In recent days, the increase in volatility in the stock market has resulted in renewed anxiety for many investors. While it may be difficult to remain calm during any market decline, it is important to remember that volatility is a normal part of investing. Additionally, for strategic investors, reacting emotionally to volatile markets may be more detrimental to portfolio performance than the drawdown itself.

We wanted to take this opportunity to share our perspective on what is moving markets, how to think about them, and what it ultimately means for your portfolio.

Executive Summary

• Markets have been digesting headwinds such as monetary policy, increasing interest rates, supply chain constraints, and higher than expected inflation.
• U.S. equity markets are down roughly 8% year-to-date (1/28/2022), while many international asset classes are down less or even positive for the year.*
• Bonds are under pressure due to the Federal Reserve’s signal to increase rates.
• Volatility is a normal and healthy byproduct of well-functioning markets.
• Risk and Volatility are two separate matters and truly understanding each is important for investors.
• Our well thought out, evidence-based portfolio strategies are designed to weather these ups and downs.
• If you are uncomfortable with the fluctuations in your portfolio, we should have a conversation about it.
• We have provided links to 3 must read articles at the end of this communication.

What is Going On?

While there is always an alarming headline to scare us, the current version tends to focus on tighter money supply (the Federal Reserve), interest rates, supply chain constraints and higher than expected inflation. We’ve seen interest rates, particularly real rates, move up significantly to start the year. It is important to keep in mind, however, that real rates and interest rates in general remain below pre-COVID levels although expected inflation is higher. So, while there is no way to know what will happen in the short term, there is certainly the potential for returns on bonds to be under pressure. Bear in mind that because our portfolios use relatively short maturity bonds and bond funds, this protects us from the larger swings that long-term bonds might experience.

On the equity side, the year has started off with downside pressure on prices (and looking back to large parts of last year and most of Q2–Q4 2020) has seen a reversal of the U.S. large-cap growth market dominance. These areas of the market entered the year with very high valuations compared to the historical norms. The broad U.S. market is down roughly -8% year-to-date and most every other global asset class is down less or even positive on a relative basis (e.g., International Large-Value equities are up about 1% YTD).*

Regarding our portfolio strategy, we remain confident that our small and value tilted U.S. and International equity exposures continue to fare well over the long-term relative to U.S. only market-cap weighted and large-growth oriented portfolios if these trends continue. These additional asset classes provide prudent diversification and are trading very near historical valuations, unlike the growth portions of the market. We would reemphasize that the potential near-term outcomes are all uncertain, but we have seen this come to fruition beginning with the rebound in equities since 2020.

We think it’s worth emphasizing, as always, a longer-term context of the market environment:

• Post 2007–2009 financial crisis, the U.S. market has had one of the best periods it’s ever experienced through the end of last year. Investors that have been consistently allocated to diversified U.S. equity over that period of time have almost certainly benefitted. If we look at the broad U.S. market from 2009–2021 compound returns were 15.9% per year.* This was achieved during a period of very low interest rates and (until recently) low inflation (and the U.S. market performed better than any other developed country’s stock market). Potential returns as noted don’t come without risk and we were bound to see some meaningful level of volatility show up at some point.
• Focusing on shorter periods, it is worth recapping that even though 2022 has started off poorly for equity and bond markets, let’s remember how much better 2020 and 2021 turned out relative to what anyone could have guessed given the many challenges we faced as a nation, and globally. Even with the recent drawdown, the last 12 months to now (1/28/2022), the US market is still up roughly 15% percent.* To earn unexpectedly positive returns (in terms of magnitude) during periods like this you have to endure periods like we are seeing in the early part of 2022 and try to mitigate the risks of owning any one asset class by owning many versus trying to time markets.

