As the new year is well underway, it is worth acknowledging that there is no cure-all for restoring losses. However, not all is lost.
Fact Checked byTaylor Hegna, CFP®
One could imagine how resounding the sigh of relief was as 2020 came to a close. In a year defined by a pandemic, job loss, and extreme market volatility, there can be little doubt that for many, 2020 brought about financial loss and stress. This likely left some wondering if they can take steps in 2021 to offset losses incurred in 2020 or to protect their portfolio from future economic turmoil. As the new year is well underway, it is worth acknowledging that there is no cure-all for restoring losses. However, not all is lost, as 2020 is filled with lessons that can be applied today in order to ensure a stronger financial future.
Fundamentals – the word stems back to the early days of learning a sport, musical instrument, or craft. Fundamentals are the building blocks on which everything else stands, and finances and investing are like anything else in this regard. Though each individual has their own investment and market philosophies, there are fundamental components that make their way into most strategies. As with most things fundamental, these components are not flashy, nor are they short-term solutions. When utilized correctly, however, they serve as the foundation for a stronger financial strategy that can better equip investors for a downturn.
The first fundamental for investing is diversification. To keep it simple, “don’t put all of your eggs in one basket.” It is the thing that can frustrate many when markets are doing great but when volatility starts to ramp up, as it did in quarter one of 2020, diversification can help protect your assets. More specifically, diversification across different asset classes (such as equity and fixed income) helps to reduce risk because when one asset class is underperforming, others may be outperforming which helps to reduce portfolio volatility. This does require diversifying appropriately across asset classes to avoid potential pitfalls. For example, during the “COVID Crash” in 2020, it would not have been enough to diversify across small-cap stocks, junk grade corporate debt, and oil, as these three moved together, despite belonging to different asset classes.
The second fundamental component is the cliché “buy low and sell high”. During the moments when an investor is watching the value of their investment drop, nothing feels more rational than to cut losses and get out. The other side of that same coin is that in many circumstances, with time, the value of those assets will recover and for some, surpass its prior high. Certainly, this was observed in 2020 as all three major US equity indices fell greater than 20% only to end the year up greater than 9% (not to mention the Nasdaq’s whopping 44.9% return) (1). It is important to note that this is not a universal truth, and some assets may in fact never recover value. However, an investor taking on appropriate risk and diversifying their portfolio is better positioned to recover from a downturn by not selling at depreciated prices (1).
Last year also served as a reminder of a third and final fundamental component which is to not bet more than you can afford to lose. Most believe this idea is just about the amount you are putting on the line but what is even more important is the type of investment. If an investor is 60 and wants to retire at 65, it may be appropriate for them to have a large amount of their net worth in investments if those investments are inherently less risky. Gauging the amount of risk an investor can handle financially (not just emotionally) is crucial in navigating volatile markets like those in 2020. It also underpins the other two fundamental components as without appropriate risk assessment, neither diversification nor buying low and selling high can effectively be utilized in order to ensure investors can meet financial goals and retire on time.
Finally, a practical opportunity an investor could have taken advantage of in 2020 was to sell some capital losses. This is called tax-loss harvesting and, with some restrictions, an investor can sell investments at a loss and use this loss to offset capital gains or income in the current year as well as in future years (2). If investors stuck to the buy low sell high fundamental described above and did not harvest losses during 2020, they can still utilize a tax-loss harvest in the future. Market corrections are inevitable and when they occur they can be hard but they can also provide opportunity. Should investors experience a correction in 2021, one of these opportunities may be to harvest some losses.
Investing, like most things, is always easier in hindsight. It is easier to see the importance of diversifying after last year’s volatility than it was during its February highs. The wisdom of buying low and selling high makes millionaires out of us all with the benefit of hindsight. Knowing a virus-induced market crash was brewing and adjusting risk appropriately is a talent and luxury very few have without hindsight. In this regard, there is nothing about the past investors can change. They can however learn from it and make adjustments now in an effort to avoid having to say, “fool me twice…” to the capital markets when the next downturn begins.