When should you plan for a market downturn? Answer: When the market is UP! The stock market recently hit another all-time high, and so many indicators are pointing to another great year. But, market indicators do not take into account those events that are unpredictable. Here are some tips for how you can prepare for the next market downturn before it happens!
Segment your portfolio. Whether you are a do-it-yourselfer, or you rely on investment advice from a professional, your investments should be suitable for you. This means every investment decision should be made after considering your income, net worth, investment objectives, risk tolerance, and your other holdings. It is very common to see these suitability elements considered for ones’ entire portfolio each time an investment decision is made. Does your financial advisor consider you a “moderate” investor and therefore apply that label to all of your investments? The truth is, you should be very conservative for the money you need in the next twenty-four months regardless of your willingness to take some market risks. Likewise, for the money that you don’t expect to need in the next twenty years, you might want to use that to your advantage by investing in longer term investments that do well over time regardless of how much they vary in the short-term. Depending on your age, you may have several other segments or time horizons that you should consider when selecting investments. An investment that is suitable for a ten-year time horizon is typically not suitable for a one-year time horizon. Segment your portfolio into five or six segments beginning with “now” money, ending with “never” money, and filling in the difference with 5-10 year segments. Call your financial advisor as he/she should have resources to help you segment your investments by time horizon.
Diversify your holdings. Look at the asset classes that make up your portfolio. This includes the investments held in your IRAs, 401(k)s, after-tax investments, Roth IRAs, bank accounts, life insurance, real estate, businesses, etc. Anything you can liquidate into cash is an investment. Now, look at your individual holdings. You shouldn’t have all of your money in any one investment type (asset class.) The purpose of proper diversification is to protect yourself from losses that may occur when “the market” loses value. If you are fully invested in the S&P 500 and it suffers a drop of 40%, your portfolio will suffer greatly, and you can make it permanent if you sell when your value is down for fear of further losses. Diversify your holdings based on your time horizon segmentation by holding more volatile asset classes in your long term investments and stable and less risky asset classes in your shorter-term investments. By diversifying your investment portfolio, you’ll create a buffer that will help reduce losses caused by unforeseen changes in the market.
Consider Investments with a Negative Correlation to the market. Defensive investments are those designed to perform better than the overall market during bad times. That doesn’t necessarily mean that they will perform poorly during market good times. Talk to your advisor about defensive investments designed to work as shock absorbers and to offset potential losses.
Consider Income Generating Investments. When you invest in assets that are expected to hold or gradually grow their value while generating income, these assets should be viewed differently than investments whose value is constantly changing due to market conditions. For investors who qualify, alternative investments could provide steady value with potential growth while generating monthly income to smooth out the ride. This is even more important if you are nearing retirement or are already relying on income from your investments.
Design your portfolio to help combat your worst enemy, FEAR. Just as euphoria may cause you to buy when the market is surging ahead but is over-priced, fear is what causes many investors to sell when values are dropping even though market-driven prices may be lower than the real (intrinsic) value of the investment. Both of these emotions can be detrimental to an overall investment strategy. A properly designed portfolio of investments will help you keep emotions in check as money needed sooner will be less impacted by market conditions, and long term money has the element of time working in its favor.
Manage the silent killer of net returns.This strategy has nothing to do with a potential market downturn. Markets could be great, and you could be doing everything right and be unexpectedly side-swiped by a force that could have a devastating impact on your net returns. Net returns are your returns after taxes are considered. Without effective tax management, you may be forced into a higher tax bracket in future years that could wipe out much of your hard-earned gains. Government spending deficits, huge national debt, and the prospect of higher future interest rates all point to higher future federal tax rates. Tax management is designed to reduce the impact of unpredictable future tax rates by using the gift of time to manage your taxes gradually and systematically. Taxes don’t care if you are in a bull market or a bear market if you are being forced to withdraw money from your tax-deferred accounts (IRAs, 401(k)s, & annuities.) Be sure your advisor works with you and your CPA to design a plan that not only helps you weather negative market conditions but also helps you keep more of your earnings with an effective tax mitigation strategy.
Drop me a note if you have questions or are interested in learning more about any of these strategies.
Roger Walker is the founder and a Financial Advisor at Walker Wealth Management, LLC, with an emphasis on tax mitigation strategies.