Monthly Outlook: December 2024
The U.S. election outcomes surprised many and have already had a meaningful impact on markets around the world. The expected upcoming shifts in U.S. policies are creating new winners and losers and the markets are adjusting quickly. For example, November was a very good month for U.S. stocks, with the S&P500 up +5.9%. International stocks however, especially emerging markets like China and Mexico, are much weaker due to expectations of tariffs and other deglobalization policies. And bonds were both up and down in November, as interest rates first rose on inflation concerns, before falling back on slowing economy concerns.
One thing is for sure, and without being political, the new regime and their proposed policies are striking, disruptive, and sizeable. As investors, we should expect more volatility, more uncertainty, and more need to be flexible and open-minded. We probably don’t even know what we don’t know yet, and we’ll need to respond as changes occur. There will surely be many opportunities for us to profit and grow portfolios. But it is equally likely that we’ll need to avoid some markets to limit losses. This will be a difficult time for analysts, pundits, and bloggers to predict and we should ignore most of them. We’ll stick with our systematic, rules-based strategy to follow price trends as they are, not as we would like them to be.
Remember the “What’s Your Risk Tolerance” Questionnaire?
Given our expectation for more volatility in 2025, it’s a logical time to revisit the concept of “risk.” In our financial advice industry, it’s common for advisors to use an investor questionnaire with their clients to assess their objectives and constraints. Questions usually focus on the clients’ need for liquidity, growth and/or income, taxes, time horizon, legal restraints, and the big one—risk tolerance. “What’s your risk tolerance?” the financial advisor wants to know. In 40 years of experience, I’m not sure I’ve really seen this question asked and answered in a concise way. And yet, it might be the most critical element of portfolio management. Is risk tolerance your tolerance for volatility, both up and down? Is it your tolerance for loss? Over what time frame: monthly, annual, or five years?
The financial industry thinks of “risk” as volatility, measured as standard deviation, which is just the dispersion of returns around an average. The S&P500, for example, has a long-term average annual return of about 8%, and a standard deviation of 17%. Assuming a bell-shaped distribution of returns, then 68% of the time, the S&P500 should return -9% to +25% (that’s 8% +/- 17%). But still, the average annual return is just 8%/year. But who thinks like this? No client has ever told me, yes, that’s an acceptable standard deviation! Ha.
Investors, our clients, think of risk as the possibility of loss. And not just the historical, long-term average loss, but the possibility of loss along the way. For example, it’s common for advisors to tout a fund with a 5-year track record of 8%/year, with a worst 5-yr total loss of only 5%. But such long-term statistics mask the real risk and volatility along the way. Let me build an example that fits this risk narrative. If a fund went up 25%/year for two years, lost 40% in year three, then went up again 25%/year for the final two years, it would have averaged 8%/year. But your portfolio would have gone from $1m to $1.56m, down to $937k, and then up to $1.46m by end of year five, for 8%/year. Could you stand for your portfolio to drop from $1.56m to $937k in year three? How’s your “risk tolerance” now?
Focus on “Drawdown” as Our Risk Tolerance
We focus on “drawdown” as our preferred risk tolerance measurement. Drawdowns are simply the peak-to-trough loss, at any time. We find that most investors only want about a 10% drawdown loss (not 40% like the example above). And here’s the big take-away: almost every diversified portfolio of stocks and bonds, at any firm, has the historical record and future potential of drawdowns of 10%, 20%, and even 50%. A buy & hold strategy will experience this. There are many ways to hedge against big drawdowns including sell-stop orders, options, futures, and tactical allocation shifts. But investors need a drawdown strategy in place to minimize drawdowns. And with increased volatility expected in 2025, now is probably a good time to redefine your “risk tolerance” as “drawdown tolerance.” If you need help, our iFolios strategy is just such a strategy.