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Good Things Can Happen in Bad Markets with Don Calcagni


We’re now in the 10th year of a bull market, and it’s been one marked by historically low volatility. Sure, we’ve had a few corrections since 2008, including a 10% pullback off the highs early this year. And though investors have been conditioned over the past decade to think corrections are rare, the fact is that bear markets, not mere corrections, take place on average about every six years.

Moreover, those bear markets have an average decline of some 33%, and an average duration of 18 months. So, what the good part?

In this episode of the Science of Economic Freedom, “Good Things Can Happen in Bad Markets,” I speak with Don Calcagni, Chief Investment Officer of Mercer Advisors. In this show, Don helps us understand how corrections and bear markets work, and how investors should react during down market cycles. Plus, Don outlines the seven outcomes of a down market cycle that are actually positive for long-term investors.

Topics discussed in this episode include:

  • How investor overconfidence and fear of missing out fuel market bubbles
  • Why rising interest rates will put pressure on the equity market
  • What the flattening yield curve means, and why it’s important
  • The nature of the current bull market
  • Recency bias and the loud voice of bear market marketeers
  • The five things you must do now to prepare for the next bear market
  • Plus, much more…


Doug Fabian: Can good things happen in down markets? Yes, they can. On this episode of The Science of Economic Freedom, Chief Investment Officer of Mercer Advisors, Don Calcagni, joins us to discuss good things from bad markets.

Announcer: The Science of Economic Freedom is intended as an investor education resource. The views and opinions expressed on this program should not be construed as a recommendation to buy, sell, or hold any specific security. Consult your investment advisor and read any investment prospectus carefully before making any changes to your investment portfolio. This program is sponsored by Mercer Advisors. Mercer Global Advisors Inc. is registered with the Securities and Exchange Commission and delivers all investment-related services. Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services.



Doug Fabian: Welcome to The Science of Economic Freedom. I’m your host, Doug Fabian. This podcast is all about helping you achieve your financial dreams. We call that economic freedom. This program is about your journey to achieve economic freedom for yourself and your loved ones.

Today, we want to help you identify your next step on that journey.

This is Episode 31 — Good Things Can Happen in Bad Markets. Today, we welcome back to the podcast Don Calcagni, Chief Investment Officer of Mercer Advisors. Today, we are in the 10th year of the current bull market. From a volatility perspective, corrections these last few years have been mild. We had a 10% correction in early 2018, and prior to that, we had a 10% correction in January of 2016. Corrections are pullbacks in stock prices between 3% and 19%. It has been 10 years since the end of the last bear market. Bear markets are normal and over stock market history, their average occurrence is about every six years and the average decline is 33%. The time to recover from a bear market is about 18 months. Bear markets are not the problem when it comes to long-term investing. Investor behavior is the problem to long-term returns of investors.

Bear markets do pose a problem for investors. Price declines get inside investors’ heads. Bear markets put emotional pressure in one’s mind that they have to do something. Bear markets bring out the worst in portfolio construction. Undiversified, concentrated portfolios actually go down more in a bear market. Now, the purpose of this discussion today and visit with Don is to understand how markets work and how investors should react to down market cycles. Now, there’s a silver lining, good things can happen in bad markets. And we have seven reasons why we look forward to the next market cycle. Here is my interview with Don Calcagni. Don, welcome back to the podcast.

Don Calcagni: Thank you, Doug. It’s great to be here.


Why taxation is important

Doug Fabian: Don, you are one of our most popular guests. As a matter of fact, your podcasts are the most listened to shows in the archives of The Science of Economic Freedom, so we thank you for joining us again. For those who are new to the podcast — Don Calcagni is the Chief Investment Officer at Mercer Advisors. He and his team are managing more than $13 billion of client assets and Don has been in the investment business for over 20 years. He is a Certified Financial Planner, he has a master’s in taxation, and earned his MBA in Finance from the University of Chicago. So, Don, you and I are going to talk about an unpopular subject today and that is down markets. Give me your perspective on why you feel this is a good subject for us to be talking about today.

