I admit it. Last week was rather uncomfortable for equity investors. But a quick study of market history shows that volatility is an ever present reality for the owners of stocks. Why are stock prices so quickly impacted by bad news or even the threat of bad news? If it can be answered simply, here is the reason: Investors value a stock based upon the stock’s future earnings and expected growth of those earnings. Any event (or threat) that changes the future earnings or the expected growth can drive a stock’s price down quickly and sharply. Conversely, good news or the prospect of greater growth can cause the price of a stock to rocket upwards. Sometimes the revised outlook is correct and sometimes not so much. But a stock is only worth what someone else is willing to pay for it at the time it is offered for sale. In our globally wired world, that is now determined almost every second of every day.
As a long-term investor (defined by me as an investor who can hold a basket of equities for five years or longer without being forced to sell that basket to raise cash to meet expenses), you must believe that corporate earnings and profits will grow over time and that you want to share in that growth. You should also realize that there will be periods of time, such as a recession, a war, or a natural disaster when corporate growth will deteriorate or be seriously challenged, but these times do not last forever. If you do not have confidence in the long-term growth of publically traded corporations and their ability to generate profits for their investors, you might want to reconsider owning equities.
Okay, on to Step 1: Understand Your Financial Stage in Life
I am not a true believer in the investing rule of thumb that one should determine the percentage of assets one can invest in a diversified equity portfolio by subtracting one’s age from 100. Your age may or may not correctly define your financial stage in life. Although it certainly can be argued that there are more than three stages, most individual investors can identify with one the following three: (1) Asset Accumulator, (2) In the Retirement Red Zone, or (3) Asset Liquidator.
The Asset Accumulator – Are you saving any money for the long-term (see definition above)? An accumulator is an individual that has the ability to add money to an account that is not going to be used for short-term or specific large expenses (such as a car or a down payment on a house). Generally, I am referring to the ability to save for retirement, but if you have young children, you might also be saving for college. Just to be clear, an individual does not have to be flush with excess cash to be an accumulator. One may only be able to save in a retirement 401k, but the goal of the money being set aside is for the future.
In the Retirement Red Zone – Are you five or fewer years from retirement? The Retirement Red Zone is the period of time when investors, although still saving money, are entering a period of transition from work into retirement. Many individuals will, in a period of a few short years, begin spending down their investments to meet their annual living needs. For individuals who will step into retirement with a defined pension benefit in addition to social security, the transition is less of a shock because they may only need to tap a small portion of their savings each year.
Asset Liquidator – Are you spending down your savings to meet your annual living expenses (or if you have saved for a child’s college education, is this child off to college)? I think we can all agree that the investor who is spending a portion of their investment portfolio to meet their annual living needs must address market risk differently than the investor who is adding cash on a monthly basis to their 401k plan.
Can you put yourself into one of these three stages? Why is it important? Because understanding your financial stage helps you to really appreciate the level of equity risk that you can expose yourself to. For example, accumulators have the advantage of being able to dollar cost average into their investments throughout an economic cycle. Individuals nearing retirement should consider to what extent they need to begin accumulating a larger cash position to prepare for funding the first several years of cash flow in retirement. And, for the asset liquidators, the key to building an all-weather portfolio is quantifying the annual drawdown required to support living needs. But don’t stop there; the next step is Understanding Your Cash Flow Needs.
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