2020 has been, in my opinion, a year that has tested the boundaries of volatility and stability in client portfolios. I thought it would be a good idea to remind investors why equities blended with fixed income under several allocations may still continue to provide downside protection, even in extremely volatile markets.
The Importance of Downside Protection
First, let's highlight the importance of downside protection for the portfolio. The more you lose, the greater the cumulative return you need to break even from the bottom. See below:
Cumulative Return to Break Even
How Long to Break Even After a Global Event?
The next question I usually receive is: When a global event happens, how long can it take to break even after experiencing a loss? I like to look at the last two significant market declines for a quick comparison: The subprime crisis, and more recently, the coronavirus pandemic.
During the subprime crisis, from September 30th, 2008 – March 9, 2009, the S&P 500 lost -41.17%. A cumulative return of 70% in the S&P 500 was needed to break even. This happened around January 8th, 2010, almost 10 months from the bottom (source: Kwanti Analytics).
During the initial equity market decline stemming from the coronavirus pandemic, February 10, 2020 to March 23, 2020, the S&P 500 was down -33.54% from its peak. The S&P 500 would have required a 50% cumulative return to break even, which happened around August 24, 2020. This was only five months from the bottom (source: Kwanti Analytics).
Next, I want to highlight some basic allocations that consist of the S&P 500 Index and the Barclay’s Aggregate Bond Index. The hypothetical does not assume fees nor does it assume rebalancing in the portfolio. It is strictly assuming a buy and hold strategy (Source: Kwanti Analytics).
S&P 500/Barclay’s AGG
100% S&P 500 TR
100% Barclays AGG
Is the Psychological Stress Worth It?
- In my opinion, you cannot time the market. Moving to cash during a volatile market may significantly reduce the ability for the portfolio to recapture the cumulative return required to break even from the bottom during a dramatic rebound, especially if the rebound happens within 6-12 months of the bottom.
- Certain fixed income instruments may be priced up as investors look for alternatives to equities during a volatile market. If asked for my opinion on which asset class I would prefer to hold to limit volatility and provide some long-term growth opportunities when paired with equities, I would consider various fixed income investments over cash.
- Although the above numbers do not indicate what may happen in the future, historical long-term returns may indicate that taking on additional equity risk (more than 60% of equities in the portfolio) may not reward the investor from a risk/return basis. In other words, your return may continue to increase, but your downside return may increase at an even greater rate.
- There is not a dramatic difference, in my opinion, between the annualized return on the historical 60/40 portfolio return and the 90/10 portfolio return over 25 years, but the difference in downside return during both major market declines appears to be more significant (and can be stressful!). Is being heavily weighted in equities worth the psychological stress during times of market turmoil?
The opinions expressed in this article do not necessarily reflect the views of LPL Financial.
Indexes are presented in their total return version (S&P 500 and Barclay’s Aggregate Bond Index). In a total return index, the dividends from securities in the index are reinvested.
This article presents past performance, which does not guarantee future results. The investment return and principal value will fluctuate thus an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than return data quoted herein.
The model portfolio results presented in this report are based on simulated investments, assuming that the holdings are purchased on the first day of the period indicated.
The measure of return used in this report include distribution income such as dividends. The simulation of model portfolios does not take into account trading costs and tax implications.
Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under-or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown.
Returns for periods longer than one year are presented in both annualized and non-annualized forms. Returns for periods less than one year are not annualized.
Kwanti uses time-weighted return (TWR) with daily valuation for portfolio returns. This method removes the effect of cash flows and is recommended by GIPS  (Global Investment Performance Standards) for portfolio returns.
Cumulative return is the total change in the investment price over a set time—an aggregate return, not an annualized one
The S&P 500 is an index that measures the stock performance of 500 large companies listed on stock exchanges in the United States.
The Barclay’s Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency)