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Guide to the Market Correction: Part Two

| February 20, 2018

In the companion piece to this post, I mentioned the different narratives that explained the current market correction. While investors will (and should) seek to understand the underlying causes of market movements, it is important to recognize the limited value of these explanations as they relate to portfolio construction. This does not mean, however, that investors should remain idle during this correction as there are several things that they can do to improve portfolio performance.

First and foremost, investors have to stick with their long-term investment plans. According to the Dalbar Quantitative Analysis of Investor Behavior study, at the conclusion of 2016, the 20 year annualized return on the S&P 500 was 7.68% whereas the average equity fund investor made only 4.79% – a spread of close to 3%. Dalbar concluded that the single largest source of this performance gap was poor decision-making on the part of investors. Specifically, decisions based on emotional and behavioral biases – especially fear-induced trading – lead to underperformance in the long-term. This reminds us that while clichés like ‘stay the course’ are easy to say, discipline is hard to maintain when hard-earned capital appears to evaporate. Equity investors must steel themselves, retain a long-term perspective, and preserve their objectivity.

In terms of more proactive steps, equity investors should consider opportunities for ‘tax loss harvesting’. Harvesting losses to minimize tax liability can be used in a variety of ways. At a minimum, it is important to remember that joint tax filers can deduct up to $3,000 in capital losses against other types of income. To be clear, I’m not advocating reducing equity exposure. Rather, investors can sell a holding that will lock in a capital loss while simultaneously buying a different equity investment. This will allow the loss to be booked for tax purposes while maintaining the equity allocation of the portfolio.

Additionally, investors should examine their portfolio rebalancing protocols and see if a rebalance is necessary. Now is an especially important time of year for rebalancing due to the multitude of investors that have made contributions to their IRAs in advance of filing tax returns. Those investors need to consider whether a portfolio rebalance is now in order. All things being equal, it would be better to rebalance (and allocate this cash) during a correction rather than wait for a market recovery.

Ultimately, corrections are normal market events. Preparation prior to the downturn – through appropriate risk budgets, intelligent portfolio construction, and understanding of a long-term investment plan – can help investors weather the storm. There is also plenty of work that can be done during a market slump. For professional investment advisors, corrections are times to review portfolio construction protocols, investment strategies, and managers, to assess performance during the period of market stress. Examining which of these elements outperformed expectations and added value can help us refine appropriately risk-aware portfolio construction processes. These steps, along with the measures described above, are keys to enhancing portfolio performance in the long run.

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