Don Calcagni: Well, thank you, Doug. It’s great to be here again. The reason why this is such an important subject is investing requires risk. Markets never go up in a straight line forever and bear markets are just par for the course when it comes to investing. So, the better we can prepare clients and investors to deal with bear markets and help them understand the pros and the cons associated with bear markets, the more successful they’re going to be in their investing experience.


Why are we talking about taxation?

Doug Fabian: Let’s talk more about the “why now,” Don. Certainly, it’s obvious that we have the age of this bull market, but give us some context around why we’re talking about this today.

Don Calcagni: Absolutely. The best time to talk about a bear market is really when you’re probably at the peak of a bull market. You certainly don’t want to be preparing for a bear market when it has already occurred.


Seven reasons to prepare for bear market

There’s seven reasons generally why I think now is an optimal time to talk about preparing for the next bear market and you already identified.

  1. This is the longest bull market in history and the fact is all bull markets come to an end. Like I said, investments, markets, they don’t go up in a straight line forever. One of the challenges with long bull markets is that they boost confidence, they actually fuel overconfidence, and they erase memories of past bear markets. And the reality is all of these bull markets will come to an end, that’s just a reality.
  2. Now’s a great time to talk about the next bear market is valuations, especially for growth in technology stocks, are becoming pretty high. I would argue that some of those companies are trading at nosebleed valuations, and I think of companies like Amazon and Microsoft and Netflix. And these are all exciting and great companies but the reality is you have some of these companies trading at nearly 200 or even 300 times next year’s projected earnings. And those are nosebleed valuations by any objective measure.
  3. Interest rates are rising. The Federal Reserve began raising interest rates again in December of 2015 and since then, we’ve seen about a half a dozen interest rate hikes. And the Federal Reserve has communicated that we’re on track for another four or maybe even six additional interest rate hikes in the next year and a half ahead of us. So, rates are rising, inflation is rising, inflation right now is close to 3%, which is actually a little bit higher than the Fed’s 2% target. So, we’re seeing inflation beginning to heat up, interest rates are rising. The yield curve which is really just how financial market participants, like ourselves, evaluate short-term versus long-term interest rates.
  4. One of the things we’re seeing is that the yield curve is getting pretty flat. And that’s typically, at least historically, that’s been indicative of a recession in the near future. And certainly, there’s a lot of healthy debate around that but we are seeing a yield curve right now that’s getting pretty flat which could suggest that we’re on the doorstep of a recession.
  5. The fifth reason would be that earnings growth for this year has been phenomenal. We’re looking at about 24%, 25% earnings growth for corporations. The reality is a lot of that earnings growth has been fueled by tax cuts and I’m not saying that’s right or that’s wrong, it just is. We had a big change in the tax laws that were passed in December of last year, and that has really been a powerful tailwind for corporate earnings growth. At this point, we’re projecting earnings growth for next year to be only about 10%. So, we are going to see earnings growth come down quite significantly from where it is today. That doesn’t mean company earnings are going to go down, it just means that corporate earnings growth is going to go down and that ultimately is going to be some pressure on stock prices.
  6. The sixth reason is that we are projecting an economic slowdown. If you just look at economic forecasts, I think the economics community as a whole is projecting a slowdown in global GDP growth in the second half of next year. Naturally, that’s going to put downward pressure on stock prices.
  7. The seventh and final reason why now’s a really good time to be talking about the next bear market is because trade tensions are rising. Just this morning, President Trump announced more tariffs on about $200 billion worth of Chinese goods and certainly, tariffs will put downward pressure on economic growth.


What can the market do going forward?

Doug Fabian: Well, Don, one of the things I want listeners to pay attention to is you and I are talking about this subject so people are prepared. And I was just thinking about it while you were going through these seven reasons as to why we’re talking about this now, there’s actually four things that markets can do going forward.

  • Markets can continue to defy all of the predictions and can continue to rise.
  • Markets can also consolidate and go sideways.
  • Markets can correct and we could go into a new market downturn.

So, again, one of the things that we’re doing is we’re not predicting that any of these things are going to come about. We have some specific action items in today’s podcast that we believe are going to help investors be prepared. But the real message of today’s podcast is that down market cycles, be it corrections or bear markets, are a natural part of the investing environment and we’re not trying to be alarmist in our conversation about this subject today.

