by Franklin J. Parker, CFA
- Earnings season is coming to a close and it is better than expected. S&P 500 companies grew earnings by about 4%, which was much better than the expected no-growth scenario. This is important because this is the first earnings increase in a year. Guidance has also generally been good, and analysts are now expecting growth in earnings for Q4 and Q1 of next year.
- Several important data releases are this week, including industrial production, retail sales, and the all-important inflation figure. Inflation is expected to post at 4.1%, and this is a figure that can move markets if it is much higher or lower because it has a direct effect on Fed rate expectations. At the moment, investors see a potential rate hike in early 2024, but the probability of that has dropped over the last few months, and many investors have started pricing-in peak rates, with a drop in rates as 2024 wears on.
- Earnings have given investors a reason to be optimistic — if companies can indeed pull off profit growth for the next two quarters, this past year may have just been a blip and the risks of recession would fade into the background. Other economic data is still negative so it is not yet time to declare victory, but the ambiguity is likely to resolve in one way or another (either more expansion, or a recession). I still see the risks to the downside, but the data is very muddy and markets need something to happen to move them higher or lower.
Let’s talk about risk control strategies.
I have regularly suggested that goals-based investors consider controlling their downside risk given the ambiguous economic data (and the danger that this ambiguity breaks by sending markets strongly lower). But how do we go about managing that downside risk? There are three basic steps we must follow.
1. Quantify the Risk
Before we can take steps to control something, we have to first understand it! This begins by understanding your financial goals, and from there extrapolating a return that we need from your investments. When coupled with your time horizon, we can do some math and understand the downside risk you can afford to weather before you’ve lost too much in your portfolio.
In fact, a few months ago, we released a simple tool to help investors assess how much they can afford to lose in their investments before they’ve lost too much (if you haven’t checked out our MAL tool, you should!).
2. Mitigate the Risk
Once we understand the downside that we can afford to weather, we can take steps to mitigate those risks. It is important to note that risks can never be completely eliminated, only minimized!
This can be done in different ways. Sometimes, simply allocating to different investments (or cash) does the trick. Sometimes, we can add a trade to your portfolio that automatically sells certain investments if they cross below a given price. Or, we could use some options strategies to hedge against certain market drops. The exact strategy will — you guessed it — depend on your goals and objectives!
3. Monitor the Risk
It is not enough to simply set it and forget it. We have to constantly monitor markets, your objectives, and your portfolio to ensure we are properly offsetting risks.
All of that said, the types of market drawdowns that can blow up a financial plan are rare. While it is important to understand them and take steps to mitigate them, there are many things going on at once in managing your investments, all of which are important. In this environment, however, downside risk strikes me as one item that is moving up the list of concerns. We’d love to chat with you if this is something on your mind, too.
Chart of the Week
The US has been the world’s largest economy for 100 years now. Over the last decade — and especially since COVID — the US has pulled much farther ahead when looking at GDP per person, and the difference is pretty dramatic. Much of that difference since COVID may be due to the drastic and sizeable measures taken by the US government relative to Europe and Asia. Understanding the “whys” of the differences in growth is important to extrapolate what may or may not be true into the future.
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