocating complex methods for limiting the downside like options or short-selling. I realize strategies like that exist, however, I don’t consider those sorts of investment discussions appropriate for the majority of my audience (yet?).

Nor will you find me advocating less radical diversification strategies like real estate. That isn’t to say that people don’t make money through being a landlord, it’s just that my eye for property is only slightly better than my stock-picking acumen. In fact, I addressed my lousy history as a stock-picker and a first-time property owner in a singular article that remains one of my favorites to this day. Check it out here. Despite this, if you remain interested in real estate as an investment option, I would recommend Rich On Money as an exceptional resource for those with pensions coming your way. Rich didn’t pay me to say that either.

Timing the Market

The final caveat I want to address is the issue of timing the market. The term “timing the market” is a reference to the classic stock investing tip to “buy low and sell high”. However, human nature being what it is, most investors actually buy high and sell low. It’s one of the reason’s the Dalbar report consistently shows that the average investor earns below-average returns. That includes professional active money managers at all levels and DIY investors like you and me.

I’ve cited this research before, and it’s shocking to see the average investor’s return hovers around 5.19% while the S&P 500 returns 9.85% — prior to considering inflation. As a result, whenever someone brings up timing the market, the popular refrain among many financial planners is that “it’s not about timing the market, but time in the market“. In other words, put your money in the market, leave it alone, and let it ride the ups and downs. It’s the core concept behind buy and hold and passive index investing.

Clusters’ Last Stand

That said, mathematical models demonstrate that missing the market’s worst days (i.e. selling at the highs before the market tanks) could increase the average return of a portfolio by a statistically significant amount above its benchmark. The trick that no one can master is consistently predicting when the worst days will come. It’s complicated even further by the fact that many of the best market days cluster close to the worst days, or vice versa. Furthermore, missing out on even a small number of the market’s best days, while participating in the worst days, is an absolute return killer for a portfolio.

Again, some mathematical modeling shows that missing both the market’s best and worst 25 days can result in small, but significant, net positive returns above the benchmark average. That same research also showed that all of the most recent 25 best/worst day clusters occurred when market volatility was above average. However, there’s still no evidence that anyone can consistently harness that knowledge for proven above benchmark returns.

Furthermore, other research I’ve found disputes the small but above average effect that missing the best and worst performance clusters has on returns. A study of the 10 best/worst performance clusters of the S&P 500 essentially showed that the net effect was the same as a simple buy and hold strategy for an S&P 500 ETF. Therefore, that particular research concludes it’s not worth expending the extra energy trying to time the market. I’d also add that buy and hold saves the added expense associated with making trades.

Timing … The Verdict

My bottom line on “timing the market” is that I’ve yet to see any hard evidence that it’s a consistently workable strategy. I fully admit there may be some evil genius sitting in his boxer shorts while living in his mother’s basement with his home-made self-aware super-computer who’s cracked the code. I know for a fact that large hedge funds full of Flash Boys successfully time the market; only they use supercomputers to do it milliseconds ahead of everyone else instead of days, weeks, or months. Those two instances aside though, timing the market isn’t really an applicable topic to the large percentage of my readers. Thus, I’m not going to discuss it further.

Investment Timelines

In lieu of discussions on timing the market, I will concentrate instead on how far into the future a person plans to use their invested money. What a person intends to use their money for, matters less to me than when; although my assumption will typically be they intend to use for retirement. At the end of the day though, whether the money is for a house, college, or retirement; the most important issue isn’t what the market is doing at the time of withdrawal. No, the most important issue is whether or not a person properly managed their money so that it grew to the required sum and was ready when needed … regardless of market conditions.

Of course, understanding how to grow money to a required sum along a specific timeline cannot be achieved without discussing Risk, so it’s to that topic I move next.

Risk Vs. Volatility

Anyone who read my Golden Albatross Vs. Risk series of articles knows that Risk is a topic I’ve thought about … a lot. However, instead of sending you to (re)read some lengthy but funny posts on the topic, let’s conduct a quick review. Investopedia states …

Risk involves the chance an investment‘s actual return will differ from the expected return. Risk includes the possibility of losing some or all of the original investment.

So … Risk is the chance that your invested money won’t be there when you need it. Some investments (like stocks) are considered riskier than others (like bonds) because their value swings more wildly from day-to-day, month-to-month, and year-to-year. The upside is that over time, riskier investments (i.e. stocks) tend to produce larger overall returns.

However, as Jim Collins points out in his book “The Simple Path to Wealth” when investing on a long enough timeline using broad-based stock market index funds, the Risk associated with the stock market simply turns into volatility. In other words, if you don’t need to sell your index funds, and you can stomach the stock market’s ups and downs, then Risk fades the longer you hold your investment because eventually “the stock market always goes up“. It’s an interesting method of Risk mitigation.