Don Calcagni: That’s correct. And Doug, I think it’s important to really underscore that bear markets, market corrections, those are just par for the course when it comes to investing. It’s how markets reconnect risk with reward. And I think it’s important for listeners to also keep in mind that — especially for those of us who were investors and in the business during the global financial crisis from 2007 to 2009, and for those of us who’ve been in the business for many decades, going back to the dot-com bust and everything else — it’s important to keep in mind that a market correction or a bear market is not a financial crisis per se.

So, I think it’s important to distinguish between what happened in 2007 to 2009 and look at that as a separate event relative to these standard, and in reality, quite normal market corrections that we should come to expect as part of the normal investing landscape.


What were the last two market declines?

Doug Fabian: Don, let’s talk about the last two market declines. We had the 2000, 2002, and when you sum up there were certainly…tech stocks declined more than blue chip stocks did, but looking back historically, we were down about 47% from peak to trough in the 2000 to 2002 bear market.

In the great financial crisis, from high to low, just measuring by the S&P 500, we were down 56%, small cap stocks were down in excess of 60%, and we really had the most serious financial crisis since the Great Depression. So, I believe that investors have a tendency to think when they look back at recent memory and go, “Oh, yeah. I remember the tech wreck. Oh, yeah. I remember the great financial crisis. Boy, I’m sure the next bear market is going to be similar.


How would you give feedback to our audience on that?

Don Calcagni: Well, I would just caution that that experience, that expectation that the near future will look like the near past is a very common psychological bias. We call it the confirmation bias. It’s not entirely true, obviously, but as emotional beings, as psychological beings, we often look at our immediate past and project what occurred in the immediate past and we erroneously think that the future will look identical to the past. When in reality, we know that’s not the case. The world is ever-changing and rarely does the future look like the past. I’ve heard a couple historians say that history doesn’t really repeat itself, but it does have a tendency to rhyme, but just because something rhymes doesn’t mean that it’s the same lyrics or the same pentameter.

So, I think it’s important to keep in mind that that is a confirmation bias. It’s a psychological bias that really could interfere with our future investment success. So, it’s important to dissociate between what happened in the past and what will most likely occur in the future.


The history of the market

Doug Fabian: I do want to touch bases a little bit on market history. If you take a look at the last 100 years, bear markets do occur about every six years. Again, we’re 10 years into this bull market. The average decline is around 33%, 35%, and so I would expect when you just look at the averages, that the next decline might be similar to that as opposed to thinking that the next decline might be worse. Again, I’m not trying to predict where markets are going to go from here. I’m just giving listeners feedback that they need to think about relative to how they’re going to manage price declines going forward and that’s a big part of what we’re going to talk about today.

But Don, one of the things that you and I did as we put together this podcast is we wanted to talk about the good things that happen in bear markets. And so we’ve identified seven outcomes of a down market cycle that are positive for long-term investors. Let’s put some context around that term “long-term investors.” Because we have some people in the audience that are at the beginning of their journey to economic freedom. We have some people in the audience and many of our clients have achieved economic freedom and now they want to keep it. And then, of course, we have a lot of people in between.


What to think about capital markets going forward?

So, what type of context do you have and feedback do you have for investors who… What should they be thinking relative to the capital markets going forward and how they should be anticipating and reacting to corrections or bear markets?

Don Calcagni: Yeah, that’s a great question. I’d argue that’s one of the most important lessons that investors should take away from this podcast, and that is to understand that to be a long-term investor means that you don’t need all of your savings to be fully liquid immediately.

So, when you think about Mercer Advisors and who we are as an organization, we’re helping investors invest for financial planning reasons, we’re a financial planning firm. Our clients are trying to accomplish very long-term objectives whether it be retirement or passing on wealth to children or funding a child’s college education. Rarely do our client’s goals require immediate liquidity of their portfolio every day of the week and so what that means is your portfolio can take longer term risks. It could be invested for a 10-, 15-, 20-year time horizon.

