The COVID-19 pandemic fundamentally has changed every aspect of our lives — from the way we live and work, to the way we view our health and well-being. For some of us, the pandemic has also affected our finances: jobless claims are the highest they have been in U.S. history, causing widespread economic hardship. And those of us who invest in the financial markets have experienced some roller coaster-like emotions lately.
Since the bear-market low we experienced on March 23, stocks have seen volatile swings both up and down. The increase in volatility has been a tough pill to swallow after the longest bull market run in history, in which the S&P 500 returned 400% and the Dow Jones Industrial Average (DJIA) reached an all-time high of 29,551.42.
Over the past few months, I have been asked one question time and again from clients, colleagues and personal contacts: What should I invest in going forward?
It’s the question that is on all investors’ minds — but the answer isn’t as easy as calling out one stock or one sector of the market. In fact, I would argue that it’s not even the question we should be asking ourselves. Here is what we need to keep in mind.
Learn From History
It’s true that the COVID-19 pandemic is new, uncharted territory. We are dealing with a highly contagious and dangerous virus the likes of which we haven’t seen before. But this isn’t the first time that we have dealt with a pandemic on a global scale. Take a look at the graph below:
The 1918 Pandemic Trajectory (H1N1 Virus)
This graph shows the three waves of infection in the 1918 influenza pandemic, which was caused by an H1N1 virus. According to the Centers for Disease Control and Prevention (CDC), it is estimated that about 500 million people — one-third of the world’s population — became infected with the virus. At least 50 million people died from the virus worldwide, with about 675,000 of those deaths occurring in the U.S.
Take a look at the size of the first wave of the virus, compared to the size of the second wave of the virus. It’s hard not to look at this graph and think about our current situation. Though we can’t draw an exact parallel between the two pandemics, it’s worth noting that we are in the first wave of the COVID-19 pandemic currently.
As the curve of cases has flattened in some parts of the country, many states have decided to gradually re-open their economies. Top infectious disease experts have cautioned that the results of these re-openings could give way to a second wave of the virus, which could bring additional rounds of shutdowns and stricter requirements that could bring more uncertainty to businesses and the economy, yet again.
The point here is that no one knows if the pattern of the 1918 pandemic could repeat itself now. In fact, we have no idea what the future holds for the COVID-19 pandemic, nor do we know how the markets and the economy will respond to future events. The real question is, given the above graph, how much risk do you feel comfortable taking right now? How much risk can you stomach? How much risk makes sense in the context of your near- and long-term goals?
Understand the Relationship Between Risk and Return
As an investor, you’re well aware of the risk/return tradeoff — the more risk you are willing to take in the financial markets, the greater your return potential, and vice versa. But the relationship between risk and return is not a linear function; it is an exponential function. That means that as the return goal increases, the risk increases faster.
Take a look at the graphic below:
Let's say that you aim for a 15% return on your investment with the related risk. You are a brilliant investor because you made a 15% return every year for three years. However, in the fourth year, you lose 15% on your investment. Your annual rate of return (you must use the geometric mean — not the arithmetic mean — to calculate this) is 6.6%.
Would it not have been better to shoot for a 7% return with less inherent risk?
The bigger the loss, the more difficult it is to recover and return to even. In this example, the hit you took in the fourth year would mean you’d have to recoup 56% just to get back to where you started. It takes time to recover those gains. For the investor who is younger and has a few decades to go until retirement, that’s all well and good — but not for the investor who is set to retire within the next five years.
Now more than ever, it is important to fully understand your capacity for risk and for weathering the unknown, within the context of your financial plan. You can’t control how the next three months, the next six months, or the next year will play out — but you do have control over the investment decisions you make today that will put you in the best-possible position to achieve your goals.
If you have questions about your investment strategy or would like a second opinion, please don’t hesitate to click here and contact me.