Summary: This article describes two ways to be prepared for downturns in the stock market. One is obvious, even though too many people don’t do it, which is to diversify the investment categories in which their net worth is invested. That does NOT mean diversifying stock categories. It means stocks real estate, bonds, cash, precious metals, private equity and more. The second way to be prepared against downturns is by choosing certain types of professionally managed stock and bond portfolios. I was fiercely resistant to having any type of certified financial planner come close to my investments for a multitude of justified reasons. Nevertheless, I recently decided to give this a shot, just before the market took its recent hit. If you are well diversified like me and have some of your net worth tied up in the stock market, you should read this article.
If you have significant investments in the stock market, you probably are somewhat nervous right about now. Exactly 3 months ago, the S&P 500 was at 2930. Today it closed at 2416 (12/21/18). That is a drop of 17.5%. That’s a lot.
When markets behave like this, we face tough questions. Should we capitulate and sell? Should we buy more now that prices are low? What if the market continues to drop? Should we have done something different earlier?
The second half of this article will focus on the more important last question which is how do we prepare for the eventual downturns that we all know happen from time to time.
First, many of us are wondering what to do now.
The experts tell us to stay the course, focus on the long term and not to make rash emotional decisions (like selling low) when the market goes down. But it’s never easy to shrug off a 17.5% drop in the value of your 401(k) in 3 months. The S&P 500 lost 6.8% just THIS week and we have record low unemployment, low inflation and a seller’s market in real estate. So, if the economy is doing well, maybe we shouldn’t be concerned. Then again, if the stock market continues to drop, we will start hearing the jokes again about how our 401(k)’s are soon going to be 301(k)’s (the punchline was “201k” a few years ago).
Here is a sobering thought…when the market falls 40%, it must go up 67% just to be where you were when you started! With the market down 17.5% over the past three months, it must now go up 21% to go back to where it was. That could take a long time, even if the slide stops suddenly right now.
I remember when the market started dropping in 2000. My stock broker had a sound bite he liked to use that was “it’s not the timing OF the market, it’s the time IN the market.” I took his advice, stuck it out and by 2002 I lost 40% of my IRA! I was in my late 40’s and I was not happy to take such a hit.
In fact, the market halved and doubled twice in the first decade of this century ending about where it started. That was absolutely terrible performance! And I didn’t have a whole bunch of decades to recover!
During those huge gyrations that ended up where we started while losing a full decade of personal financial growth, many of us finally asked the question, who cares more about your money, you or your stock broker or some talking head on a financial news network?
It’s now time to think about yourself and it now time to think FOR yourself.
After the 2000-2002 crash, I got smart. I started investing in real estate part-time. I also decided to diversify my investment portfolio and include things like precious metals, private lending and eventually private equity (like Shark Tank deals).
So, while the 17.5% drop in the S&P 500 in the past 3 months bothers me, it does not have anywhere near the magnitude of impact it had when most of my liquid net worth was in the stock market and nearly all of my retirement funds were in the stock market.
How do you prepare for a bear stock market?
There are several answers. I would like to discuss here two answers for your consideration. Please be aware that I am not a licensed financial advisor so I am not giving investment advice. I’m just providing food for thought.
Answer #1: Diversify the composition of your net worth.
Imagine if your net worth was 50% in rental real estate, 25% in the stock market and 25% in other investment vehicles (precious metals, private lending, private equity, notes, bonds, cash, other). If your stock holdings drop a whopping 20%, then your net worth suffers 5%. While that stings and is not pleasant, it’s also not devastating.
Answer #2: Advisor Managed Portfolios
The second answer I would like to discuss is one I learned just recently from a certified financial planner.
I have been fiercely resistant to financial planners for decades. I have a whole bunch of good reasons for that. As just one example, they rarely include real estate in their recommendations and most licensed financial advisors are not real estate investors. This is problematic since rental real estate generates passive income and the reality is that passive income is more important to financial freedom and retirement feasibility than net worth. If a financial planner ignores real estate (other than REIT’s), they are missing one of the most reliable passive income generators that changes people’s lives. That’s just one example.
