Are you concerned that a big stock market drop is looming? Who could blame you? The stock market, as measured by the Dow Jones Industrial Average (DJIA), is up over 300% since March of 2009. That’s an annualized return of over 18% per year for the past eight years. The historic annualized return of the DJIA, which measures large company U.S. stocks, is around 10% per year. It is unlikely that an asset that averages 10% will run at an 18% pace forever. It would be logical to assume that stock performance will return to its long-term average. Of course, this return to the average could happen all at once, with a big stock market drop like the one we saw in 2008, or it could happen over a longer period of time with lower returns lasting for a period of years, think 2000-2002. The question now is what can you do to protect the gains you’ve received over the past eight years while at the same time not overreacting, pulling everything from the stock market, and hurting your long-term investment performance? Here are some steps you can take now:
Adjust Your Allocation Now, While Stocks Are at All-Time Highs
First of all, the time to adjust your stock, bond, and cash allocation is when stocks are at highs not at lows. This means if your portfolio is currently invested 75% in stocks, but based on your age or other parameters, should be closer to 50% stocks, you should make the change from 75% to 50% now while stocks are at or near all-time highs, not after a drop occurs. Most people do the opposite. Now is a good time to reevaluate your allocation to make sure it fits your tolerance for risk and your future goals.
A good guideline to determine your stock exposure for your investment portfolio (money after emergency reserves have been subtracted) is to take the number 110 and subtract your age. The result is the amount to invest in stocks (see chart below). So, for example, if you are 60 years old this formula would allocate you to 50% stocks (110-60=50% stocks). This would be a good time for a 60-year old investor who is sitting 75% in stocks to reduce his stock exposure from 75% to 50%. This allocation change would force 1/4th of the portfolio, stocks, to be sold at or near all-time highs and be reinvested in bonds which have historically carried much less risk.
Fill Up the Buckets
Another way to reduce portfolio risk is to invest your money based on when you plan on spending it. Consider pouring your money into three buckets. Bucket one is for money you are going to spend in the next 1-2 years (short-term), bucket two is for money you’re going to spend in years 3-10 (intermediate-term), and bucket three is money you don’t plan on spending for more than 10 years (long-term). For example, if you are retired and are withdrawing $20,000 from your $500,000 portfolio each year you could keep $40,000 in bucket one. This money would be invested in bank investments, like checking, savings, money market, and CD accounts. No market risk is taken with this money since you know you’ll be spending it in the next two years. Next you would place $160,000 into bucket two. This money would be invested in bonds (government, corporate, and international). Individual bonds or bond mutual funds could be used. This money would be spent in years three through ten. And finally, the balance, $300,000, could be invested in a stock portfolio using a diversified portfolio of individual stocks or stock mutual funds (diversified across eight to nine stock asset classes). The overall allocation in this case would end up at 60% stocks, 32% bonds, and 8% cash.
With this approach, ask yourself, “How worried would I be if another 2008 stock market drop occurred?” The answer is, hopefully, “Not very.” You would have your spending needs met for the next ten-years via your cash and bond portfolio. As long as stocks rebound and provide a decent return over the next ten years your portfolio will likely be fine. You wouldn’t have to worry about your stocks if we did have another 2008 because they wouldn’t be needed for another 10-years.
Now is also a good time to rebalance your portfolio. If your allocation targets are set where they need to be based on your age and goals you are likely a little heavier in stocks now than when you set your target weightings, since stocks have grown faster than bonds. For example, if your target portfolio was originally allocated at 80% stocks, 15% bonds, and 5% cash in 2009, today you are sitting closer to 90% in stocks due to the market’s rise (example below). Rebalancing is a process that allows you to buy low and sell high. In this case 5% would be chipped away from large-company growth stocks and added into the bond portfolio bringing the portfolio back to 80/15/5. Again, it makes sense to rebalance when stocks are at all-time highs like they are now.
Don’t forget to diversify. I’d suggest your stock portfolio have exposure to eight to ten stock asset classes (large-cap, mid-cap, small-cap, international, growth, value, etc.) and three to four bond assets (corporate, government, international, etc.). Diversification means two things. First, you will likely always have something that is performing well regardless of the stock market’s direction. For example, in 2008 long-term government bonds gained 22% while large U.S. stocks, as measured by the S&P 500 Index, fell 37%. Or in 2000, large-cap U.S. stocks fell 25% while mid-cap U.S. value stocks climbed 25%. Diversification also means that you’ll always be disappointed in something that you own since there will always be some that will lag in a diversified portfolio. Now is a good time to make sure you’ve spread your risk over multiple pieces of the stock and bond market. I’d suggest covering the following bases:
What if you knew? Would you do anything differently?
If you knew 2008 was just around the corner, what would you do? To answer that question let’s look at eight different investors, how they handled the 2008 drop, and how they’ve done since. Four of the investors are retired (Investor’s 1-4) and are withdrawing money from their portfolios. Each investor has a $500,000 nest-egg starting on January 1, 2008. Below you can see how they each did from January 1, 2008 until May 31, 2017. You can examine their results and see what problems 2008 caused.
