The Pacific Northwest has it all: mountains, freshwater lakes and the expansive waters of the Puget Sound and San Juan Islands. If you don’t know, the San Juan Islands are some of the most beautiful, accessible places in the world. It is a fortunate few who get to experience the serenity of a PNW starlit sky on a gorgeous summer night.
If you’re exploring Puget Sound by boat, you’ll be well served to know the tides. Low tides, high tides, and the transition between the two can significantly affect your experience. If you drop anchor in a new place, pay close attention or you may be left high and dry.
Much like boating without an awareness of the tides, investing without awareness of how much markets can move can leave people in a difficult situation. There will be periods of high tides and low tides and sometimes rough seas in between. For those with relatively little experience, it can take a significant toll.
High Waters
When markets experience significant growth over many years without significant drawdowns (i.e., sell-offs), investors can begin to feel as though the value of their investment portfolio is permanent. They forget, or depending on when they started, never experienced first-hand the volatility of the markets. As a result, they will often begin to treat the value of their entire portfolio, or even a specific stock, as a new reference point against which future gains and losses are measured.
Investment values go up and go down, but when the tide is in, investors can quickly reset their expectations about their financial position and how they see their portfolio strategy. They may even begin to believe they have a superior approach to investing, as evidenced by their portfolio values being at an all-time high. At times like these, investors would be well served to remember two familiar sayings:
“A rising tide lifts all boats” – an older New England saying popularized by John F. Kennedy
“You only find out who has been swimming naked when the tide goes out” – Warren Buffett
Markets reach new highs regularly. When they do, many assets will benefit from the market-wide valuation increases. The increase in asset prices may or may not be warranted across different assets and it can be hard to tell when the tide is in for all asset prices. But markets periodically sell off, and those declines can leave an unprepared investor frustrated or even stranded.
Consider an investor whose portfolio reaches $10 million before falling to $8 million during a bear market. The investor may feel like $2m of their net worth has been wiped away, never to return even if the investor originally started with a portfolio value of $5m. The $10 million high-water mark has become the investor’s reference point, making the subsequent decline feel like a significant loss, even though the portfolio remains well above its original $5 million value. Prospect Theory, developed by Daniel Kahneman and Amos Tversky, suggests that losses relative to a reference point generally have a greater psychological impact than equivalent gains. As a result, this can feel like a major blow to financial progress.
The last few years have been good for US and international equities. With markets being so strong, there can be a tendency to forget how difficult investing can be over the long term. But that would ignore a basic reality of investing: markets move through highs and lows like the tides. A sound investment strategy and financial plan should be built to accommodate the changing economic forces and market conditions.
Finding Balance Through Diversification
The adrenaline of high market returns and the financial possibilities that come with it can be enthralling. In that environment, any asset class with a different return and risk profile can be less appealing. The benefits of holding a more diverse set of assets can feel like a wasted opportunity in the face of a bull market run. However, as is true in life, finding balance in your investment strategy can help get you through unexpected, difficult periods.
In one of our most recent blog posts by Ryan Moriwake, he calls out the need to “protect what you no longer need to risk.” This is a powerful statement when it comes to our financial lives. Taking advantage of big market upswings by harvesting gains and diversifying into other assets that may not be “in favor” can be difficult, particularly while the assets you are trimming continue to rise. But the question is straightforward: at what point does the additional risk outweigh the potential reward?
High Mountains
Market highs and their subsequent lows are like the highs and lows in life: they are not permanent. Historically, market lows have been followed by recoveries. And while the timing of these recoveries is unpredictable, patience and commitment to a well-built, long-term strategy can help you navigate these different economic seasons.
As someone who enjoys the waters of the PNW in the summer and skiing its snow-capped mountains in winter, I admit I find it difficult to balance risk and reward sometimes. Hurling oneself down a mountain on a pair of wax-laden sticks with sharp edges is a great thrill. However, a wrong turn, a hidden rock or a patch of crusty snow, can turn that thrill into 6 months or more of recovery due to a torn ligament.
Does that mean I don’t ski? Absolutely not. But I do weigh the risk-reward tradeoff much more carefully, as I realize with time what is worth protecting. Striking a balance in life can be difficult and reminding yourself of what you have to lose can keep you from overcommitting to a situation that has marginal upside relative to your life’s goals. Especially when you remember there’s always aprés-ski waiting for you back down at the base.