Managing Your Investments During a Down Market

Farm Business Management Update, October-November 2002

By Alex White

Just look at recent headlines in newspapers: "DJIA closes down 150 points," "NASDAQ at 6-year low," "Economic reports drive down stock prices." Then look at your monthly investment account statements - your investment is rapidly melting away. You really wonder why you listened to the "experts" and invested a portion of your income in the stock market when you could have reinvested in your farm or business. What a waste of money, right?

Good question, but a more relevant question is what should I do with my investments in this down market? In such a market, the temptation is to cut your losses, sell your stocks, and reinvest the money into the business. But before you do, you need to examine your financial goals and your reasons for investing in the first place. Four of the main reasons small business owners and consumers invest in the stock market are

1. Because they see their neighbors and friends "making a killing" in the market;
2. Because they hope for substantial short-term profits;
3. Because they seek the potential to earn long-term gains; and
4. Because they want to reduce their overall risk exposure through diversification.

If you fall into group 1 or 2 above, chances are you shouldn't have money in the stock market at all, unless you can afford to lose that money. These types of people are gamblers (maybe speculators is a more politically-correct term) rather than investors. They are playing the market versus investing for their future. My advice to someone in these groups is cut your losses, and use the capital loss to reduce your income tax liability.

For those of you who fall into group 3 or 4, you have some more questions to answer:

Question: How much risk can I handle?

Hopefully, you were well aware of the inherent risk of investing in equities before you committed any funds. Stock prices can be extremely volatile over periods of time, causing a significant fluctuation in your paper net worth. But these losses are unrealized unless you decide to sell your stocks. In the long run, these volatile equities (especially corporate stocks) offer investors one of the best average rates of returns available. It's the old risk-return tradeoff - to obtain higher returns you need to face higher risks.

Typically, investors with a longer planning horizon are more able to handle higher levels of risk because they have time on their side - time to make up for short-term losses. But some people just don't like the day-to-day volatility associated with the stock market - and there's nothing wrong with that! Every investor must identify his/her risk tolerance, and then invest in assets that are consistent with that tolerance. My rule of thumb on risk is, "If your investments are keeping you awake at night, you need less risk in your portfolio." That is, replace the riskier assets that are causing you to lose sleep with more conservative assets. Life is too short to lose sleep over your investments!

Answer: If you are not comfortable with the amount of volatility in your current portfolio, you might want to replace your riskier assets with less volatile assets (such as blue chip stocks or high quality bonds). On the other hand, if you are comfortable with the volatility and you have a clear goal for the funds you have invested, remain disciplined and stick to your long-term investment plan.

Question: Is my portfolio well diversified?

Many investors have misguided views of diversification. To the average investor, a mutual fund that invests in 50-75 companies is well diversified. It may be diversified in terms of numbers of companies, but does it invest in companies from different sectors of the economy? Does it invest in income versus growth firms? Does it invest in bonds as well as stocks? Does it invest in foreign economies or only in domestic firms? Does it invest in large firms as well as small firms?

A well-diversified portfolio is capable of significantly reducing your risk exposure by investing in assets that have a low correlation. Assets with low correlations typically do not move in the same directions - when one asset is falling in value, the other asset may be holding constant or increasing in value. So while one investment may be losing value, your other investment assets may actually be increasing in value, thereby reducing your risk exposure. Theoretically, removing all non-systematic risk is possible by investing in two assets that are perfectly negatively correlated. But in the real world, it is virtually impossible to find two such assets.

An often-overlooked aspect of diversification is a strategy called asset allocation. Asset allocation refers to spreading your assets among different asset classes (stocks, bonds, real estate, etc.) in a manner consistent with your financial goals and risk tolerance. A well-diversified portfolio is not only invested in a wide range of domestic corporate stocks, but in domestic bonds (long and short term), foreign stocks and bonds, real estate, precious metals, and cash.

Answer: If your portfolio is not well diversified, you might want to take this opportunity to restructure your investments. This restructuring may significantly reduce the amount of investment risk to which you are exposed. For those of you who have a well-diversified portfolio, take this opportunity to rebalance your portfolio so that you will remain on course towards your financial goals.

Rebalancing is an extremely important aspect of diversification that is oftentimes forgotten. For example, during the incredible technology stock boom of the late 1990s, a portfolio could easily become over-weighted in technology stocks. With periodic rebalancing, the profits from the technology sector would have been redistributed among other sectors (foreign stocks, bonds, etc.) that were not performing quite as well at the time. But wait - doesn't rebalancing channel funds away from a good-performing asset and into an under-performing asset? The answer is yes, but you need to keep in mind the cyclical nature of the global economy. For example, US stocks (S&P 500) have had the highest annual rate of return only 5 years since 1972. Over this same time period, European/Asian stocks have lead the way in 7 years, while real estate has outperformed in 10 of those years. When the technology sector bust occurred, a rebalanced portfolio would have redistributed the previous earnings amongst other assets and significantly reduced potential losses. What rebalancing accomplishes is simple - it channels funds away from an over-performing asset and into lower-priced assets, all the while keeping your desired allocations relatively constant. A portfolio should be rebalanced at least every quarter. However, be aware of any tax implications of rebalancing a non-tax-sheltered portfolio.

Question: When will I need the funds that I have invested in the stock market?

Answer: If you will need those funds within the next year or so, you may want to think about moving the funds to a more conservative asset, such as a certificate of deposit or a money market account. This action will reduce your risk exposure and will help to protect the value of your investment.

However, if you have a longer time horizon before you need the funds, the answer becomes less straightforward. Again, you need to re-evaluate your financial goals and risk tolerance. When you have these factors squared away, you need to determine if your current portfolio is consistent with your goals. If it is consistent and you are comfortable with the associated level of risk, try to remain disciplined and stick to your long-term financial plan - even in the face of falling asset prices. If you determine that your portfolio is not consistent with your long-term goals, you should consider making some changes in your portfolio. You may want to consult with a financial advisor on possible changes to your investment portfolio.

Question: What can I do today?

Answer: A down market can be depressing for investors. Watching the value of your investments fall from month to month can be hard. But the pain is more bearable if you have clear financial goals, understand your risk tolerance, and have a well-diversified investment portfolio. That being said, here are a few tips to make the down market a little less depressing and a little less painful:

1. Don't open your monthly account statements! Avoid the pain!
2. Resist the temptation to realize those "unrealized losses" by selling at a low price. However, selling at a loss can be a powerful tax strategy - consult a tax planning professional for more details.
3. Continue to dollar-cost average into proven investment assets. As my advisor told me, "It seems counter-intuitive, but the absolute best situation for your investments is for your mutual fund to stay at a very low price until the day before you want to take the money out of it. That way, you are buying at a low price up until the day you need the funds." Remember, dollar cost averaging helps reduce your average cost - and you don't even have to think about what you're doing! Just invest the same amount of money into the asset(s) every month!
4. Rebalance your portfolio. In extreme markets (up or down) your portfolio can easily get "out of whack." Rebalancing offers a method of reducing your risk and maintaining your overall financial plan.
5. Consult a financial planning professional. Sound financial advice is just as important in down markets as it is in up markets! A financial planning professional can be a great resource for you in achieving your financial and life goals.

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