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Investment Principles Trump Outlook (and Buying During A Downturn)

During a recent group call amongst the partners at Trailhead Planners, one of us recounted a recent experience during an extreme down day in the market. The partner was adding money to their personal Roth IRA and was about to invest in a stock fund for long-term growth. Then, an interesting thing happened.

Given the time horizon to retirement, 30+ years, and the fact that Roth IRAs, from a tax perspective, should usually contain the highest risk/reward investments in an investment portfolio, the partner was about to put the bulk of the contribution in a US Small Cap Value Fund. Historically, US Small-Cap Value, as an asset class, has been the best performer over long time horizons as it takes advantage of two ‘factor premiums’: a) the Small-Cap Premium (smaller stocks tend to outperform larger stocks) and b) the Value Premium (cheaper stocks tend to outperform more expensively priced stocks).

That said, small-cap value can get badly beat up in a downturn. For example, in 2008-2009, small-cap value (as measured by the Morningstar Small-Cap Value Total Return Index) was down 63.06% as of the March 9th, 2009 bottom. From peak-to-trough, that same index was down 48.87% on March 23rd, 2020. Time will tell if that date will end up being the bottom of this bear market or if we are still to probe further lows.

However, over the last twenty years (April 3rd, 2000, to April 3rd, 2020), Small Cap-Value (Blue, in the chart below) has more than doubled the performance of the S&P 500 (green), inclusive of the recent downturn. We know from both ample investment experience and over a century of market history that right now is likely an incredible investment opportunity even as we confront the real risks of a human tragedy.

Trailhead Planners fee-only financial planning small-cap value vs S&P 500

Source: Kwanti, Trailhead Planners

Knowing all of this, it should have been easy for our partner to pull the trigger on the buy. They cut their teeth as a financial advisor during the Great Financial Crisis. If the last decade has proved anything, it’s that buying during a time of panic can be beneficial to your wealth. But, it wasn’t easy. In fact, our partner felt fear.

What if the stock market goes down further? What if we are under-appreciating the economic effects of social distancing? What if we need to social distance for much longer than currently anticipated? These thoughts, and more, circled through their brain.  And, for a moment, they were paralyzed.

We’ve been coaching our clients to add to their stock portfolio where appropriate throughout this downturn. We understand that can be frightening.  We know that because we feel it too. 

It’s true that we have no idea what the stock market will do over the coming months. Similarly, we struggle to discount the full effects of social distancing on the economy. We suspect it will be bad. It already is.

Yet, in the face of all this uncertainty (and the future is always uncertain, we just feel it more intensely at times) our response must not be ambiguous. It must be clear.   

At Trailhead Planners, we collectively fall back on our core investment mantra during tumultuous markets:

Investment Principles trump Investment Outlook.

Put differently, the future is always ambiguous. As a result, instead of predicting what will happen and then making decisions based on the low probability event that we are correct, we instead rely on a core set of principles to guide our investment decision making.

So, what are our investment principles? Well, we thought it might be helpful to summarize them for our shared recollection at this moment.

First Plan, Then Invest

Your financial plan is primary and dictates every part of your financial life, including investments. The plan tells us your goals, your current resources, your expected future resources, and your cash needs. From this basis, and only this basis, can we start making investment decisions. Before investing one cent in the stock market, you need to know what future goal, or financial need, that investment is expected to fulfill.

Focus On The Long-Run

Over the last few months, we’ve been reminded to dramatic effect that the stock market is incredibly volatile over the short-term. What’s the stock market going to do tomorrow, next week, or next year? We have no clue and no one else does either. Even a given year or series of years is anybody’s guess.

Yet, we know that since 1928, a period that includes the Great Depression, about 2/3 of all years are positive in the S&P 500. Yet, even that isn’t a number you want to play the odds with. How’s this? Since the Great Depression, there have only been two rolling ten-year periods in the US stock market that have been negative. Notably, you have already lived through them as it was two ten-year periods between the Tech Bubble and the Financial Crisis. This trend, of course, continues. Fifteen-year and twenty-year rolling periods look even better.