Intra-year Declines are Normal:

Looking at calendar year returns for the US stock market since 1979, as well as the largest intra-year declines that occurred during a given year tells an important story. During this period, the average intra-year decline was about 14%. About half of the years observed had declines of more than 10%, and around a third had declines of more than 15%. Despite substantial intra-year drops, calendar year returns were positive in 34 years out of the 41 examined. This goes to show just how common market declines are and how difficult it is to say whether a large intra-year decline will result in negative returns over the entire year.*

Perspective on Risk and Volatility:

What would you do if your investments declined 10% in just a few days? A) Add more money to my account. B) Hold steady with what I own. C) Yank my money; I wouldn’t be able to stand any more losses.

If investors buy the right investments but sell them at the wrong time because they can’t handle the price fluctuations, they may have been better off avoiding those investments in the first place. Most investors find it difficult to accurately judge their own risk tolerance, feeling more risk-resilient in up markets and more risk-averse after market declines. However, focusing on an investor’s response to short-term declines inappropriately confuses risk and volatility. Understanding the difference between the two and focusing on the former is a potential way to make sure you reach your financial goals.

Volatility encompasses the changes in the price of an investment, a portfolio, or a market segment, both on the upside and downside, during a short time period like a day, a month, or a year. Risk, by contrast, is the chance that you won’t be able to meet your financial goals or that you’ll have to recalibrate your goals because your investment comes up short. So how can investors focus on risk while putting volatility in its place?

The first step is to know that volatility is inevitable, and if you have a long enough time horizon, you may be able to harness it for your own benefit. Diversifying your portfolio among different asset classes can potentially help reduce the volatility. It helps to articulate your real risks: your financial goals and the possibility of falling short of them. Finally, plan to keep money you need for near-term expenses out of the volatility mix altogether.

What This Means for Us:

We’re now clearly at the start of a change in policy at the Federal Reserve. This change in policy likely means the end of historically low interest rates. Given how accommodative the Fed has been, it doesn’t seem inclined to turn the temperature of the economy from hot to cold in one quick motion. Like past rate-hike cycles, we’ll likely be in the warm zone for a while.

Rising rates has its pluses and minuses. On the plus side, higher interest rate levels mean we may see increases in our cash savings accounts, money market funds and other savings accounts. On the negative, rising interest rates typically send bond prices lower and create more price uncertainty for stocks. Fortunately, our investment preference for shorter-term bonds, which are less sensitive to changes in interest rates than long-term bonds, should help reduce the impact of rising rates on our bond positions. For stocks, rising rates may translate into more stock market volatility, so effective diversification will truly be our friend as rates start to rise.

As we’ve all seen multiple times over the past few decades, the Fed will influence interest rate levels to increase or decrease the overall speed of economic growth. With low unemployment and rising inflation telling us the economy may be moving too fast, it seems like the right time for the Fed to begin nudging things in a new direction.

While market volatility can be nerve-racking for investors as the market digests new challenges, reacting emotionally and changing strategic investment portfolios in response to short-term declines could prove more harmful than helpful. By adhering to a well thought out investment plan, ideally agreed upon in advance of periods of volatility, investors may be better able to remain calm during periods of short-term uncertainty.

Lastly, we have provided 3 informative articles we encourage you to read that reinforce our evidence-based investment strategy. Our intention is to provide you with additional education from trusted sources and to encourage your confidence in staying disciplined to your plan.

Why I’ll Always Be Optimistic About the Market, by David Booth, Executive Chairman and Founder, Dimensional Fund Advisors

https://www.dimensional.com/us-en/insights/why-ill-always-be-optimistic-about-the-market

The Two Things to Do When the Stock Market Gets Crazy, by Jason Zweig, The Wall Street Journal: The Intelligent Investor

https://www.wsj.com/articles/what-to-do-when-the-stock-market-gets-crazy-11643385571

As Goes January, So Goes the Year?, by Larry Swedroe, Chief Research Director, Buckingham Wealth Partners

https://www.evidenceinvestor.com/as-goes-january-so-goes-the-year/

We hope this letter will provide greater clarity and context regarding recent market volatility. And as always, when you have any questions about your investments, need to inform us of family or work-related changes, or want to discuss your financial planning needs, please reach out. We are ready to help.

Best wishes,

The Collective Wealth Advisors Team