Financial Planning

The past year of market volatility has clearly shown that making investment decisions based on one, three, five or ten year average returns will blindside you when the market starts trending downward. It simply takes too long for a market turn down to be reflected in long term averages. Some people say that long term investing should only consider long term windows. This may be true, but I would prefer that my client's portfolios not drop 25% before the downward trend is acted upon.

The economy is a self-correcting mechanism. It moves from a high called a peak downward via a contraction to a low side trough. From here it experiences an expansion carrying it back to a new peak. Historically each successive peak tends to be higher than previous peaks. This is why the market has averaged about a 10% growth over the past 100 years or so. The length of time between when the contraction ends and the expansion begins varies but usually lasts between 6 to 18 months. The expansion phase itself can last for years given investors a false sense of well being as if the good times will last forever.

Sometimes if the contraction is deep enough a recession will occur. Recessions are marked by increased unemployment, businesses closing down and a reduced demand for goods and services. Recessionary periods dot the American economic landscape. During 1837 - 1843 it was the collapse of a large insurance company combined with falling grain prices and land speculation. In 1873 it was the collapse of a major bank. Twenty years later another recession followed the failure of a railroad company. In more recent times, it was the oil crises of the mid 1970's, the saving and loan bailout in 1981 and who could forget the dot-com meltdown in the early 2000s. And today we have the housing market collapse and credit crises. The takeaway is that these economy cycles exist, they will happen at random intervals and we must learn to live with them.

Knowing the cycle occurs is one thing, but seeing your portfolio drop by 50% is quite another. An ideal investment strategy would be to take profits during the expansion phase of the economic cycle and protect the profits during the contraction phase. One passive investment strategy could be to take 50% of the equity capital gains and distributions earned as the market expands and move them to a mutual fund or ETF that has less volatility than the market. This could be a money market fund or preferably a bond fund that pays more interest. This effectively locks in profits and works to reduce the volatility of your portfolio. The 50% left in the equity accounts gives them room to grow and hopefully increases the amount transferred to the bond fund or money market account each year.

The 50/50 strategy may be too conservative if you are in your twenties. A better ratio may be the decade approach. If you are in your 20’s, then reallocate 20% of the gains to a bond fund and leave the 80% in the equities. When you reach 30, change the allocation to 30/70. In your 40s to 40/60. When you reach 50, do a careful review of your allocation percentage between your conservative investments and your equity investments. By this time you will likely have experienced five or six major market contractions and probably a couple of deep recessions. And you will know how to adjust the reallocation ratio to ensure you meet your target goals by the time you reach 60. The ratio can also be adjusted year to year taking more profits when times are good and less when the market is contracting.

What investment strategy you use is not as important as having one in the first place. The secret to accumulating wealth is time, having a diversified portfolio and a strategy for protecting your gains. If you are unsure how to put together a diversified portfolio then hire a financial planner. You will pay for the service, but usually the money they make you will far exceed their fees.