A few months ago, I caved and I finally accepted one of those marketing invitations to have dinner at a nice restaurant on the condition that I sit through a 1-hour presentation by a certified financial planner, Mike. Most of you have received such invitations and toss them, as junk mail, just like I did for many years. I listened to Mike the certified financial planner and he said the right words, had a trustworthy energy and had data and graphs to support his points. But I was still far from convinced. So, I met with him 1-on-1 for an hour and a half to grill him on his approach and details of his strategies.
Mike starting showing me graphs. He knew that I was very data-oriented and that I would challenge all analyses in detail and reject all hype. Mike stated the obvious which is that if you pull out of stock market downturns before they get too bad, then re-enter the stock market on the way up, your long-term performance is GREATLY improved.
The problem is that I have zero confidence that anyone can predict the high points and low points of the market. Anyone who says they can nail these predictions is lying to me, to themselves or both.
Nevertheless, Mike showed me graphs of three portfolio management models that were very interesting. The graphs compared the S&P 500 with their portfolio performances. I was particularly interested in the comparisons from 2000 to 2013 when the S&P 500 went from about 1600 to about 800 and back TWICE.
The three models showed very dampened losses during the downturns while realizing most of the gains during the upswings. The models did not totally eliminate the downturns and that’s good because I perceive that to be impossible to achieve consistently without dumb luck. So, I would instantly dismiss any claim to be able to predict the market lows and market highs.
I am not at liberty to reproduce the graphs here but I will say that the models that dampened the downturns while re-entering during upswings is based on a combination of the underlying fundamentals of individual stocks and technical analysis of trends. The three models use different algorithms but their results over the crucial period of 2000-2013 clearly outperform the S&P 500 by a lot.
When we met in mid-October, the stock market was off it’s all time high but was still enjoying the 9 year upward run. I was getting nervous having a non-negligible chunk of my retirement funds in the stock market. Of course, I was already well diversified with most of my retirement funds tied up in high cash flow rental real estate bought at a large discount to market value. In fact, I have much more of my net worth in tax-free rental real estate than in pre-tax stock market. So, I feel rather protected. Nevertheless, I have enough retirement funds in the stock market that a 20% drop does hurt me psychologically.
On October 30, 2018, I moved the stocks in my traditional IRA to a managed portfolio that was split between the three models. At that moment, the market was 9.3% below the high in September. When it dropped to roughly 10% under the September high, around mid-November, the models pulled the trigger and moved about 76% into bonds.
In the past month after the flight to safety, the stock market dropped another 7.5% while my managed portfolio lost 2%. I am paying a flat fee of 1.95% (no transaction fees), so the decline in the value of this portfolio is pretty much the fee.
Quite frankly, there is no way that I would the effectiveness of the decision to move to a managed portfolio after just one month. It is still way too early to tell whether this managed portfolio is the right path. I will say that the timing was interesting since I moved to this managed portfolio a couple of weeks before one of the biggest drops in the stock market in the past 9 years. I will give this managed portfolio one year before I decide whether to continue or whether go back to my previous total lack of confidence in the financial services industry.
The only hard data I have right now, is that this managed portfolio has so far avoided the last 5% decline of the 7.5% decline since I made the transition.
I will report back to this blog in a year and the performance will speak for itself.
In summary, the primary way I protect against stock market downturns is to have a very diversified portfolio of investments. This includes having less net worth in the stock market than in income producing real estate that was bought at a huge discount to fair market value (which means that the real estate market must drop 30% for me to break even…not even lose money). This also includes having more net worth in my retirement plans than outside retirement plans. That’s another component of my asset protection that will be discussed in another article.
The secondary way I just started to protect against stock market downturns is to move my stock market holdings in my traditional IRA (my self-directed 401k holds rental real estate) from self-management into a portfolio that uses certain models that is managed by a certified financial planner who I screened and put through the wringer.
The point is that if you have significant enough holdings in the stock market that make you nervous about downturns such as the one we are experiencing now, you should consult with a licensed financial advisor or certified financial planner about your risk tolerance and have that advisor present options with which you will feel comfortable.