The spread of Covid-19 has been referred to as a “black swan” event by some, meaning an occurrence with potentially severe consequences that were unpredictable. The consequences have certainly been severe with disruption to jobs, schools, and everyday life (though health experts would argue whether this was unpredictable). The first quarter of 2020 saw a nearly 35% market drop from the all-time highs of February, in a matter of weeks. The volatility index, or VIX, sometimes referred to as the “fear index” shot through the roof. In the short-term, the U.S. economy, along with many others across the globe, has certainly entered recessionary territory.
What does the Coronavirus pandemic mean for my portfolio?
Recent market volatility has led many investors to re-think how much volatility they can withstand, often referred to as their risk tolerance. You might be one of them. Risk tolerance has two components: (1) risk ability, or the likelihood of being able to meet stated financial goals based upon various market conditions and available resources, and (2) risk willingness, defined as the level of comfort with volatility during market cycles. A mismatch between ‘perceived’ and ‘actual’ risk willingness can lead to emotional distress described frequently as the “inability to sleep at night”. The importance of discussing, visiting, and revisiting risk tolerance regularly cannot be overstated.
The guidance in this post, however, is meant for those who are looking to increase their allocation to stocks and understand the potential benefits and risks of doing so. It is also important that a potentially higher allocation to stocks does not jeopardize your long-term financial goals.
Given market performance during the pandemic, how should I think about adding stocks in my portfolio?
Pandemic or not, there is already a great deal of data on the various approaches to funding your portfolio. The mathematical evidence tells us that investing available cash immediately in a lump sum, as opposed to incrementally, leads to superior returns about 65-70% of the time (see Vanguard’s whitepaper on the topic here). Equity markets tend to go up over time, so having dollars invested sooner rather than later tends to be beneficial, generally speaking. Adding funds in regular amounts and/or set time periods is referred to as “dollar-cost averaging” or DCA, and the longer these time periods, the larger the out-performance tends to be in comparison to a lump sum investment.
Of course, we do not all have large amounts of cash lying around to invest, but DCA is likely familiar to you already since this is the way most people add money to their 401(k)/403(b) plans from regular paychecks. Investing also has a behavioral aspect that is important to consider – human psychology dictates that we feel the pain from a large investment loss much more than we feel the satisfaction of a large gain. As investors, we tend to be risk averse. This begs the question: What about the other ~30-35% of the time when a lump sum investment does not outperform DCA?
Buying Stocks Using Price- and Time-Based Strategies
In volatile markets like these, we often hear a version of the following from clients – “I would like to add to stocks, but I’m worried the market will take a dive after I do.” The desire to avoid feeling buyer’s remorse stems from that risk aversion engrained in our investor DNA. To address this, consider implementing a combination of a time/calendar-based approach and price-sensitivity based approach to increasing your equity allocation.
A time/calendar-sensitive approach is simply DCA purchases in action. Stock purchases are done at set intervals (weekly, monthly, quarterly) no matter what, removing emotion and timing from the equation. In practice, this could look like the following:
Alex is a 46-year-old sales rep with a tech company making $300k per year and has a portfolio worth $1.5M, primarily for his retirement. After a good 2019, he receives a large bonus of $250k in March 2020. Alex wants to continue to be aggressive and is comfortable investing for the longer-term.
Alex invests $50k on the first of each month, until the full $250k is invested.
The intervals to reach the end equity target should last no longer than 12 months depending on comfort level and mutual agreement with your advisor. The more a timeline is stretched out, the more you run the risk of diluting the potential advantages of the increased stock allocation in the first place.
A price-sensitivity based approach involves the use of options, specifically the sale of a “put” option on a stock you own and want to buy more of. For simplicity, let us assume the S&P 500 index rather than an individual stock. The sale of a put option gives the buyer (someone else) the right, but not the obligation, to “put” the stock to the seller (you) at a lower exercise price than current market levels. The buyer is likely trying to hedge his/her risk or protect a gain in case the stock goes down. In exchange, the seller gets to collect a premium, but must buy the stock if the option is exercised. Below are the possible scenarios:
- The price goes up and the put option “expires worthless”. The seller has collected the premium and made a small profit.
- The price stays about the same and the option “expires worthless”. The seller has collected the premium and made a small profit.
- The price goes down enough and the option is exercised, meaning the seller is obligated to buy the stock at the strike price.
Remember the goal here is to increase your equity allocation to a higher, desired amount. Scenario c) helps accomplish just that and at a lower, more attractive purchase price. There are two main considerations here – the need for underlying cash in the event the option is exercised, and what to do if scenarios a) and b) occur and there is no exercise. Those scenarios would see your equity allocation stay the same. In other words, a price-sensitive strategy only helps if the market declines! Let’s see both strategies together:
Alex would like to buy into the market at a lower price if he can, investing the same $250k. For the first $50k portion he instead sells put options to buy the S&P 500 index at 10%, 20%, and 30% below its current price. The options expire in 30 days and he collects his premiums. If the S&P falls below these levels in 30 days, the respective option would be exercised by the buyer (not Alex), obligating him to purchase the index at the now lower price.
10 days later, the S&P has fallen by a cumulative 10% and one of the options is exercised, obligating Alex to purchase the $50k position he wanted.
For the remaining purchases, Alex makes $50k purchases on the first day of the next four months for the remaining $200k.
As the volatility experienced by the markets in 2020 is likely not yet concluded, the above strategies offer ways to continue investing in equities while hedging fears about buying “at the top of the market”.
As we frequently stress, putting the above into practice should only be done as part of a broader, agreed-upon financial plan. We encourage you to reach out to your advisor with questions.
For more on planning considerations during Covid-19, see our other blogs “Take Action During the Pandemic: Ways to Update your Estate Plan and Factor in New Legislation” and “Planning Strategies to Consider in a Volatile Environment.”