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Are you ready for it? You need to be.
I started thinking about disaster because of the old Wall Street saying "as January goes, so goes the year." No, I don't believe that a bad January guarantees a bad year, but there does seem to be a slight correlation between the two. Of course, there's probably the same correlations between bad Aprils and bad years, and bad Februarys and bad years, etc. -- a bad year is going to have some bad months. Anyway, so far, January isn't looking too hot and today sure didn't help. But whether January has anything to do with it or not, face it folks, we're due for a bad year. Probably not this year, although who knows. I only make vague, generalized predictions that can't be checked! Like this one: Sometime before the close of the next millennium, the market will have a bad year or even two or three in a row.
The folks that lose when the market goes on strike are usually the ones who panic and sell rather than simply waiting it out. So today let's see what you can do to prepare yourself for an eventual investing disaster so that you aren't one of those who sells at the bottom. What's the stock market equivalent of stocking the basement with beans and bottled water?
Conventional wisdom says to keep some bonds in your portfolio to guard against a rainy day. OK, I will be the first to admit that there are times when a portfolio full of bonds will look like a well-stocked basement. And as folks develop substantial portfolios, buying some insurance in the form of bonds becomes very appealing.
But bonds aren't the safe haven that they are sometimes made out to be. Consider this scenario: The market goes south in a hurry and interest rates go UP as happened in 1981 and 1990. What happens to bonds?
That's right, when interest rates go up, bond prices go down. Holding a bunch of 30-year treasuries in such a market means that if you need liquidity -- say a daughter gets married or that cruise to Tahiti goes on sale -- you can't sell your bonds for as much as you paid for them. Sure, you'll get your principal back at the end of the term, but meanwhile, the value of your bonds will rise and fall inversely proportional to interest rates.
The problem with bonds is that by the time you really need them, it's often too late to buy them. If the market heads south and stays for a while and interest rates go up (they are more likely to go down, but not always), then every time rates increase some more, your bonds are worth less. If rates go down, you're sitting pretty, of course, but only if you bought early enough.
Buying short-term bonds is an answer but it leaves you vulnerable to "reinvestment risk." Reinvestment risk is the risk that when your bond matures you won't be able to find another that pays as well. That's what happens when rates fall, which they usually do if the market stays low for a while.
So which is it?
Bonds are guaranteed?
Bonds are risky?
Both of the above?
Both of the above. That's why you don't hear a lot about bonds here at The Motley Fool. If you think they are good for your portfolio, great. Buy 'em. But we aren't bond pushers.
So how do you prepare for Bad Times?
First, as always, you need to have a rainy day fund (three months' to a year's worth of expenses, you'll know what's best for your situation) that is kept in something truly liquid like a money market fund, very short-term bonds or a short-term bond fund, or even a bank account. For that matter, considering the puny interest those accounts pay, you can bury it in the back yard. (Just kidding, close those e-mail windows!)
The rainy day fund has two purposes and its less obvious one may be the most important. Obvious: Hey, if you get kicked out of your job, you'll need rent money (not to mention orthodontic payments, car payments, gas money, and the occasional box of Pop-Tarts). Not so obvious: Just having that cash readily available and knowing that you haven't overextended yourself to invest in this hot market may keep you from panicking and selling at the bottom.
Second, you need a short-term goals account. Look out three to five years. Keep the cash for anticipated expenses out of the market. You can modify this depending on the nature of the expense. If your daughter is getting married next year and you intend to do the conspicuous consumption wedding thing, better not put that cash into Internet IPOs. Planning a trip around the world when you retire in three years? How important is that trip? If you intend to go come Southwestern Bell or high Dow, don't invest that money in stocks. The market could be down 30% when the balance on your cruise is due, and you could find yourself on a freighter instead of a cruise ship. On the other hand, if a freighter sounds OK... well, maybe you can invest that cash and hope for the best knowing that the worst won't break you.
Again, the less obvious benefit is knowing that you have things covered -- that you can ride out the storm. Having your financial house in order is the best, maybe the only, way to develop and hang on to a long-term perspective.
More aggressive investors may want to combine the rainy day account and the short-term goals money and they may want to classify many of their short-term goals as "Freighter, OK." I have no problem with that as long as it's done with full understanding of just how risk-tolerant you are. Overestimating one's risk tolerance is probably the single greatest cause of investment mistakes.
Suppose you are retired and living off your investments? The same rules will work. Keep three to five years of expenses out of the market, or at the very least in highly stable stocks. Or use TMF Pixy's 5% formula. The point is to have a plan that covers you when (not if) the market loses its luster.
By now you've noticed that this column isn't about picking stocks that will survive disasters. I don't know how to do that. But I would like to point out how the Foolish Four fared during the last real disaster, the recession of 1973-1974. That was a bad one and it didn't go away soon. It came at the end of a very interesting period, too. During the '60s, tech stocks were big, P/Es were climbing sky high, and lots of people were getting back into the market that had been scared out by stories (or experiences) from the Depression years. When disaster hit, how did the Foolish Four fare?
Interestingly, after languishing during the '60s and early '70s, essentially keeping pace with the market but not really outperforming, the recession was the Foolish Four's finest hour. In 1973, the Foolish Four (version 4.2 in the table) outperformed the S&P 500 by 32 percentage points, and in 1974 it beat the market by 46 percentage points. (Bear in mind that the market was way in the hole both years.)
Obviously, I've been drawing parallels between that time and this, and that's a dangerous thing to do. I don't want to suggest that if the market falls apart, the Foolish Four will save you. History doesn't repeat itself that conveniently, and in other bad years, the Foolish Four has failed to beat the market (see 1990!). Still, it's reassuring. Even more reassuring is the performance of both the Foolish Four and the market in general in the years immediately following those bad years. Whoosh! Watch that rebound!
But mostly, I think that the best defense against a bad year or two is having your financial house in order AND the frame of mind that comes with it. It's far easier to hang in there and wait for the rebound when you've got your mental basement well stocked.
Fool on and prosper!