Sweat In Up Markets So You Don’t Bleed In Down Markets

One of the many benefits of running Dough Roller for the past four years is that the articles act like a diary for me. It’s fun to go back and look at older articles to see what was going on in the world or my life at the time. So today I ventured back into 2008 to look specifically for investing articles. It was ugly.

There was, What to do when the stock market crashes, which noted that as of October 2008, the S&P 500 was down more than 40%. And then this one, Be a Do-Nothing Investor in a Falling Market?, which included a Washington Post quote from an investing “professional” who said,

Now is not the time to drink the “buy and hold” investment strategy Kool-Aid. Be conservative, limit your risk–and sleep well knowing your investment principal is not going to continue to decline.

Boy, was that guy wrong! A good friend of mine recently told me that in March 2009, his wife wanted to follow this guys advice and pull all their retirement savings from the market. My friend prevailed, they stayed in the market, and were up 45% during the remainder of 2009.

So here’s a stock market prediction–it will crash. Now you probably want to know when it will crash. I have no idea. A good economist predicts what or when, but never both. And no, I’m not an economist, but I am a lawyer, so you can trust me–the market will eventually fall so hard and fast you’ll feel like tossing your cookies. That’s just what it does. The important question, however, is what you do when that happens.

And that long introduction brings us to the point of this not so concise article–we need to prepare now, during an up market, for the inevitable down market. So what should we be doing? I’m glad you asked. Here are a few suggestions.

Fear the Right Things: Hibah Yousuf and Penelope Wang recently wrote an article for Money Magazine called, The Young and the Riskless. The story came with a picture of a young woman, and under her picture was the following: “Caroline Chesnutt was once an enthusiastic investor. Now she shuns the market.”

Here is her story, as reported by Yousuf and Wang:

She started early, at age 24, socking away money in both a taxable account (where she focused on individual companies like Starbucks and Wal-Mart) and a Roth IRA (holding two stock funds). Sure, being 100% in equities was aggressive, but not out of line for her age, and she enjoyed trading several times a month.

Then, in 2008, the bottom fell out of the market. Though her taxable account was unscathed (fortunately she’d sold her shares shortly before to free up cash to buy new stocks), her Roth plummeted 55% by year-end.

Chesnutt quickly closed the trading account and later cashed out the Roth, moving most of her money to two savings accounts (except for a mandatory 401(k) that her employer invests in a target-date fund).

“I don’t want anything to do with stocks,” declares Chesnutt, now 30 and a nurse at Vanderbilt University Medical Center in Nashville. “Watching so many people lose all their savings was life altering.”

Chesnutt did exactly, precisely the wrong thing. Had she stayed in the market, she would have recouped her losses by now. Instead, she’s likely moved her capital into bonds. And with interest rates poised to move up, she’s invested in bonds at exactly, precisely the wrong time.

So if we shouldn’t fear market losses, what should we be afraid of? Fees, taxes, and inflation. Fear the high fees of some funds. Be mindful of the tax implications of your non-retirement investments. And be deathly afraid that your real return, after accounting for inflation, will be negative.

Give Serious Thought to Your Investment Allocation: Have you ever taken one of these quizzes offered by online brokers that ask you a series of questions to gauge your tolerance for risk? They include questions like, “If the market fell 50%, you would (a) buy more stocks, (b) do nothing, (c) sell, or (d), curl up into the fetal position and cry like a baby.”

If you want to take one, you can check out Vanguard’s Investor Questionnaire. But there are two important realities about these questionnaires you need to keep in mind:

  1. You’ll never really know how you’ll react to a bear market until you live through one; and
  2. How you’ll react to a down market will change as you get older and your financial picture evolves.

The second point is critical. It’s one thing to lose 40% when you are 25 and have $10,000 invested. It’s a whole different situation to be 55 and have $500,000 invested when the market goes into a free-fall.

Now, a well thought out asset allocation plan will help you get through the down markets both psychologically and financially. The key is to settling on a plan that works in good markets and in bad. And this takes some honest thinking about how you will react in a down market. Experience investors should already know how they’ll handle a falling market; new investors will learn sooner or later. And if you are new to investing, I’d highly recommend Richard Ferri’s book, All About Asset Allocation. It’s a must read. And you should also check out the SEC’s Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing.

Invest for a Falling Market: This is one of the most important concepts that many investors never consider. And an example is the best way to explain it. Early in my investing career I bought shares of Bill Miller’s Legg Mason Value Trust (LMVTX). I began investing in LMVTX because it was a value fund. And as it turned out, the investment worked out very well for me. As some of you may recall, Bill Miller beat the S&P 500 with this fund for about 15 years running. I sold at about year 12. Why?

I determined that if the fund started to drop well below the S&P 500, I’d be too tempted to sell. And selling in a down market is the LAST thing I want to do. The issue here wasn’t just that LMVTX is an active fund, but also because of its expense ratio (currently 1.76%). I still own actively managed funds, but their costs are much lower.

Now, I could point to 2008 when LMVTX experienced significant loses, wiping out its gains of the past 15+ years. But that’s not the point! In fact, 2008 could have been the best time to BUY LMVTX. The point is that LMVTX is not the type of investment I’m willing to stick with through good times and bad. It’s just too expensive. (If you are interested in the LMVTX story, Tom Lauricella from the WSJ wrote a great piece on Bill Miller back in 2008.)

So now that we are in an up market, take a good, hard look at your investments and ask yourself the following question: Would I stick with these investments if they dropped 30% this year? If the answer is no, you need to rethink your investments NOW, not when the market drops.

Get Out of Debt: This last tip is critical. When we have too much debt, it can cause us to make bad investing and business decisions. It’s one thing to see the market going down, it’s another to watch your investments fall while you’re sitting on high interest credit card debt and a mortgage you can’t afford. I’ve seen the same problem with folks in highly leveraged real estate deals.

I’ve been fortunate in that my wife and I have very little debt. My online businesses have zero debt, the mortgages on our rental properties are very manageable and more than covered by rent, and the only personal debt we have is a mortgage. This allows us to make investing and business decisions that aren’t based on cash flow issues or a need for capital. It may take time to get there (it did for us), but it’s well worth the effort.

If you have any tips on how to survive a falling market, share them in the comments below.

And I’ll leave with this video of a lecture by David Swensen, who is the Chief Investment Officer at Yale University. It’s a long lecture, but well worth the time:

Published or Updated: February 20, 2011
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. Outstanding post; the story of Chesnutt is far too common: http://www.mymoneyblog.com/401k-failures-over-last-20-years-the-average-investor-did-worse-than-cash.html
    And thanks for the Vanguard questionnaire – I’ve been looking for a good one.

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