Published by Robert W. Huntley, CFP®, CHFC®
Let’s play a game.
Imagine it’s April 2019 and you begin seeing headlines like the following:
“The DOW was down today by a record single-day point loss of 1500 points.”
“Economists say there’s no end in sight to this current market sell-off as the Federal Reserve meets to consider options for stabilizing market volatility.”
So far, the market has fallen from its previous highs by almost 50% and all you see are headlines on how bad it is and that there is no way to know when this is going to stop. Suppose your portfolio is down in this major market sell-off. 15%. 20%. 30%.
At some point, you are going to have a reaction to this. Where is that point for you? Just the relentless headlines for months can beat you up mentally.
We often refer to this line of thinking as a “Life Boat Drill.” The reference is to a sinking ship. At what point do you as a passenger conclude that the “ship is going down” and run for the lifeboat?
Be brutally honest with yourself for a moment and imagine this market sell-off is really happening to you early next year. How bad would it have to be for you to “run for the lifeboat?”
What would you do?
- Sell, Sell, Sell. Go to cash.
- Call your broker/advisor and discuss whether to sell before it gets worse.
- Ignore it because you’re confident you have a plan well designed that protects you from this sort of massive market sell-off.
Here’s the deal. None of us can just brush off this sort of thing as if nothing is happening. We are, after all, emotional creatures. Non-stop headlines do take an emotional toll on anyone.
“You can’t control the wind, but you can adjust the sails.”
We cannot control world events, interest rates, economic cycles, Government debt levels, etc… Those are the equivalent of trying to control the wind, not possible.
We can, however, control the risk budget in our investment portfolios. We can set up strategies that allow us to weather the storm without making emotional decisions at the worst times.
There are many ways to manage downside risk protection. Some of them involve the investment strategies you use. Other ways involve having adequate liquidity to tap into as needed while you wait for markets to cycle back up after a sharp correction.
There is no one-size-fits-all solution for anyone.
The correct plan depends on your unique circumstances. For example, consider the following items in the process of setting up your overall investment plan:
- How much income do I need annually from my investments?
- What’s the necessary return I need to average for my long-term plan to work?
- How much total loss of portfolio value can I stand before feeling panicky?
- Are there any special tax issues I need to keep in mind before making any rash buy/sell decisions if markets move suddenly downward?
Once you’ve thought through these 4 key questions, you are ready to begin thinking about how you’ll allocate your investments.
There are so many ways you can go. The most common approach used over the past 50 years to manage volatility is commonly referred to as “Modern Portfolio Theory.”
It boils down to blending stocks, bonds, cash and other asset classes like real estate or precious metals. The idea is to find asset classes that move differently from each other. That, in theory, should smooth out your roller coaster ride when markets get spooky.
But we all saw first-hand in the market correction of 2008 that theory doesn’t always perform according to expectations. So, what other options are there?
Here is a quick summary of a couple of other options:
- You can always use cash or cash-based options to remove or limit market risk. Bank products carry FDIC insurance on top of being non-market based. Other products like fixed and index annuities can offer cash-based performance. The downside on some of these options is lack of liquidity and limited return potential.
- You can use certain computer and data-driven strategies that follow market moving averages. The idea is to look for momentum based on market trends and then buy in or sell out based on the trends. This can be very effective in the right market environment, but it can also do poorly in other environments.
- Other techniques for trading such as “stop loss” trades can automatically kick in when markets fall rapidly by a predetermined level. Some strategies build these into the disciplined decision-making approach, so you don’t have to “make the call” for it to happen.
These are just a few ways you can customize your portfolio “risk budget.”
Ideally, you want to have your accounts set up where even in a serious market sell-off you have a pretty high level of confidence that your holdings, when viewed all together, would only be down as much as you have predetermined you can stand to see happen.
Having things set up in this way allows you to tune out the noise and go about your business.
If you are not sure about your current situation or you’d like a second opinion, we can certainly help. Feel free to reach out to us.
In the meantime, the first place to start is by looking at your Risk Tolerance Quotient. This link is free and will let you answer a few questions and see what your current level of comfort is with risk in the markets.
After you know the answer to that question, it’s a matter of seeing if your current investments are consistent with the results. Is the risk you are taking more or less than the risk you are comfortable taking?
Let us know how we can help. We are available and willing to help you think this through. If you know someone who could use this sort of thinking, feel free to forward this post to them too.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.