Financial fire drill: be prepared for unavoidable financial disasters.
Just as physical calamity can turn lives upside down, financial upheaval can lead to an unrecoverable loss. Fortunately, we have the ability to prepare for financial uncertainty in the same way we prepare for other exposures. As the current bull market is now both the fourth longest in history (64 months) and the fourth largest (+192 percent gain), now would be a perfect time to ensure you are prepared for the next market pullback.
Run a Portfolio Fire Drill
You can run a fire drill for your portfolio by understanding the loss potential of your holdings. It is critical to recognize the amount of volatility your portfolio will experience in declining market environments is dependent on your asset allocation--how much of your account is invested in stocks versus bonds. The larger the percentage of stocks in a portfolio, the more the portfolio's value will increase during bull markets but decrease when the market declines. Let's look at the historical performance and risk levels of a range of diversified stock-to-bond ratios.
After determining the asset allocation of your portfolio, ask yourself how you would respond to another market correction like we experienced in 2008. For this exercise, considering loss in dollar terms is particularly productive. For instance, if 80 percent of your portfolio is invested in stocks, you might be able to convince yourself that you could sustain a 30 percent loss. However, supposing you have $500,000 invested, a 30 percent loss would mean your portfolio is suddenly depleted to $350,000. To many, the thought of losing $150,000 is more uncomfortable than the thought of a 30 percent loss.
Next, picture every media outlet sending warnings day after day about how the market is only going to get worse. Imagine yourself checking what the markets are doing multiple times a day and constantly being disappointed that it is another day of losses. Last, visualize your friend, neighbor or family member bragging about how he got out of the market before the collapse and telling you how you are a fool for not doing so.
How would you respond in such an environment? Would you have a hard time sleeping or digesting your food? It's critical to be honest with yourself. If you would stray from your long-term investment strategy by selling after a market drop and waiting for the market to recover, your current portfolio may be too aggressive. If so, scale back the assertiveness of your portfolio by reducing your stock exposure now because selling stocks during a market decline is the last thing you want to do.
Sound financial planning suggests individuals should scale back the assertiveness of their portfolio as they approach retirement. While a young worker with 30 years until retirement can afford to be aggressive and has time to recover if a large loss is suffered, a person who is closer to retirement can't afford to endure a significant loss right before the invested funds are needed to cover life expenses.
Maintain Emergency Financial Storage
As stocks and bonds are the long-term portion of your investment portfolio, cash equivalents are your tool for dealing with short-term spending needs. Before investing, everyone should have an emergency reserve holding enough cash to cover three to six months of expenses. These funds should only be tapped in the event of a job loss or a medical emergency.
Additionally, investors who are taking withdrawals from their portfolio in order to meet cash-flow needs should also have the equivalent of two years of necessary withdrawals in cash at all times. These funds should be used to cover living expenses during the next market correction. Having this emergency financial storage will prevent you from having to take withdrawals in a down market and allow your portfolio time to recover.
Lon Jefferies is a fee-only certified financial planner with Net Worth Advisor), Group (www.networthadvice.com). He can be contacted at (801) 566-0740 or Ion@ networthadvice.com.
Asset Allocation - Risk and Return (1970-2013) Portfolio Allocation Average Annual Largest Loss in a Return Calendar Year (2008) 100% Stocks 10.85% -39% 80% Stocks / 20% Bonds 10.33% -30% 60% Stocks / 40% Bonds 9.99% -20% 50% Stocks / 50% Bonds 9.76% -15% 40% Stocks / 60% Bonds 9.49% -11% 20% Stocks / 80% Bonds 8.85% -4%
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|Title Annotation:||Money Talk|
|Comment:||Financial fire drill: be prepared for unavoidable financial disasters.(Money Talk)|
|Date:||Sep 1, 2014|
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