LOFTB Developing Appropriatte Stratagy in Five Minutes

How to Develop an Appropriate Investment Strategy in Five Minutes or Less

March 27, 2012 By Bill Bullington

When I was a relatively new financial advisor (they called us stockbrokers back then), I’d heard that Warren Buffett had said: “If you can’t stand to see the value of your stocks drop by 50% or more, don’t buy stocks”. I was hoping he was wrong. More accurately, I naively thought to myself that he was trying to scare people from investing in the stock market.  Now I know better.

I knew from studying history that the stock market had been down more than 50% in the 1970s. I also knew that the same thing happened during the Great Depression. Still, I held out hope that maybe I’d get lucky in my career and wouldn’t have to go through one of those bone-chilling, nightmare-inspiring visions of working as a fry cook in my 70s due to stock declines of 50% or more.

We all know how that turned out. The stock market has been down more than 50% twice in the last ten years. However, I am still handling portfolios, not burger orders.

Thankfully, I’m not one who likes to be unprepared for disasters, so I sought to learn a few techniques to reduce the impact a large stock market decline can have on your portfolio. I’ve learned quite a few, and now I would like to share with you one of the simplest methods and most effective methods: Don’t panic! (One of the best aspects of this advice is that it doesn’t require filling out a ten-page questionnaire).

Before I get into the details, however, I would like to address a couple of minor issues. The first has to do with those Internet ads claiming to tell you exactly when to get in and get out of the market. I’m here to tell you that if any of these advertisers could actually forecast market declines with any degree of accuracy, you’d never hear from them. They’d be too busy flying their private fleets, cruising in their yachts, and whatever else anyone with that kind of ability wants to do. I’m not going to waste a lot of time or energy trying to discredit the stock market soothsayers. I think the old saying, “If it sounds too good to be true, it probably is” says it well enough. I’ll also add a line from Forrest Gump: “That’s all I have to say about that”.

Second, you don’t have to own a working crystal ball in order to earn above-average returns and keep your risk at an acceptable level.

This should come as a great relief to many people.

Are you ready?

Since most risk asset classes have a tendency to move together (in finance class they called this being “highly correlated”) when the stock market drops, most stocks tend to go down with it. In fact, most world stock markets have a tendency to move in unison today, much more so than in the past few decades. Therefore the only real way to reduce the drop in your own portfolio is to reduce the amount you have invested in the stock market to begin with. Does that make sense?

To determine how much of your portfolio you should have invested in stocks depends upon how much you are willing to watch your portfolio decline in an effort to reach your long-term goals. The quick method is to decide how much of a decline in your portfolio value you’d be willing to sit through. Then double that number to arrive at the percentage of your money you should invest in a diversified stock portfolio.

I feel an example coming on. Let’s say I’m moderately aggressive and don’t mind being down 30% in a major decline if I think I’ll make it back up and more in my lifetime. I should be able to invest 60% of my money into a diversified stock portfolio, exchange traded funds or mutual funds and, if a 50% decline comes along, my diversified portfolio probably won’t be down much more than 30%.

If I’m conservative and can’t stand more than a 10% decline in my portfolio, I’d limit my stock mutual fund exposure (someone with a risk tolerance this low doesn’t have any business with individual stocks – too volatile) to 20% of my account value. Again, if a 50% decline in the stock market were to occur, you’d only be down about 10% or so — assuming you stuck with broadly diversified funds.

Now you know how to determine—without a painful financial inquisition accomplished through a long questionnaire—what is the appropriate percentage of your portfolio you should be investing in diversified stock portfolios, stock mutual funds or exchange-traded funds.

I told you this would be simple. In a future post, we’ll talk more about what comprises a diversified portfolio.