The first quarter of 2022 reminded investors of a market concept that had been all too forgotten since the lows of March 2020: volatility. A combination of high valuations, high inflation, rising interest rates and geopolitical uncertainty sent prices reeling to start the year. Below is a brief summary of what happened in financial markets between January 1 and March 31, 2022, followed by some perspective on markets in both the present and the future.
Stock markets had a volatile first quarter with the S&P 500 down -4.6% and the Russell 3000 dropping -5.3%. International markets struggled with the MSCI EAFE losing -5.9% for the quarter and the MSCI Emerging Market Index slipping ‑7.0%. Value stocks beat out growth stocks, and large stocks outperformed small stocks.
In the fixed income markets for the first quarter, the yield curve flattened as short rates rose more than long rates. Corporate spreads widened modestly over the quarter. Overall, the fixed income market suffered its worst quarter in the past half century. The core US government and credit market fell ‑4.5%, high yield bonds gave up ‑4.4% and global bonds lost -6.2%.
For most investors, volatility can be scary, especially after a prolonged period of steadily rising prices. However, a seasoned investor understands these fears can be abolished by breaking volatility management down into two stages: the Mitigation Stage and the Opportunity Stage.
The Mitigation Stage
Although it may come as a surprise, volatility management begins during times of stability. Several measures can be taken before market tumult begins to ensure that the swings in value an investor feels are both within expectation and within reason.
Volatility management begins with the correct asset allocation for each portfolio. As WoodTrust has defined in its Investment Principles, “Asset Allocation is the Greatest Determinant of Risk”. Risk, in this context, is directly synonymous with volatility, and a client’s Portfolio Manager works extensively with each individual to determine his or her investment objectives, risk tolerance and overall circumstances to define an optimal asset allocation. The amount of money allocated to stocks, bonds and cash at the outset is established with regard to the swings a client is and should be capable of handling.
After constructing an optimal asset allocation, WoodTrust focuses on diversification across company size, company geography and investing style. By allocating to each of these factors, an investor mitigates the risk of volatility caused by relative outperformance amongst them. Importantly, “optimal” is not always “equal” as each factor has a unique risk and return profile.
The final volatility mitigation step is portfolio rebalancing. While setting the optimal asset allocation and being properly diversified is fundamental to success, market moves cause the portfolio to stray away from “optimal” almost instantly. Therefore, rebalancing to the initial targets brings an investor’s portfolio back into alignment; and, in doing so, allows the Portfolio Manager to trim relative winners and reallocate to relative underperformers, setting the portfolio up well for the market’s tendency to revert to the mean over time.
The Opportunity Stage
The Opportunity Stage begins when downside volatility strikes. Dramatic intra-day swings, reactive market moves and a general downward trend in stock prices characterize this period. Having a pre-determined set of actions to take during this stage allows an investor to swiftly take advantage of the opportunities that downside volatility presents.
The first tool a Portfolio Manager has at his or her disposal to benefit the investor’s portfolio during the Opportunity Stage is the same as the final step in volatility mitigation: rebalancing. By rebalancing during times of wild price moves, a Portfolio Manager can, for example, shift money away from the defensive portfolio positions after they have done their job (protecting the portfolio’s downside) toward the positions that were hurt the most during the selloff (which may see outsized price appreciation going forward1). Rebalancing during the Opportunity Stage ensures that the investor maintains his or her strategic asset allocation throughout the market cycle.
The next action to take within an investor’s portfolio involves the individual investments they own directly or own via a mutual fund. Both the WoodTrust Investment Committee as well as most of the institutional managers that WoodTrust utilizes maintain a list of high-quality companies that may trade at too high of prices. These are best-in-class businesses with a robust track record that investors want to own but that trade at prices above which the investor is willing to pay. However, when fear takes over the market, companies are often sold indiscriminately. These businesses can trade at dramatic discounts to recent prices, allowing managers to add these quality companies to their portfolios. This concept embodies Warren Buffett’s timeless quote, “Be fearful when others are greedy and greedy when others are fearful.”
The final opportunity to take advantage of downside volatility exists for portfolios that are not yet fully invested or that are experiencing new cash inflows. Often, a Portfolio Manager will recommend that a portfolio be invested into the market over a period of six-to-twelve months. This process is called dollar-cost averaging2 and smooths out portfolio fluctuations, preserving portfolio value while avoiding the risk of erroneous market-timing. However, while it is very difficult to time the market, markets tend to spend significantly more days increasing than they do decreasing.3 When markets are down materially, investors should still expect them to recover in the future and eventually make new highs. This means that when prices are well off their peaks, a Portfolio Manager can increase the speed at which the portfolio is being invested to take advantage of lower market prices, likely improving returns over the long-term.
Volatility can be detrimental to an emotional investor without a plan. Without proper mitigation practices, swings in portfolio value can be dramatic and startling. Correspondingly, impulsive decision-making after volatility has set in can compound the problem, locking in losses and permanently damaging long-term portfolio potential.
Your Portfolio Manager as well as the broader Investment Committee have managed money through multiple market cycles. The Research Committee has dug deep into market trends, risk management and historical anomalies. Together, this level of experience and depth of research have armed your investment management team with the tools necessary to mitigate volatility and pounce on the opportunities it presents.
As always, we thank you for your trust and look forward to our meetings with you in the near future.
1It is important to emphasize that this expectation is on average. It is inevitable that there will be anomalies; however, more often than not the positions that had the most price action to the downside during a sell off will see the most price action to the upside during a recovery.
2Dollar-cost averaging is also often referred to as “legging into the market”.
3WTAM Research Committee found that of the Russell 3000’s 495 rolling 12-month periods from 12/29/1978 to 02/28/2021 only 112 had a lower price at the end of the period than the beginning.