And I often hear investors come to me and they’ll be 65 years old and on retirement’s doorstep and they would say, “Well, I’m a conservative investor, right? I mean, I should be conservative.” I actually correct them and I say, “Well, no. You’re going to be alive, at least statistically, for another three decades and so we need your next egg to last for three more decades.” And so by definition that means we have about a 30-year time horizon for, I would say, probably 90% of that portfolio. Certainly, part of that portfolio has to be very liquid to provide income for our retirees. But I do see many retirees erroneously invest way too conservatively because they perceive that their portfolio must be fully liquid at all times and I would argue that’s not entirely true.

Doug Fabian: We’re going to talk a bit about portfolio construction today as a part of our coaching for the audience. But I wanted to bring in this analogy, and the analogy is this, ladies and gentlemen. For those of you who own real estate and if you have a piece of property and you’re planning on being in the neighborhood for 5 years, 10 years, maybe your kids are going into grade school, middle school, high school, you’re planning on being in the same spot. Let’s face it — people don’t move that often. But one of the things that you don’t have at your home is you don’t have a market valuation of your property on a daily basis.

So, if you knew your property was going to decline 15%, 20%, even 30% in value over the next two years, but over the next five years it was going to be just fine, would you move out of your home with all of your possessions, try to rent a place or try to buy another place because you believe that your property was going to decline? I believe for most people, the answer would be no, absolutely not, I’m just going to stay put.

It is that kind of logic that we believe you should be applying to your investment portfolio. Now, we’re going to talk about a properly constructed investment portfolio as we go through today’s broadcast. But it is important that you sit still and not get shaken out of the market or scared or making a short-term change in the market because of something that you read, something that you saw, something that’s happening on a short-term basis.

So, let’s, Don, move right into our seven outcomes, positive outcomes, of a down cycle and we’ll kind of discuss these on a one-on-one basis. Let’s begin with number one, Don.


Why are bear markets required

Don Calcagni: So, the first thing to keep in mind, Doug, is that healthy financial markets require an occasional bear market. Bear markets or market corrections, however we want to characterize a declining market, that reconnects risk and return which is critically important. Bear markets remove what I would call dead, dying, or even zombie companies from the financial ecosystem. And the analogy I like to use is that of a forest fire. I know forest fires are certainly tragic and something that we generally attempt to avoid, but the reason why Mother Nature has forest fires is to remove the dead undergrowth from the forest floor and that makes room for new growth. It’s very hard for forests to remain healthy when they aren’t being occasionally thinned out, either through logging or through a natural forest fire. So, bear markets are really no different for financial markets. They remove these dead and dying companies from the financial ecosystem.

Doug Fabian: We’ve been talking about this a lot, ladies and gentlemen, about the importance of understanding market history. Don and I are both students of the financial markets and we’ve looked at history very closely over the past 100 years. And you can see a regular rhythm of down market cycles, be it a correction or bear market.

So, it is not an unusual phenomena, even though when you’re going through a down market cycle, the news headlines are piqued, the media has a tendency to exasperate the discussion of a down market cycle, there are predictions that things are going to be worse than they actually become. So, that’s just something for us to be aware of. Don, reason number two that we are looking at positive benefits for long-term investors from down market cycles.


Opportunity to harvest tax losses

Don Calcagni: The second reason, which I would argue is one of the most popular reasons that we hear from financial advisors is that bear markets provide us with the opportunity to harvest tax losses. Like I said a few moments ago, bear markets are just par for the course when we are investors. It is a reality, our markets require bear markets in order to remain healthy. However, that doesn’t mean that we can’t take lemons and make lemonade. And so what we often find is there are assets in a diversified portfolio that obviously will experience a loss during a bear market.

And the great thing about the income tax code is that it will subsidize those losses by allowing our investors, all of you listening to this podcast, to harvest those losses and thereby capture a tax deduction. You can deduct those tax losses against your income up to $3,000 annually or you can carry them forward indefinitely to ultimately net against gains in your portfolio, capital gains. And when you net losses against capital gains, the income tax code has no limit on using tax losses to offset capital gains. So again, I would characterize tax loss harvesting as taking lemons and making lemonade.


Portfolio rebalancing

Doug Fabian: Number three, Don, portfolio rebalancing. And this is something that we do for clients all the time, but really coach the audience, some of whom are managing money on their own, about the benefits of rebalancing, and maybe an example on how rebalancing is actually put into practice.