You’ll notice that each investor was rewarded for sticking to their investment strategy. They all recovered their losses. The key for you as an investor is to have a pretty good idea of what to expect from your portfolio when we do have stock market problems. If you are educated you are not likely to overreact and make poor decisions when your emotions are high. The mistake many investors made in 2008 was jumping out of stocks after stocks dropped and then not getting back into stock to enjoy the 2009 rebound. Trying to time the market hurt many.
The chart below shows many different allocation strategies and how they’ve performed since 1926. Find the allocation that most resembles your own. Look at the risk associated with your mix of stocks, bonds, and cash. Are you comfortable with that amount of risk? If not, begin reducing your stock weighting so you are not caught with a pullback you can’t handle.
Over-Concentration in One or Two Stocks
If you are over-concentrated in just a couple of stocks, now may be as good as any to sell and diversify, or at the least begin to trim back your position. Your positions have likely enjoyed growth similar to that of the overall stock market or maybe even much better performance, depending what sectors you are invested in.
If you are heavily weighted in just a couple of stocks and having a hard time getting yourself to sell in order to diversify, remember that even large solid companies can fall, and often when they do it occurs very quickly.
How much should you sell? For example, let’s say you own Microsoft and it represents 50% of your portfolio. In 2008 Microsoft fell 44%. Ask yourself the question, “How much would Microsoft’s price have to fall before I’d have to continue working or dramatically decrease my lifestyle?” The answer to this question will set your price trigger.
Let’s say you have $500,000 and $250,000 is invested in Microsoft. At $500,000 and using a 4% withdrawal rate you could safely withdraw about $20,000 per year from the portfolio. However, if Microsoft drops 44% to $140,000, your nest-egg would now be reduced to $390,000. At this point you could continue withdrawing 4%, and reduce your annual withdrawals to $15,600 which might not be enough to cover your living expenses, or you could continue to spend $20,000 from the now, $390,000 portfolio and risk depleting your portfolio too quickly. You may conclude that if Microsoft drops 15% you can still meet your objectives. However if it drops more than 15% you are going to have to reduce your lifestyle or go back to work. If this is the case set a price trigger and sell when trigger is reached.
You may want to establish multiple price triggers, or pre-set prices to get out if things go south. Currently Microsoft is up 358% since its March 2009 low. You may want to sell 10% of your position if it drops 10% and another 20% if it drops another 10%, and 30%, if it drops another 10%. In addition, you may just want to start dollar costing out of the stock by selling a certain number of shares each month or quarter regardless of the price. In any case, make a plan before any problems arise.
Watch Overspending (Over withdrawing)
If you are retired and withdrawing money from your portfolio, make sure you’re are not withdrawing and spending too much. Generally a balanced stock and bond portfolio can handle a portfolio withdrawal rate of around 4% per year. Withdrawing much more than this each year is dangerous and will put you in a position where you are running a higher risk of depleting your nest-egg prematurely. A market plunge will exaggerate the problem if you are already withdrawing money too rapidly. In an ideal world your budget won’t be too tight, and if the markets do pull back you’ll be able to reduce your spending a little, reduce your withdrawals for a time, and take some heat off of the portfolio for a year or two.
As you could see in the previous chart, a 50/50 investor starting with $500,000 in 2008 was able to withdraw $20,000 per year (4% withdrawal rate) and still end up with $599,201 in May 31, 2017. However, an investor withdrawing $40,000 per year (8% withdrawal rate) didn’t fare so well. The $500,000 portfolio would have been knocked down to $339,927 in February 2009 and only bounced back to $344,016 by May 31, 2017. A big market drop and a high withdrawal rate is a double whammy for a portfolio that must last a lifetime.
If you don’t already have a financial plan, this is a great place to start. A properly designed plan will allow you to look at the big picture and examine many “what if” scenarios. You can see the impact of good and bad markets on your future. You can determine your target rate of return, the return required to get you to your goals, and determine how to allocate your money to obtain that return. As part of your plan you can develop an investment policy statement (IPS) that will act as a framework for how to manage your investments going forward. This will be helpful if we do see some volatility in the future. When things get tough you just maintain your strategy as outlined in your IPS. With your IPS in place no decisions will need to be made when emotions are high if the markets fall. A well-crafted plan will examine your taxes, retirement, budgeting, spending, investments, insurance, estate plan and more. Studies show that people with financial plans have twice as much money as those without plans.3
There are many things you can do to prepare yourself for rough markets. Don’t wait until there is a crisis to make decisions about your portfolio. Contact a fee-only investment advisor at Net Worth Advisory Group to evaluate your portfolio and help you be prepared for the future and whatever it may hold.
Net Worth Advisory Group
9980 South 300 West, Suite 110
Sandy, Utah 84070
1-Dow Jones Industrial Average from 3/9/2009 to 6/13/2017. Actual 304%. Dividends reinvested.
2-All portfolio hypotheticals were derived using Morningstar Office and are for the period ending May 31, 2008.
3-HCBC, “The Future of Retirement, The Power of Planning,” (2011): 40.