If you’re panicking now, it might be time to revisit your asset allocation

There is a lot of fear out there these days.

Major institutions like RBS are calling 2016 a ‘cataclysmic year’ and advising clients to sell everything and head for the safety of bonds. The economist there even went so far as to compare today’s market mood to the mood experienced in 2008 right before Lehman Brothers and the corresponding stock crash. RBS certainly isn’t alone in this as analysts at other brokerage houses like Morgan Stanley also warn of oil possibly dropping into the low teens and advising clients to sell stocks on any bounce.

The media certainly does a great job of supporting the same possibility as any significant movements in the stock market are market with a BREAKING NEWS banner in red on many financial websites. BREAKING NEWS : DOW SINKS 200 POINTS said one such banner a few days ago as if 200 point declines in a basket of 30 stocks are very news worthy. The next day if the DOW rises 200 points, the same headline might read BREAKING NEWS : DOW BREAKS DOWNWARD SLIDE, RISES 200.

And through it all – the banks and brokerage houses are making out like bandits with an increase in trading profits and the potential of purchasing equities at a lower price. Before you act on any article that tells you to sell or buy at any particular price – ask yourself one question – is Morgan Stanley also selling everything – is RBS also selling everything?

Every time an investor or an institution buys and sells any security, someone in that exchange has to be on the winning side of the deal whether that be in terms of capital gains/loses, opportunity cost by being out of the market in cash or trading costs. With that in mind – why would any major company push the idea of selling everything any time a little bit of market turbulence comes along. That’s right, it’s because they want to be on the winning side of the deal.

Why would RBS or Morgan Stanley benefit from having individual investors liquidate their positions en masse and move into either cash or bonds? There’s more to it than just trading costs and it comes down to their ability to then buy securities at a lower price – wait a bit and then sound the all clear for the individual investor to get back into the market and improve profits. Not only have they gained in trading costs but also have improved their long term positions by buying securities at a lower price.

On top of that most of these large institutions also do business on the other end of the scale. They make money if the stock market sinks as well by being short. They also generally offer bonds as well which is the obvious alternative to get into when stocks are trending down.

There is a lot of fear out there these days and the point I’m trying to make is that this fear is often manufactured for the benefit of the companies and not the benefit of the individual investor.

That’s not to say that stock prices are fairly valued now and that Morgan Stanley and RBS are lying purposely to their clients.

I don’t believe there is any ill intent here but I do believe that companies like MS and RBS understand that short term fluctuations have happened in the past and will always happen in the future and they can use those short term fluctuations in the market to improve their profit margins by influencing emotional individual investor.

The media certainly does a good job of making that easier for them as well with overly melodramatic headlines and massive coverage of the day to day movements in the stock markets. The S&P is down 12% since its 52 week high – not a devastating decrease for those invested in a diversified portfolio but the drama out there makes it seem like things have gotten much worse already and will get even worse in the near future.

Imagine if all the SELL EVERYTHING headlines were more realistic – would the investors panic as much?

Bond seller RBS says equities are over priced – urges investors to buy bonds!
Morgan Stanley owns puts on the S&P 500 and oil that expire next month – urges investors to sell – also increases own stake in S&P 500 after 10% drop last week!

Not so scary sounding now right?

It’s not just the headlines that make investors weary about their own portfolios. There’s certainly an emotional aspect beyond any headlines that makes investors reconsider their choices when they see their portfolios drop by 10-20% and perhaps more but that’s not an issue that getting out of the market will solve.

I’ll use myself as an example I happen to agree with the people who are critical of current stock market valuations and would completely understand a 20-30% decrease in current price. If that’s the case then I should obviously get out of the stock market and wait for the appropriate time when I think equities are valued fairly to get back in right? After all – if I see my portfolio fall another 20-30%, I’ll feel foolish right? Well – sure maybe a little bit but…

The problem is that I don’t actually have a crystal ball and can’t predict stock movements as well as I may think I can. I may believe that the stock market is 20-30% over priced but what if the market disagrees with me an continues rising despite the OBVIOUS over valuation. If I sold out – I’d have missed out on a lot of potential gains. On top of that, even if I sell now and stocks do sink – how do I know when to best get back into the stock market? I can certainly set certain criteria for myself and get back when those are reached but what if they never hit those criteria and then the stock market bounces back and rises beyond my initial sales price. I’d have missed on those gains as well as any dividends accrued during that time line. What if buy back in at a much lower price and the stock market keeps sinking. Do I sell again and try to get back in later?

Remember 2008 and the Lehman Brothers fiasco? Well, the same institution that is currently projecting a ‘cataclysmic year’ for stocks had to be bailed out by the government as well. Wonder why they didn’t predict that?