Don Calcagni: Rebalancing is probably one of the most underappreciated exercises that all investors should be going through. And Doug, like you correctly point out, we rebalance client portfolios on a very regular and systemic basis here at Mercer Advisors where balancing is a exercise, whereby we sell winners and we buy losers. And for that fact alone is why I think so many investors are against rebalancing. And that’s because they like to hold onto their winners and they really don’t want to acknowledge the fact that they’ve had a couple of losers in the portfolio.

But rebalancing effectively forces you to sell high and buy low. And if there was one rule that would fully encapsulate the best investment advice I can give somebody — you want to buy low and sell high. All right? Rebalancing forces you to do that. And when you rebalance, you’re selling those winners at a capital gain. And like I just said a moment ago, if we’re harvesting losses, what they means is we can take those losses to net against those gains.

If you think about the bull market for the last 10 years, mathematically it is a fact that when the market is going up, your portfolio is becoming riskier and riskier with every tick in the Dow Jones or the S&P. That is a fact. And so here we are 10 years into a bull market, if you have not rebalanced your portfolio over the past 10 years, I can assure you that your portfolio has a significant amount of down side risk.

So, rebalancing is that exercise that allows us to take risk off the table. And the great thing about rebalancing is that you’re in control of taking that risk off the table, the market isn’t doing it for you. And so when you are in control and you’re rebalancing, you yourself are reducing risk, harvesting the tax gains that you want to harvest, and then also harvesting the tax losses that you want to harvest. So, at Mercer Advisors, I mean, for all of these different reasons, this is why this is just built into our DNA and is a common practice here at our company.


Are there pros of a bear market?

Doug Fabian: Don, you mentioned this in the setup to this discussion about the seven reasons, seven positive things that happen in down market cycles — reconnecting risk and reward. Explain a little deeper about what that means.

Don Calcagni: If you think about what financial markets are, they are basically really just a mechanism where we take those who are in search of capital and team them up with people, with investors, who have capital to lend or to invest. The reality is that oftentimes markets get ahead of themselves. We all think we’re going to get rich investing in Netscape or Yahoo or something like that and today it’s Apple and Amazon.

But the reality is is if we disconnect risk from reward, the problem is the market eventually will recalibrate and reconnect those. And you certainly don’t want to be investing in companies, stocks, or bonds without first understanding the risk. And we see this all too often, we saw it in the late ’90s with the dot-coms. These are companies with zero earnings that offered investors significant risk and investors thought they were just going to go up indefinitely. All investors collectively in the late ’90s suffered from that confirmation bias and we all bought into that herd like behavior.

So, it’s very dangerous when markets become disconnected from risk and reward. When risk and reward are not linked, markets can become very inefficient, very irrational. And when risk and return are reconnected, that could be a very painful exercise for those investors who were ignoring risk. It is required, though, that markets always keep reconnecting risk and reward, there’s no free lunch. Think of somebody who is trying to borrow money for a mortgage, or a credit card, or to buy a vehicle. Obviously, those people with higher credit scores are going to pay lower interest rates and vice versa. Financial markets are no different so we have to keep that connection in order for markets to remain healthy.



Doug Fabian: Number five on our list, Don, is valuation. And one of the interesting things about valuation is when you get into a down market cycle, valuations decline, stocks become of better value. Talk about that.

Don Calcagni: If you think about a bull market, what’s really happening is that stock prices keep rising and rising and rising. And oftentimes, those stock prices rise faster than earnings can keep up. And if you think about buying stock in a company, the only reason you buy stock in a company is because of the promise of future earnings. That’s the only reason, I won’t get into all the academic theory behind it, but that’s why you buy a company, is that it’s going to earn profits and hopefully, they’ll pay those profits out to the investors some day in the form of a dividend or something like that.

So, when valuations get really, really high, what it means is investors are willing to pay higher and higher prices for each dollar of earnings. Think of a bank CD that’s yielding 5% and maybe one that’s yielding only 2%. Well, if you think about it, what’s happened over the last 10 years is that the bank CDs that were yielding 5% have really been bid up quite aggressively in price to where now effectively the yields on those are only about 2%. The same thing happens with stocks. And so the great thing about bear markets is it pushes those valuations back down to where the investments are no longer, quote, “overpriced.”

