By Mark Haefele, Global Chief Investment Officer, UBS Global Wealth Management
A near decade-long bull market barely failed to last another year. For global stocks, the bull market expired the day before Christmas, having falling 20.8% from its high point in early January. In Asia, of course, market volatility has been with us for longer, with the Chinese market now down 31% from its peak, due to concerns about US trade policy, and about the Chinese domestic economy.
We believe that there are good reasons to expect a market recovery. The global economy is still growing, as are corporate profits, and stock valuations look attractive. But even if equities stage a comeback, prudent investors should take steps to ensure that their finances are well-positioned for the next bear market.
Bear markets are not only costly due to declining asset prices. Transition points can be when many investors make their most costly errors, like being forced to sell in periods of market panic. Ill-prepared investors can face permanent, rather than temporary, destruction of wealth.
When we talk about building a long-term plan with our clients, we use the so called “3L” approach, which allocates wealth into Liquidity, Longevity, and Legacy strategies.
This aims to ensure that investors are able to limit the damage from bear market, while exploiting the opportunities it presents. The approach starts with ensuring that investors have sufficient Liquidity to meet their liabilities for the next two to five years – everything from home or business purchases to school fees. These investments are typically in low volatility, safe assets and so can be accessed to meet short-term requirements. Importantly, holding this liquidity means that investors do not need to sell their longer-term investments, in assets like equities, during times of market turbulence, allowing them time to recover. The psychological benefit of knowing that your spending needs are separated from market volatility is more difficult to quantify, but no less important.
The market action in the run-up to the end of 2018 illustrates how the presence of a Liquidity strategy could help investors avoid some of the dangers from volatile of falling markets. An investor who was compelled to sell on December 24 after an 11% fall over the prior 2 weeks of trading, would have crystalized their loss and missed out on a 5% rebound on 26 December, the best day for the S&P 500 since March 2009.
The Longevity strategy meanwhile, is intended to meet financial goals for the remainder of a lifetime, which reduces the temptation to overreact to near-term market developments. With short-term spending needs met by the Liquidity, investors can use periods of equity market weakness to their advantage, by rebalancing. While selling top-performing asset classes and buying worse-performing can be counterintuitive, our analysis shows that establishing a disciplined rebalancing approach within the 3L framework can add an additional 0.8% alpha on an annual basis.
Finally, Legacy assets are intended for purposes beyond the investor’s lifetime. Thinking about assets from a multigenerational perspective can allow investors to invest in assets that might otherwise seem too risky or illiquid, like private equity, or those which might take a long time to deliver returns, like infrastructure or emerging technologies. It also reduces the temptation to trade too frequently. In “Trading is Hazardous to your Wealth,” Brad Barber and Terrance Odean found average households with the highest level of portfolio turnover underperformed average investors by 5% per year, and trailed low-turnover investors by almost 7% per year.
The 3L framework isn’t a panacea for solving our own emotional biases, but it does provide a concrete framework for decision -making that investors can fall back on during times of market stress. Investors are likelier to think twice about selling assets which are associated with long-term objectives. By embedding major financial decisions in specific financial goals and objectives, the framework provides guidance for action during difficult periods. Looking back over the last 80 years, our analysis indicates the 3L strategy would have added an average of 0.25% in annual alpha during each bear market cycle.
And if, as we expect, equities recover their poise, investors who have adopted the 3Ls strategy will remain in a good position to capture the upside from rising markets.