Put simply, volatility of returns moves inversely to time horizon.  The longer the time horizon, the more confident we can be in positive stock market performance. That’s why we say to focus on the long-term, like decades, when it comes to stock investing.  

Bear markets feel painful, but historically they have been blips on the radar within a long, upward trend.


There’s a saying that diversification is the only free lunch in investing. We think that’s largely true. Diversifying your investments across global asset classes is a key step toward portfolio optimization. What do we mean by diversification? Well, instead of just owning one stock or a handful of stocks, it is usually better, from a risk/reward perspective, to own a basket of stocks.  Instead of owning just U.S. stocks, we suggest owning European, Japanese, and South American companies (amongst a whole host of other countries).

Additionally, it is near impossible to know what asset class, be it U.S. Large-Cap stocks, or Japanese Small-Cap stocks will be the best performer over any period. In other words, diversification also means minimizing active bets in your portfolio to the extent possible.

Of course, the amount of diversification necessary in your portfolio is dependent on your financial plan (see: ‘First Plan, Then Invest’). Additionally, our internal approach to diversification can get technical. However, the basic concept stands. To reduce risk (i.e. volatility) in your investment portfolio, invest broadly.  

Reduce Taxes

Here’s a fun fact for you: Most academic finance ignores taxation because it was largely written for large endowments and foundations that do not pay taxes. Here’s another fun fact: You do pay taxes. 

Our fourth investment principle is “Reduce Taxes.” We believe taxes are wholly unappreciated by most financial advisers, leading to sub-optimal investment decisions. Every investment decision you make must be filtered through a tax planning lens to minimize the taxes you pay. Questions we ask when customizing an investment portfolio for a client include:

  • How can we make this portfolio as tax-efficient as possible to reduce current taxes?
  • Which investments should be held in which types of accounts to ensure tax-aware investing?
  • What actions can we take now to reduce taxes in retirement? 

Less taxes paid means more money for you, your family, your enjoyment, and the causes you care about.  

Minimize Costs

Whether it is trading costs or internal fees charged by mutual funds or ETFs, the investment fees you pay matter to your long-term investment performance.  For example, if two funds track the S&P 500, the fund with lower internal costs will likely perform better over time. Paying attention to investment fees and minimizing them to the extent possible will serve dividends over the long-term.

Stay The Course  

This is the hard one. Every other principle can be in place, but if you can’t stick with your investment strategy or financial plan through thick and thin, you will never reap the rewards. Dalbar, a Massachussets research firm, calculates the difference between investor returns (the return the average individual investor in a mutual fund receives) and investment returns (the actual return of the underlying investment). Their research confirms the anecdotal evidence: we (i.e. humans) suck at investing. We panic, we get greedy, we buy high and sell low, and we fall victim to a whole host of other behavioral biases.

Here’s the amount, in percentage terms, the average investor trailed actual stock market returns annually, according to Dalbar (Source: NY Times):

  • 5.88%, annualized, over 30 years
  • 3.46%, annualized, over 10 years
  • 4.35%, annualized, over 5 years

On top of this, bond investors, according to the study, haven’t even kept up with inflation. And this is during a 30-year bull market in bonds!

As you can see, we are our own worst enemies when it comes to investing. For this reason, we believe everyone should work with a financial planner. And yes, even financial planners should work with financial planners. Why? Because to succeed over decades of investing and various markets we need to be held accountable to our goals and kept from our own self-defeating impulses. Great financial planners aren’t immune to this when it comes to their own money. And if the experts aren’t, neither are you. So yes, build the plan, focus on the long run, diversify, reduce taxes, minimize fees, but don’t forget the last crucial step: Stay the course.

Back to our story from the beginning. Acknowledging that they were feeling an emotional impulse around investing, our partner called up another Trailhead partner and admitted to what was happening. They talked about all the uncertainty in the economy and the markets. They talked about fear of the unknown. And they talked about whether things were going to get worse or better. And then the colleague said, “But none of that matters to this decision. Your job is to stay the course and continue to invest in the markets year after year.”  

And they did.

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