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Scott Neal

Scott Neal, CPA, CFP, is the president of D. Scott Neal, Inc., a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville. Reach him at or by calling 1.800.344.9098.

Investment Markets: Problem? or Opportunity?

The current economy, marked by the combination of high and rising inflation, low unemployment, and the near-zero interest rate policy by the Federal Reserve, is like nothing that we have experienced over the past 40+ years. The uncertainty of the situation has resulted in falling prices of both stocks and bonds at the same time—also a first in a very long time.

At this writing the aggregate U.S. Bond market (AGG) is down nearly 9% year-to-date, Treasury Inflation Protected Securities (TIP) down 6.4%, and U.S. stocks as measured by the S&P 500 (SPY) are down 18.1% and recently dipped temporarily into correction territory, defined as -20%.

The Problem

If you are feeling uneasy about your investments, rest assured that you are not alone.

Perhaps you, like most investors and many professionals, follow the investment protocol popularized as asset allocation. You likely know the drill: own a basket of securities that contains traditional asset classes, usually cash, stocks, and bonds. Allocate the entire portfolio across those asset classes and then periodically rebalance the portfolio back to those prescribed allocations. “Wash, rinse, repeat, and your investment portfolio will be fine,” say it’s proponents. The portfolio objective of this strategy is to achieve market-like returns within the particular asset classes while reducing volatility of the entire portfolio by holding securities that move counter-cyclically with each other. In other words, the theory assumes that volatility, not loss of capital, is the chief risk that we face. Won’t we accept, even desire, all the upside volatility we can find? It’s the downside that keeps us awake at night. But what happens when all the usual asset classes are all declining at the same time? Turn to cash?

When it comes to investing, any inclination to “throw in the towel” or to “go all in” is usually a mistake.

Thanks to Federal Reserve policy, the interest rate on cash remains at nearly zero. With inflation running rampant at about 8%, holding cash while we wait for the markets to settle down means that purchasing power of those dollars is evaporating.

Remember that the Fed only controls short term interest rates. The bond market controls the rates of longer-term bonds. The interest rate on a bond is fixed at the time it is issued. The bond market fulfills its function by bidding up or down the price at which it is willing to buy bonds that pay a specific rate of interest. As interest rates increase, the price of the bond must fall to provide that rate.

I am sure that you probably think that the current market only presents a problem. However, we invite you to join us in seeing it as an opportunity. Please look at your portfolio performance (both the percentage return and the number of dollars gained or lost) for the trailing twelve months. Make an honest assessment of whether your portfolio is aligned with your objectives. There is still time in this market cycle to make adjustments.

There is a strong chance that traditional stock and bond losses will get worse before the markets turn around. If you are losing sleep now, just know that although not guaranteed, things can get worse and that you have a wonderful opportunity right now to accept or adjust your risk tolerance and thereby impact future performance. Now is a good time to assess your risk tolerance and to take steps to get it aligned to reality if you find the two are incongruent. Talk to a professional.

Our Solution

In 2002, while still attending to the tenets of traditional asset allocation, we began to select stock and bond mutual fund investments based, in part, on momentum. Each asset selected for the portfolio was growing at a faster rate than its peers. We likened our analysis to watching a horse race and seeing a particular horse moving through the pack toward becoming the leader. Initially, we invested in this way without imposing risk controls of selling those securities that lagged the others. We called it our Momentum Growth Strategy. This subjected the portfolio to drawdowns consistent with the market.

In 2007, we became aware of the work of Dr. Mordecai Kurz at Stanford University. Among other things, Dr. Kurz posited that most of the risk in the market is endogenous to the market and not to some outside forces. This discovery has far-reaching significance for portfolio managers. We asked our clients with which they were most concerned: a) failing to achieve market returns, or b) losing their capital. Many responded that they were more concerned with the latter. In response, we developed the Wealth Preservation Strategy just in time to prevent significant losses in the 2008 downturn for those clients who chose that strategy over the Momentum Growth Strategy. This strategy also worked very well to protect capital in the downturns of 2011 and 2018.

One aspect of the Wealth Preservation Strategy has been the use of technical analysis to determine the entry point for adding new securities to the portfolio mix. Attention to risk controls for each individual security and position sizing are other aspects of the strategy designed to control drawdown. We did not allow small losses to turn into big ones. The strategy also usually carried a rather significant allocation to cash. This worked as long as inflation remained low or non-existent. Now we are at a different place and a different time.

As the markets’ access to “free” capital via the Fed’s zero interest rate policy kept driving up the stock market, it was quite normal for some investors to totally abandon Wealth Preservation for the sake of seeking higher returns.

At times like the present, when all the usual asset classes are turning down, we instead hear investors clamoring for more Wealth Preservation. Rest assured, when it comes to investing, any inclination to “throw in the towel” or to “go all in” is usually a mistake.

So, what is a person to do?

Our present solution is to blend the two strategies in proportions that will attend to a particular investor’s tolerance for drawdowns while also attending to return needs that address particular investor objectives. Rather than mandate the allocation to particular asset classes i.e., stocks and bonds, we advocate that an investor allocate a portion of assets to each of the two strategies. The amount to allocate to which strategy will solely depend on one’s risk profile. Do you detect a theme here?

Regular rebalancing is also important and should be done quarterly or quantitatively when the total portfolio gets out of balance. The more risk tolerant you are, the more you will invest in a Growth strategy. Wealth Preservation will continue to protect from further drawdowns. Risk tolerance can be assessed in many ways. We recommend using one that has been proven to be psychometrically valid.

Going beyond allocating the portfolio to different strategies, we recommend that you choose specific assets that you believe will perform well in the current economic environment. Consequently, some of your traditional stocks or funds can be retained, but you might also consider ETFs that track commodities, precious metals, and real estate rather than exclusively investing in traditional stocks and bonds.

A relatively new breed of ETFs is now readily available and can provide a way to hedge against further losses by placing some of your assets in those ETFs. They move in the opposite direction of a chosen index on a daily basis. Think of it as a way to short the market without selling short. Use them with extreme caution and close supervision. We hope that inverse ETFs, as they are called, or alternative investments, do not turn out to be long term holdings because they are expected to perform well while the market is going down and inflation/interest rates are rising. We can only hope that policy makers will soon get our economy back on track for sustainable growth. Meanwhile, we must dance to the music we hear.

Scott Neal is the president of D. Scott Neal, Inc., a fee only financial planning and SEC-registered investment advisor with offices in Lexington and Louisville. You may write to him at or all 1-800-344-9098.