For those of us who call the Sunshine State home, June 1 is a meaningful, if not entirely welcome, date: the beginning of the Atlantic hurricane season. It’s the time of year when government officials, meteorology experts and news stations across Florida implore their fellow citizens to dust off their hurricane supply kits, check their generators, and stock up on batteries and gallons of water. It’s also the time of year when 98% of Floridians ignore this advice.
Instead, they choose to wait until a Category 3 storm is bearing down on the state and then join the apocalyptic mob at Home Depot and Publix brawling over the last sheet of plywood or case of bottled water. If you haven’t observed this phenomenon firsthand, just substitute hurricane for Black Friday, Home Depot for Best Buy, and plywood for the latest 4K television, and you’ll get the idea.
In many ways, investors tend to behave like Floridians (never mind that some portion of those populations are actually one and the same). They’ve heard the repeated admonitions from financial experts for how to prepare for a loss of income or market downturn, and they know they shouldn’t wait until we’re in a market correction to safeguard their financial lives and portfolios. But many don’t see the need to put safeguards in place right now because the economy is doing well and the market has been rising for most of the last nine years.
Part of our job as advisors is to help our clients see the importance of preparing for potential disaster in advance. It could be as simple as helping them make and periodically review a “hurricane checklist” to prepare them for major swings in the market. Here are a few ideas we recommend to our clients:
1. Make sure you have sufficient emergency cash reserves
Keep at least 3-6 months of living expenses in cash, money market funds, or other extremely liquid investments. You don’t want to have to draw on your longer-term investments during a downturn and lock in losses.
2. Align your long-term allocation with your goals and risk tolerance
In our private client business, we’ve found that most people’s optimal risk/reward tradeoff is a moderate balance of stocks and bonds — around 60/40. Most investors don’t have the emotional fortitude to stick with an all-stock allocation that is down 30-40%, even if in the long run it has better potential returns. Having a chunk in bonds can provide ballast to partly insulate the portfolio in turbulent markets.
Another habit that may benefit investors during major market swings is dollar cost averaging, because you end up buying more shares when prices are cheaper and less when they’re expensive. This is one of the best features of 401(k)s (besides employer matching) — they encourage a disciplined stream of dollar-cost-averaged contributions over a long period of time, which can be a great way to build wealth.
3. Diversify, but don’t “diworsify”
Do you have any stocks you’ve owned for the last nine bull market years that have ballooned to 10-20% or more of your portfolio? If so, it’s a good idea to pare back those concentrated positions, which should reduce overall portfolio risk. The last thing you need is to be stuck in a position where 80% of your portfolio is in five tech stocks when bad company news hits or the market starts getting volatile. In many cases, you may have unrealized losses that can offset some of the gains from those sales.
The benefits of diversification have been well established, but diversification is like wine — a glass a day may be good for you, but that doesn’t mean a bottle a day is better. It is possible to over-diversify, or as we like to call it, “diworsify.” Empirical studies have shown that 30-40 stocks are all you need to virtually eliminate company-specific risk, and anything beyond that has little incremental impact.
At Intrepid, part of our process is to limit positions to maximum 4-5% weights at cost, so on average each strategy generally holds 25-40 positions at a time. We want enough holdings that one company can’t tank the whole portfolio, but few enough that we can have a thorough understanding of everything we own.
4. Know what you own
Not truly understanding the businesses behind the stocks is what causes most investors to buy or sell at the worst times based on emotion. Look for companies that are profitable, generate positive cash flows, and trade at a reasonable multiple of those profits and cash flows. This may eliminate many of the most popular high-flying growth stocks, but it also tends to help avoid landmines.
For those who outsource their stock and bond selection decisions, the same principle applies to investing in mutual funds — if you don’t fully understand the underlying strategy, what it owns, and when it’s likely to outperform or underperform, you’re very likely to lack conviction and abandon ship at the first sign of trouble or underperformance. Rule of thumb: Whether it’s a business, a fund, or a cryptocurrency, if you can’t clearly explain it and articulate why you own it to a fifth-grader, you probably don’t understand it well enough.
There’s clearly much more to safeguarding your investments, but investors who follow these suggestions are likely to be much better prepared than most of their peers in the next economic or market downturn. No one knows when the current cycle will end, but like hurricanes in Florida, it’s only a matter of time. Are your clients ready?
Reprinted with permission from the June 5, 2018 issues of ThinkAdvisor. ©2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.