We saw this earlier this year in February when we had what they’re now calling the volatility flash crash back in early February. One of the things we witnessed with that mini market correction, as I’m calling it, is the valuation of stocks, specifically the S&P 500, came down quite nicely and offered a great entry point for those investors who were rebalancing their portfolios judiciously, and really just made companies overall more affordable for those investors who were still saving to accumulate wealth.


Systematic investment plans

Doug Fabian: Number six in our list — systematic investment plans. And this is where I really want the younger people in the audience to pay attention, because you really get a gift in a declining market. Don, explain.

Don Calcagni: You are so right, Doug. When you think about systematic investment plans, let me just give you an example. That would be a 401(k) plan. You work for an employer, maybe you get paid once a week or once every two weeks. Every payroll period, your payroll department is withholding part of your pay and sending it into your 401(k) provider and then they are subsequently investing those dollars. So, a systematic investment plan is just any investment plan where you are saving a set amount of dollars on a regular basis and investing it into your portfolio. So, you can do this through an IRA, you could have a Roth IRA, maybe you’re doing $100 a month or whatever it might be. Those are systematic investment plans.

And for all of us on this call who are in what we call wealth accumulation mode, think about it for a moment. You’re building wealth, you’re buying assets, you want to buy stocks and bonds at a discount. You want the market to actually be volatile and to go down so that you can purchase these investments at cheaper and cheaper valuations. And that goes back to what we were just discussing a few moments ago around valuations. So, bear markets, market corrections, these are phenomenal opportunities for systematic investors to benefit and really build some solid long-term wealth.


Interest rates decline

Doug Fabian: Lastly, on our list of good things that happen in bad markets is interest rates and interest rates have a tendency to decline in down markets. Don?

Don Calcagni: And that’s absolutely right. The Federal Reserve does not want to hurt the financial markets. The Federal Reserve’s role is to combat recessions and to ensure full employment and to keep inflation in check. We saw this during the great financial crisis from 2007 to 2009. Heading into 2007, the Federal Reserve was actually raising interest rates because the economy was actually overheating just a little bit.

But coming out of the crisis and actually in the crisis, we saw the Federal Reserve aggressively cut interest rates. And even after the crisis, in order to jump start the economy, many of the listeners on the call may recall a term called quantitative easing, or QE, as we call it in the business. And that was really the Federal Reserve’s way to just push down interest rates to rock bottom levels. And this is how many people were buying homes with 3% and 3-1/2% mortgages.

For those of us who can remember the ’80s and the early ’90s, I mean, we had double-digit mortgage interest rates at one time, whereas coming out of the global financial crisis, the Federal Reserve had cut rates so aggressively you can borrow for 3-1/2% to 4%. So, absolutely. A decline in interest rates does help consumers and helps aspiring homeowners and so that’s a good thing coming out of a bear market.


How to prepare for a bull market

Doug Fabian: One of the things in summary that we’ll mention, ladies and gentlemen, is every bull market does come to an end, but so does every bear market. And a bear market is a needed phenomena in order to be able to start the next bull market.

So, we’re on a long-term journey, the journey is not in a straight line, and we want to prepare you for all market cycles. Certainly, we’re not trying to make a prediction that the market is going to correct or that we’re going to have another bear market starting next week. But we know we’ll have another one someday and we want to make sure that you’re fully informed on how to be able to react appropriately for your situation and that’s what this discussion’s all about.

Now, Don, there’s some things that we came up with that investors could do now to prepare for the next market correction or bear market. I’ll let you begin on this.


Context for a bull market

Don Calcagni: Absolutely. And I think the first thing is really the most important. And that is to keep things in context. A bear market does not mean financial Armageddon. It does not mean another global financial crisis. Like we’ve said multiple times on this podcast, bear markets are normal. Like Doug said, once every six to seven years is the normal cadence with which bear markets occur. I would also add to that markets generally fully recover within about 18 to 24 months of the beginning of a bear market.

So, like Doug just said, bear markets have a beginning, a middle, and an end, just as bull markets do. And while we all have certain world views on politics and markets, my advice is that we be very careful not to allow potentially our world views or our political beliefs to really seep into our investment decision making. And I know that can be really challenging but oftentimes, the best advice is to stick to the science, stay diversified.