Risk Tolerance

However, this understanding of “Risk as volatility” implies an understanding of two other types of Risk: Risk Tolerance and Risk Capacity. Risk Tolerance is simply an investor’s ability to psychologically withstand the urge to sell when the markets crash and their portfolio’s returns start to plunge. Some people can take the wild ride that is a portfolio invested in 100% stocks in order to obtain maximum returns. Other people can’t stomach that ride, so they smooth it out by allocating their money to other investments like bonds or real estate that hopefully perform independently of the stock market. The downside is that those independent performing investments provide a smaller return on average than stocks.

The key to understanding Risk Tolerance is that it’s NOT predicated on the need to sell. The investor doesn’t need the money for immediate use. Often times though, investors get tripped up by Risk Intolerance because they don’t understand their own psyche. Thus, they simply cannot withstand the urge to sell when the market goes down.

Risk Capacity

Risk Capacity is distinctly different from Risk Tolerance. Capacity implies the ability to absorb the loss. In other words, what happens when a person needs the money, goes to sell the investment, but the required value isn’t there? Maybe it’s not there due to volatility in the markets at the time they sell. Or, maybe it’s due to a poor investment choice like a single stock vs. a broad-based index fund. Regardless of the reason, can the investor absorb the loss? Do they have time to recover or an ability to generate more money? If the answer is “no”, then they should invest in a manner with less Risk.

It’s important to note that Risk Capacity also changes over time. A young investor with plenty of time on their hands and no immediate need to withdraw their invested money can afford the Risk that a 100% stock portfolio represents. They can afford to ride the ups and downs of the stock market and reap the larger returns since they have no need to sell. Again, as Jim Collins pointed out, it’s merely volatility.

Alternatively, someone close to retirement can’t afford the same amount of Risk in their investment portfolio that 100% stocks represent. For them, it’s no longer about growing their money at the largest return possible. Rather, it’s about preserving their money with a modest growth rate, so it’s there throughout retirement. Thus, a drop in the stock market to them is a real Risk, not volatility, since they will need to withdraw money to fund their retirement no matter what. Thus, a portfolio with a large percentage of bonds and/or cash might be more appropriate.

Risk vs. Reward in Investment Planning

Of course, less Risk equals less reward. Therefore, an investor needs to manage their expectations based on their goal and the investment’s lifespan. They shouldn’t expect larger returns from a less risky portfolio later in their investing careers. Money should be invested with a clear understanding of the amount required at the end of the investment period. Doing so will provide average target returns over the proposed lifetime of the investment.

How an investor chooses to achieve those average returns can then be considered against their Risk Capacity and their investment timeline. If it’s early in their investment timeline, they can take more Risk in order to achieve higher returns. If it’s late in their timeline, they can’t. At any moment, if Risk Capacity dictates the need to seek smaller returns than intended target returns, then the underlying fundamentals like the investor’s savings rate, or the proposed target amount, must be re-examined. Approaching investments in this manner should mean an investor never takes on more Risk than they can afford to absorb. At the same time, it should also mean they achieve their investing goal without taking more Risk than necessary.

Investing In a Nutshell

As it turns out, what I just outlined above is my investment philosophy in a very wordy nutshell. Let me recap before I move on because my philosophy forms the basis for the Trump-Trade War Mitigation Strategies I lay out in subsequent articles.

1. Set clear investment goals by understanding the amount you’ll need at the end of the investment timeline.
2. Based on the timeline and amount, determine the average returns required (which you can easily do with any number of calculators here).
3. Adjust average returns based on your Risk Capacity along the investment timeline in consideration of the following two points:
   1. Understand that early in the investment timeline your Risk Capacity is greater. Greater Risk equals potentially greater returns.
   2. Understand later in the investment timeline Risk Capacity is lower. Less Risk equals potentially lower returns.
4. Continue to adjust target returns based on previous returns. If future required target returns don’t match the Risk Capacity model, re-address either:
   1. Inputs such as savings rate (i.e. save and invest more to make up for lagging returns)
   2. Outputs such as the target amount (i.e. adjust your budget down by planning to spend less).
5. Never Risk more than necessary to achieve the goal based on time and capacity to absorb loss.
6. Keep it simple and cheap with a buy and hold strategy of broad-based index funds.
7. Don’t try and time the market.

Conclusion

I hate to say it, but that’s all I got for this post. I originally tried to follow my investment philosophy with a discussion on investment strategies designed to mitigate the worst potential effects of the Trump Trade War, but the article grew far too lengthy. As a result, I split them up. Keep my investment philosophy in mind though, it will prove useful when you read my follow-on article. I know all three of my loyal readers are jumping at the bit to get to the discussions on investment strategies. I hope I can make it live up to the hype! As always, thanks for reading this post and supporting the blog. Please provide questions or comments down below in the comments sections.

— GM