While COVID-19 is going to be here with us for some time, the economic recovery seems to be underway. Of course, there are no guarantees, and should deaths spike suddenly the bottom could be upcoming rather than in the rearview mirror. Whether we’re at the bottom or not, there are five steps an investor can take to help get the best bang for their buck.
1. Get In
On March 23, 2020, the S&P closed at 2,237, a number not seen since the end of 2016. From the high of 3,386 in mid-February, it represented a nearly 34% loss. Now sitting at 3,116 (July 1, 2020), it’s up 39from the low and is only 6.5% off of its all-time high.
The Russell 2000, the smallest part of the stock market, hit its low April 3 at 1,052. Its high was 1696, making the drop 38%. The Russell is now back to 1,427 up nearly 36% from the low, still off by around 16% from where it was earlier in the year.
Many investors exited the market in March and continue to remain on the sideline. Their main concern is getting back in only to have the market drop again; perhaps in the Fall, if not sooner. It’s not an irrational fear. Nobody can accurately predict where the market will be over any length of time, and given the final chapter of COVID-19 is far from over, it should give any rational person pause to dive back in.
The issue comes in the framing of re-entry. If a person has to put a down payment on a house in the next few months, then putting that cash in the market doesn’t make any sense. If you’re a forty-five-year-old with an IRA, then the best time to put your money back in the market is now. Long term portfolios shouldn’t be concerned with short term fluctuations no matter how severe.
A common refrain from the media is that the stock market is like gambling in a casino. The mental imagery invokes a scene from a craps table, where a roll of the dice determines a win or a loss. The stock market is like a casino in the sense that money is involved, but that’s where the similarities end. In truth, the stock market is more like owning casinos. If you own a casino, you can be fairly certain that over long periods of time you’ll make money (a lot of money).
But what if you owned several casinos? If you one had a bad night, it’s okay because one bad night from a portfolio of casinos would hurt your overall business far less than if you just had one casino. What if you owned every casino in the US? If one or two had a bad year, you wouldn’t be sweating it.
By owning all casinos, you’ve brought your risk way down. You’re not insulated from risk completely, but you have used the power of diversification to your advantage. So should you use the power of diversification for your stock portfolio? It’s tempting to buy the hot stock or mutual fund, and diversification doesn’t guarantee gains, but to maximize your return, and minimize your risk, diversification is the best way to go.
3. Tilt Your Portfolio
Just because you diversify doesn’t mean you can’t use the best in financial research to tilt the possibility of results to your favor. There are a few factors that tend to bring better returns over time.
Stocks tend to return better than bonds. Certainly, in down markets during times like the Coronavirus that isn’t true, but markets tend to go up over time, and at a much faster rate than bonds. That doesn’t mean you should make your portfolio 100% in the market, it means tilting to stocks should give you better long term results. Cash flow and short-term needs should always be thought through before investing.
Small stocks tend to return better than large stocks. It isn’t always the case, but over twenty years, we can anticipate small stocks doing better than large. That doesn’t mean you should ignore largely, but having a healthy amount of small stocks is part of a well-balanced portfolio.
Value stocks tend to outperform growth stocks. There are many ways to determine what is a value stock versus a growth stock. Common metrics use price/earnings ratios, price/book ratios, and book to market ratios. Each one is trying to get at the companies which may be undervalued relative to other companies. Those value stocks tend to do better over time.
4. Be Careful With Long Term Bonds
Coronavirus has done something more amazing than thought possible. It managed to push interest rates even lower. The lowering of the interest rate tends to make the price of bonds go up. Of course, the opposite is also true, where increasing interest rates tend to dampen bond returns. If we are at the lowest interest rate that we have ever seen, there should be a significant concern that rates will at some point go up.
Should rates go up, and it may not be for several years, we know that the value of the longer-term bonds will fall precipitously. Therefore, taking a risk on long term bonds should be done with extreme caution.
5. Asset Transfer
As mentioned previously, the interest rate has fallen by quite a bit. This means that there is a tremendous opportunity for intra-family wealth transfers or transfers to charity. If there is stock in a privately held company that you want to give to your kids, using a grantor retained annuity trust (GRAT) has never been more attractive. In a GRAT, you put an asset plus cash inside of a trust and pay yourself an annuity (set with the prevailing interest rate) over a couple of years. Any value left inside of the trust goes to your kids. Since the prevailing interest rate is so low, it will be easier to transfer a greater amount to the next generation.
Certain types of charitable giving are also very attractive. Charitable lead trusts (CLATs) can give you a hefty tax deduction upfront, and allow you to move assets to your kids, or retain assets for yourself. It involves giving assets to a charity for a period of years, and distributing a certain percentage to a qualified charity. After the trust ends the assets go to the remainder beneficiary. In a time of low-interest rates, the IRS assumes that there will be less leftover for the next beneficiary, and so the amount of the deduction goes up. If the asset outperforms the interest rate significantly, not only did the donor get a bigger tax deduction, but the beneficiary gets a bigger pot of money in the end.
While COVID has certainly made finances more uncertain for us all in the short term, there are opportunities that will have great long-term effects. Contact the professionals at WRP Wealth and WRP Tax to discuss the right strategies for you.