I have heard a variety of comments about the market lately. “I just want to stuff what’s left in my mattress,” said one person. “I’m going to bury my money in the backyard,” said another. “It’s a black hole… this market,” said several folks. Believe it or not, these difficult economic times often cause successful, smart, rational people to think irrationally. The severity of the bear market makes it completely understandable when this happens. It is not uncommon for some people’s portfolio to be down 20, 30, even 40 percent or more. With treasury bonds one of the few investment categories that showed a gain last year (albeit a meager one), traditional asset allocation didn’t have much effect in stemming losses. The current market decline - one of the worst since the Great Depression - has caused everyday good people to think and even behave in ways that are not in their best interests. Times like these call for unprecedented levels of calm, resolve and critical thought. Whether you are somewhat rattled or stoically calm, the methods of dealing with a battered portfolio may be used by investors of every state of mind.
If you consider yourself an investor that is a little more uncomfortable with current market events, consider market fundamentals. By a variety of measures, the market is oversold and severely undervalued. Many market prognosticators have said that this may be the best buying opportunity in 20 years. Don’t get me wrong, this market and economy is sick, very sick. We may have some more downside. Years of recovery may possibly lie ahead. But any examination of a stock market chart since before the great depression shows that the S&P 500, for example, tends to bounce back sharply after some of its worst performing years. The following chart shows the worst S&P 500 returns and what happened the year after:
Clearly, some bad years are followed by an additional bad year. But subsequent five-year average annual returns have always been positive. The lesson here: markets always rebound and, by staying in the market, you may recover your losses over time. Clearly, if you are a retiree or imminently retiring, this does not apply to you. But, if your time horizon is five years or longer, stay with the market, but have a strategy to move forward. But beware: even a flight to money markets today can enable you to lose money safely (see my article from last month entitled, The Good, the Bad and the Ugly of Low Interest Rates). Preparing your portfolio now for an eventual rebound makes more sense.
So, what are some of the ways to deal with a portfolio that has taken a massive body blow? First of all, any strategy will require careful reevaluation of your asset allocation, examining any correlation between investments and a thorough analysis of each individual investment. This should be done with your financial advisor. If you find assets that have losses and your analysis indicates there is little hope of recovering the loss, “realize” the loss by selling the asset. You may offset up to $3000 of the loss against earned income, and additional losses may be offset against capital gains. No gains to offset, you say? You may keep track of these losses, and they may “carried forward” into the future, to offset any future gains.* You may create a tax benefit by this action, either now, in the future, or both. Another benefit is that you may use the cash generated from the sale and place it in assets you deem to have more upside in the near term, thus offering your portfolio a better chance to recover.
Another way to help recoup losses is by lowering your cost basis. You’ll need additional cash to do this, but it simply entails buying more of a position at a lower price. If you double your number of shares with this strategy, it is also referred to as “doubling-down.” If you have identified a position in your portfolio, for example, that has lost 30 percent of its value and you think the fundamentals indicate that it will recover, you simply buy more of the position at the lower price. Thus, your average cost is reduced. This is important because at a 30 percent loss, you need almost a 43 percent gain to make your money back. By lowering your average cost, you need less of an increase in the price of the stock to begin to realize a profit than you would have if you had just stuck with your existing position. Be careful here though. Analysis prior to executing this strategy is critical. If you continue to buy more of a stock that keeps declining, you’ve made the situation worse. As they say in the business, “…better to not try and catch a falling knife.”
Dollar cost averaging (DCA) is a strategy similar to lowering your cost basis, but it is done over time. Investopedia (www.investopedia.com) defines DCA as buying a fixed dollar amount of a particular investment on a regular schedule regardless of share price. More shares are purchased when shares are low, and fewer shares are purchased when prices are high. Eventually the price of the security will become smaller and smaller. DCA lessens the risk of investing a large amount in a single investment at the wrong time. This is a particularly good time to be using this strategy, since many portfolios have investments whose prices are lower than the have been in years. Also, if you still think the market has some downside, DCA prevents you from plowing all your “dry powder” (i.e. cash) back into your portfolio now, which may be invested at even lower prices in the future. If you participate in a 401(K) plan at work, and are investing a portion of each paycheck in to your plan, you are essentially using a form of DCA. By the way, the 401(K) plan is a fabulous was to invest for retirement since money grows tax-deferred. Regardless whether you are getting a company “match” at this time (but especially so), you should be putting as much money into your plan as you can afford.
A few more techniques for dealing with bear markets include, but are not limited to, entering stop-loss orders on existing stock positions and the purchase of non-correlated asset classes in your portfolio. A stop-loss order involves entering an order to sell an existing equity position in your portfolio once it reaches a certain price. This will limit your loss on that position. A good rule of thumb is to enter a stop-loss order at 10 percent below the purchase price. This limits your loss to 10 percent. It also prevents that common, “deer in the headlights” reaction, where you freeze up and allow the stock to free-fall. It also prevents the even worse reaction where you fail to admit you’ve picked a poor performer, and you refuse to sell the stock until it makes your money back. This can result in some serious losses when the stock never recovers!
Also, as we have seen, even seemingly well allocated portfolios may have losses exceeding 40 percent in this market. Having large-cap, small-cap growth, value, international, real estate and bond positions used to qualify as a “diversified” portfolio, but not these days. A positive correlation between these types of investments, even if small, is not negative. Further, in declining markets, correlation between investments increases. This past year we saw some quality bonds even lose 30 percent of their value right along with small-cap growth stocks, for example. So, look for truly non-correlated classes of investments such as commodities and currencies. Even if you don’t have a commodities or currency trading account, you can purchase these types of assets through exchange traded funds (ETFs), unit investment trusts and, to a lesser extent, mutual funds. Where appropriate, gold is often an excellent commodity to own in your portfolio, for example.
We have witnessed a historically bad market related to a cavalcade of bad economic events. It may get worse before it gets better. But by stepping back, taking a deep breath, and analyzing your portfolio, you can develop a rational approach to positioning your portfolio for a recovery by utilizing a variety of techniques available to you. Purchasing “put” options, short selling and hedge funds are among the myriad of additional ways to deal with (and prevent!) portfolio losses, but you should be discussing these with your financial advisor.