Doug Fabian: We have five of these topics for investors to look at in order to be able to prepare for the next market correction or bear market. And the second one is connecting with your advisor and reconnecting with your financial plan. Don?


Contact an advisor

Don Calcagni: Absolutely. In my role, I’ve had the privilege of working with some of the largest investors in the world and I can assure you that the largest investors in the world do not invest a single penny without having a written, documented financial plan. And that’s true for large pension funds, large sovereign wealth funds, and high-net-worth and ultra-high-net-worth families. And it certainly should be true for those of us who are still in the wealth-building phases of our life.

So, connecting with an advisor is critically important to helping provide some context. Investing at its core, because we are emotional beings, is a very emotional process. We are not well-engineered to be highly rational investors. And I think engaging with an advisor and brainstorming on ideas and reconnecting with our financial plan allows us to really acknowledge how we’re feeling around markets, but also having that independent expert to hold up a mirror to us and remind us of why we’re investing in the first place. Somebody to run interference with our immediate knee-jerk reaction to what may be happening in the market.

So, working with an advisor helps you slow down your decision making a little bit, and there’s lots of evidence that shows that that pays big dividends when it comes to your investment strategy.

Those investors who emotionally react quickly to what’s happening in markets, believe it or not, those investors get hurt the most. The investors who do the best are those who slow down, evaluate what’s happening in the environment, and discuss things with their advisor.


Realizing capital gains and losses

Doug Fabian: Don, we also want to bring to everyone’s attention this concept around realizing capital gains and sometimes capital losses. Explain.

Don Calcagni: I think it’s important to understand that realizing capital gains, by which we mean selling a winner, something that you’ve earned a positive return on, that that’s not a bad thing. I often see many investors trying to move mountains to avoid paying taxes. And while I certainly support legitimate and very sophisticated tax planning when it’s appropriate, it’s important to keep in mind that when we make a decision not to rebalance our portfolio or to not realize a capital gain, we’re making a conscious decision, whether we admit it or not, to keep a significant amount of risk in our portfolio.

And I think it’s important that investors understand that tradeoff. That if we don’t want to pay taxes on our winners, what it means is we must be okay with this added level of risk that we now have in our portfolio. And so I think it’s critically important that we just make sure that we understand that. At the end of the day, paying taxes, it means that you’ve won. It means that you have successfully harvested some great returns. And for that, I would congratulate you, but I would still make sure that you understand the tradeoff between not harvesting capital gains and keeping risk in your portfolio.

Doug Fabian: I’ll add to that, Don, that people need to understand that we’re not suggesting that they’re selling all of a single position. Positions can be broken down and you can sell number of shares, you can sell 10% of a position or 15% of a position. When you sell that position, you’re not realizing capital gains on every dollar of the position sold. You’re going to have a cost basis. But it is a part of the systematic way about going about managing a portfolio and if you have highly concentrated positions in your portfolio on individual securities that have appreciated significantly, you have taken on extra risk from the market. And the idea of realizing some gains and taking some chips off the table is all about getting your portfolio back to a better place and taking some risk off the table.


Rebalancing back to your original asset allocation

Let me bring up point number four, rebalancing back to your original asset allocation. Don, this goes back to the basis of our financial planning exercise with clients, what we’ve been coaching people with here on the podcast is everyone should have an asset allocation that is customized and appropriate for them. But markets, when they move up, you get off of your asset allocation and you need to go back and recheck it. Explain how you do that.

Don Calcagni: That’s absolutely right and this goes back to what we were saying earlier around rebalancing. If you think back to what your target asset allocation was in, for example, let’s say 2010, and let’s just say you were at 50% stocks and 50% bonds. And if you’ve never rebalanced your portfolio, by today your portfolio is about 80% stocks and 30% bonds. And so if you think about the risk tolerance of an investor who wanted a portfolio that was 50% bonds and 50% stocks, I would argue that that risk tolerance is very different from somebody who has a portfolio that’s 80% stocks and only 20% bonds. So, the rebalancing exercise allows you to get back to your original risk tolerance level by rebalancing back to that initial asset allocation.

