The third step in my series on dealing with volatile equity markets is: Fill Your Investment Baskets Based upon Steps 1 and 2.
If you have been following this series, you have already completed Step 1, Understand Your Financial Stage in Life, and Step 2, Understand Your Cash Flow Needs. Before anyone invests a dollar into an asset whose value can change on a daily basis, I believe one must know what they are saving for and what level of price volatility one can accept given the timeframe of this savings goal.
What is the biggest risk an investor faces? Is it a market decline or is it that the investor must sell an asset at the wrong time to meet some cash need? I believe it is the latter. The prices of investments can change drastically in a short period of time. Prices can also remain under stress for much longer than our patience and mental health can tolerate. Generally, however, this type of volatility is manageable within a well-developed investment strategy.
Volatility and uncertainty definitely increase the likelihood that emotion may force us out of a good investment at a bad time. Knowing you have cash in the bank to meet emergencies, knowing that you are saving on a regular basis, or knowing that you only need to spend 4% of your portfolio annually to meet your annual cash needs, all give you greater control over what often appears to be an out-of-control market.
What are the investment baskets? At the simplest level, they are:
(2) bonds – debt instruments that pay interest
(3) equities – the stock of publicly-traded companies
These baskets can quickly become more complicated because within the bond and equity universes are many choices. Additionally, available today are alternative investments, currencies, commodities and the list goes on and on. But my goal is to provide a framework for helping you deal with market volatility, so we will stick with the basics.
The first bucket you fill is cash. Regardless of your financial stage in life, you need to have some cash tucked away. But the amount of cash can vary greatly depending upon your personal situation. You really do have to know your best and worst-case budget. If employed, a rule of thumb is to have 6 months to one year of cash to meet your needs if you lost your job. If you believe your job may be difficult to replace or you have a one- income household, adjust accordingly. If you are retired, the cash bucket can vary greatly depending upon other streams of income (pension and social security) and the amount of money you need to withdraw from your savings each year.
The second bucket you fill is bonds. The bond portion of your portfolio can do two things. It can provide downside protection during a bad equity market (assuming it is not all high-yield bonds). It also provides a reservoir of money (and a psychological reservoir) that you can draw upon when the equity market is in a multi-year funk. For example, if you are retired and the equity portion of your portfolio loses value, the bond bucket should be able to cover 8 to 10 years of cash needs (more if you want to be more conservative). This allows one to know that he/she has the time for the equity market to recover before being forced to sell into an unpleasant market to meet living expenses. This does not mean that an investor has to wait for a complete market recovery to reposition assets, but it does provide the investor the peace of mind of knowing that they don’t have to make adjustments to the portfolio immediately.
The third bucket you fill is equities. After the last few years, you may have decided that you are going to leave this bucket empty, but I encourage you to at least consider some allocation to an equity strategy. A diversified portfolio that includes equities has, over time, provided investors better annualized rates of return than bonds and certainly better returns than cash. Today, as we look at the very low yields bonds are providing and the almost zero return cash provides, the case for equities appears even stronger.
There are, however, caveats to filling the equity bucket. If you fill it, make sure that the strategy that you employ is one of broad diversification. Individual companies do go bankrupt in bad times (think GM) or become the victim of changing technology (think Borders). Additionally, don’t make a decision to buy equities because you think you can get out when times get treacherous. Trying to time the market has proven hazardous to many investors’ bottom lines. Studies show that individual investors drastically underperform the equity markets over market cycles because of two age old human problems: greed and fear. In scary times, investors sell their equities (sell low) and when things are going great, investors climb back on board (buy high).
Lastly, here are a few things to keep in mind when you are filling your investment buckets. If you are saving for retirement, you should not fill the bond bucket before starting the equity bucket. If you are targeting a 60% equity, 40% bond portfolio, for example, you should save into that allocation on a prorated basis. This allows you to take advantage of the movement of prices in both types of investments over time. If instead you are within five years of retirement, the Red Zone, you should begin actively building your cash and bond positions over the remaining time you are employed so that when you reach retirement, you have your desired retirement allocation in place.
Next week, we will wrap up this series with: Evaluate Your Strategy Annually or Earlier if Cash Flow Needs Change.
Did you miss Parts I, II, or III? Review all articles from the "Hang in There" series.
© 2011 Schneider Downs. All rights-reserved. All content on this site is property of Schneider Downs unless otherwise noted and should not be used without written permission.
This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.