2022: Preparing for What’s Next
Contributed by Doug Walters, Max Berkovich, David Lemire
Year two of the pandemic posed many problems across the globe but was another good one for disciplined investors. Inflation, supply chain disruptions, and healthcare challenges did not phase US stock investors as major equity indices saw another year of double-digit returns. But as we put 2021 behind us and look forward to 2022, investors have several questions that need answering.
Investors likely enjoyed positive returns in 2021 if they stayed invested despite frequent unnerving headlines. A key concern for many was inflation which dominated headlines and was tangible at the gas pump and in certain aisles of the grocery store. But investors also had to contend with multiple new Covid variants that raised fear and cast doubt onto the timing of recovery. We preached lessons such as “patience, not panic” and “preparation, not prediction” in our year-end report last year (2020: Exit Smarter). These practices would have served investors well in 2021.
As we enter the new year, the lessons from 2020 are just as relevant. Yet there are a few questions that are top of mind for investors. To answer them, we present below our 2021 Pop Quiz.
SEVEN QUESTIONS TO ENTER 2022 A SMARTER INVESTOR
Bond funds produced negative returns in 2021, prompting investors to ponder their place in portfolios. But persistent negative bond returns are quite rare. The last time bond returns were negative two years in a row was in the 1950s. However, even if returns are low or negative in the short term, bonds play a critical role in controlling portfolio risk and providing an important rebalancing lever for stocks.
US stock investors have enjoyed three years of 18%+ returns. The only three times in history this has occurred saw a fourth big year follow. So, yes, the rally can continue. But history does not have to repeat itself, and the future is unknown, so the question is flawed. The right question is, “Are you taking the appropriate level of risk to achieve your goals?”
No. Shorting stocks is a gamble where the odds are stacked heavily against you. Successful long-term investors continuously look to stack the odds in their favor based on evidence. Over the past 25 years (including the dot com crash, the 2008 financial crisis, and a global pandemic), the S&P 500 has produced an average annual total return of nearly 10%.
Performance leadership varies dramatically year-to-year unpredictably. When your home country is outperforming as it did in 2021, it is easy to wonder why you should invest anywhere else. Rather than attempt to outguess hundreds of millions of market participants, investors are better off taking advantage of the one free lunch in finance – diversification. Adding international exposure improves portfolio risk-adjusted returns.
The Fed has begun tapering its asset purchases and expects to raise rates in 2022. But this does not necessarily signal weak performance in the coming year. We experienced tapering in late 2017 to mid-2019, when stocks returned about 18%. In addition, historically, a rising Fed Funds rate is often accompanied by buoyant equity markets. For now, the Fed is not taking its foot off the accelerator; it is simply lightening the pressure.
Inflation is high, and the Fed has stopped referring to it as “transient.” Nobody knows the path inflation will take from here, but we know that inflation has been too low in recent years. A modest, long-term uptick could be a positive. Historically, stocks have provided investors with some inflation protection. In addition, diversification into precious metals (gold), emerging markets debt, and inflation-protected bonds also help prepare for inflation. Rather than try to predict the path of inflation, investors should prepare for it with a well-diversified portfolio.
This is a trick question. You cannot invest in cryptocurrencies, you can only speculate in them. They have no fundamental valuation and are not an investment. The same is true for NFT art and many other shiny objects that have popped up in the past few years. Purchases of these items should come out of the same pool of money you set aside for your trip to Las Vegas.
There is a common theme to the answers to our pop quiz questions: no one can predict the future. Stocks may be set for another year of double-digit returns, or we may experience a correction. Bonds may have a rare second year in a row of negative returns, or not. For long-term, evidence-based investors, these are the wrong questions. So what are the right questions?
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Am I invested at an appropriate level of risk?
Your risk allocation is personal to you and depends on your ability, willingness, and need to take investment risk. Your risk allocation can vary over time as your unique situation evolves but should never change based on what you think may happen in the future. That is speculative market timing, not investing.
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Is my portfolio well-diversified?
There is a difference between being diversified and well-diversified. A well-diversified portfolio looks deeper than just “stocks and bonds.” It is about having positive exposure across the economic cycle through factors, having healthy geographic exposure, avoiding concentration risk, capturing the benefits of small-cap stocks, gaining inflation protection through multiple sources (e.g. equities, gold, and Treasury Inflation-Protected Securities), and avoiding risky, illiquid, expensive asset classes like alternatives and cryptocurrencies.
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Am I benefiting from market volatility?
In a well-diversified portfolio, there will always be best and worst-performing assets. Sophisticated portfolio monitoring and rebalancing can enhance returns by systematically selling winners at a high price and buying underperformers at a low price.
On behalf of the entire Strategic team, I would like to thank our incredible community of clients, associates, friends, and family. In many ways, the past two years have been a challenge, but we hope we have done our part to help each of you achieve your best life. Best wishes for a bountiful new year!
About Strategic
Founded in 1979, Strategic is a leading investment and wealth management firm managing and advising on total client assets of over $2 billion.
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