My whole point here is that if you’re not comfortable with your portfolio decreasing in size and are pondering potential movement. These may include  but not be limited to selling everything and buying a bunker in Arizona to get ready for the end of the world ‘cataclysmic year’ that is OBVIOUSLY coming then you might have an asset allocation problem.

If you’ve read my posts up to now you can see that I have a pretty aggressive asset allocation with a low bond allocation and an increase in small-caps and mid-caps over the typical investor. This is because I know my own risk profile and am pretty comfortable with the idea that my portfolio can sink 50% in the blink of an eye. I’m a firm believer in the stock market being the best tool for retiring early and am still relatively early in my accumulation phase with 10+ years remaining before I may need the money. With this in mind, I was comfortable setting my asset allocation in a way that would allow me to maximize my gains without being too concerned about potential dips in the market. Dips that will be there because in times like this small-caps are hit harder than mid-caps which are hit harder than large-caps so my potential losses during these 10% or 20% or 30%+ years are greater than the average investor.

And I’m OK with that.

I have modified my asset allocation/investment plan slightly from what I usually see by adding the capacity to have up to 10% cash. This helps me in two ways. One is that by allowing me to stretch my financial degree muscle and do some stock analysis with up to 10% of my overall funds – I can have some fun with my investments as well as move some cash to the side when I think(like I do now) that the stock market is over priced. Secondly, it also gives me some peace of mind because cash on the side is always a good thing to have when the stock market starts sinking. It allows me to sell when I think things are over priced and buy when they’re priced fairly. The 10% max is in place to make sure I don’t get away from my overall these that time in the market beats timing the market but it does allow me some flexibility when times get a bit tough or when stocks get a bit too expensive. I generally keep at least some cash on the side but very rarely get to the 10% max so the fact that I’m there now is mainly some lucky timing on my part as I sold off a few securities last year before the market sank due to a belief that they were over priced.

Now this plan works for me because my risk profile is relatively high but it may not work for everyone. And that’s the question an individual investor has to ask themselves during times like these. For some of us – those that started investing after 2008 – this might be the first time we’re experience this sort of market volatility and it might be the first time you face this question.

If you’re not reacting to this volatility well then it’s probably time to revisit your asset allocation and see if your investing thesis still makes sense.

If you’re an individual investor in certain sectors, you might have had a rougher recently than those in a diversified index fund. Dividend investors as an example who were heavily invested in oil companies like KMI or anything tied to commodities have seen not only a big decrease in their principal but also a big decrease in their dividends. Those in safer dividend plays have done better but even the idea of dividend growth investing – long thought a slightly safer play than just regular stock investing has seen its share of tough times. Investors seeking income poured into higher risk high yield plays and drove those prices up beyond a reasonable level and are now seeing those prices fall faster than the rest of the market. Certain sectors have done worse than others and now the rest of the stock market is showing some weakness as well. If any of this recent turmoil has scared you then it might be time for some changes.

The point I’m trying to make here is that stocks will never be a truly safe play – no matter where you look and this might serve as a wake up call for some whether you’re a dividend investor, a sector investor or even an index investors. If you’re planning some moves now when the S&P 500 has dropped 12% then what will you do IF it drops another 20% from today? Will you panic and sell it all? If that’s the case then you might need to revisit your original investment thesis and see if your allocation to stocks is too high.

Through all this – please also remember your investment time line. If you’re investing for 10+ years in the future then what does today’s price really matter? If stocks fall and you’re consistently investing then you are simply buying at a lower price and have 10+ years of dividends and potential price gains to recover those early losses.

There’s certainly no reason to panic. Stocks go up and stocks go down. The long term trend is up and I believe it will continue to be up. There will be blips – some smaller and some larger but in the end – the stock market is still the best place to park your money for the long term.

However, if you’re already panicking then it might be worthwhile for you to sit down and take a close look at your investment plan and see if it’s right for you. High stock exposure leads to high potential gains but also high potential losses. No one is comfortable seeing 50% of their investment income disappear but that’s reality with stocks and if you’re the type of person that will sell midway through a big drop then you might consider an allocation to bonds that will temper that risk.

https://www.portfoliovisualizer.com/backtest-asset-class-allocation is an excellent tool to help you out with that as it will help you visualize what the expected gain and max losses are for various asset allocation scenarios. Still – you have to keep your time line in line as well as you can limit your risk of max loss with a 100% bond allocation but your ability to retire at a comfortable time might be limited. At the end of the day – the asset allocation you pick should be something you will be comfortable with for years to come so it makes sense to spend some time developing it before implementing it.

I might do another post about asset allocation in the future although I think my initial posts about my strategy cover my decisions relatively well as asset allocation will be a personal decision based on each individuals’ own risk profile.

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