Obviously, like we said a moment ago, if you were to do that, you would have to harvest some gains and you may or may not have to pay taxes depending on where the portfolio is. Maybe it’s in an IRA and in that case, there are no tax implications. But just to echo what Doug said a moment ago. If we take that portfolio that was originally 50/50 and it grew and now it’s 80/20, if we rebalance back to 50/50, that does not require us to sell all of our stocks, by no means. We only have to sell that 30% component over and above the 50%, if that makes some sense.

So, when we talk about rebalancing, we’re talking about these small moves where we’re shaving a position and just dialing it back slightly. And now, 80 to 50 sounds pretty dramatic, but that would be, for example, for a portfolio that was not rebalanced over the past eight years. If you’re rebalancing your portfolio quarterly, you can imagine that these are very minor adjustments that you can make along the way while still keeping your portfolio dialed in to its original risk tolerance level.


Stay diversified

Doug Fabian: Last item on our list of five items to prepare now for a correction or bear market and that is stay diversified. Don?

Don Calcagni: This is a bit cliché but it’s definitely worth underscoring. And the best advice we can give investors is to stay diversified. There’s absolutely no better way to manage risk and achieve your long-term financial goals than through a globally diversified portfolio of stocks and bonds. And it’s important to note that during bear markets, we often see sales people and commercials suddenly pitching all sort of strategies that supposedly would have worked to protect our portfolios from a market decline and all of us have seen sales pitches regarding gold and annuities. We’ve even talked to friends and families about things like bitcoin. And all of these different assets or strategies are typically pitched as some sort of panacea that’s going to protect our portfolio from market corrections.

I would argue that’s just not true, that is just not true. Many of those strategies are just expensive, many of them are just — from a financial perspective — they’re just not very good and often will irreparably harm your portfolio in such a way to where you won’t be well-positioned for the next bull market. So, I would argue be very careful of the false promises that we hear around all of these different products and strategies that would supposedly have, quote, “protected us” from a market decline.


Action steps

Doug Fabian: Don, one of the things I like to do at the end of a podcast is to give our listeners some action steps. I know we gave a lot of commentary around what you could do now to prepare for the next market correction or bear market. Let me go through these again briefly as we wrap up today. Action steps to prepare for the next market correction or bear market.

  1. Keep market declines in context. They are normal and healthy.
  2. Speak with your advisor and stay connected to us right here on The Science of Economic Freedom. We are going to be producing a podcast each and every week. The purpose of these podcasts is to walk hand in hand with you on your journey to economic freedom and we’re going to be able to help you understand what’s happening in the financial markets over time and stay on track. And as you speak with your financial advisor, make sure you have a real financial plan for yourself and your family.
  3. Rebalance. Not only rebalance an individual position or your allocation to stocks, bonds, and cash, but highly concentrated positions and tax losses. This is something that investors need to look at closely. Remember those highly concentrated positions actually are indications of higher risk in your portfolio, so you want to keep that in perspective.
  4. Review your overall asset allocation, and number five, properly diversify your portfolio.

You do these things now, ladies and gentlemen, you will be prepared for the next market correction and/or the next bear market. Don, closing comments for our audience on good things that happen during down markets?

Don Calcagni: I think it’s important to just keep in mind that down markets are par for the course when it comes to investing. Markets don’t go up in a straight line. And in order to have a successful investing experience, it’s important to understand that bear markets are reality, just prepare for them and then take advantage of them.



Doug Fabian: Don Calcagni, Chief Investment Officer of Mercer Advisors. Don, great to have you back on the podcast. Thank you very much.

Don Calcagni: Thank you, Doug. It’s an honor.

Doug Fabian: Ladies and gentlemen, this is Doug Fabian. You’ve been listening to The Science of Economic Freedom and we thank you. Have a great day.

Announcer: The Science of Economic Freedom is intended as an investor education resource. The views and opinions expressed on this program should not be construed as a recommendation to buy, sell, or hold any specific security. Consult your investment advisor and read any investment prospectus carefully before making any changes to your investment portfolio. This program is sponsored by Mercer Advisors. Mercer Global Advisors Inc. is registered with the Securities and Exchange Commission and delivers all investment-related services. Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services.

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