This is a historic time in our country given the dramatic events in our financial markets. We have seen the demise of such companies as Bear Sterns and Lehman Brothers and a federal takeover of mortgage giants Freddie Mac and Fannie Mae.
The Feds infused $85 billion into insurance giant AIG, fearing that their demise would lead to a greater shock to our financial markets. As AIG’s potential demise developed, investors flocked out of ultra-safe money market funds and into Treasury Bills, creating the potential for a liquidity crisis our country hasn’t seen since the great depression.
Experts can pontificate until the cows come home about what direction the market will take next, but no one truly knows. We can quote historical market statistics as easily as any economics professor, but that would be an exercise in futility. Lastly, we can tell you to stay the course like every other market “expert,” but that advice may actually lead you on a financial crash course if the markets deteriorate.
Let’s cut to the chase: What can you, an individual investor, do to deal with market volatility and an uncertain future? Here is a six-step process for you to implement today that will help you protect your family finances. Follow these steps to pave the way toward financial independence.
1. Take a snapshot: Before we can take a course of action, we first need to understand where we stand. Make a list of your assets and liabilities, being certain to use realistic values for your home and other assets. As part of this, review how much money you spend on a monthly basis. As many people freeze up and do nothing when the word “budget” is discussed, simply look to see if your bank balance in the last six months has gone up or down. If you continuously have credit card balances, this indicates you spend more than you make.
2. Become a control freak: Clean up your balance sheet. Forget about trying to control financial markets, and look to fix things that are within your control. Balance sheets often reveal that individuals inflict more harm on themselves than the financial markets do. If you have credit card debts or other short-term loans, make adjustments now to pay the debts off. Loan repayments are consuming a greater percentage of American’s paychecks, and limiting their ability to save and invest. If the economy worsens and people lose their jobs, debts still must be paid. By eliminating everything but mortgage debt, you are putting yourself in a stronger position to weather a financial storm and save for your future.
3. Join the reserves: Build up a cash reserve. It is imperative to have a cash reserve on hand to pay unexpected bills and to provide a financial safety net in the event you lose your job or suffer an unexpected hardship. No one wants to spend the money to fix the roof, replace the furnace, put braces on the kids, or pay the vet bill when Fido swallows a spoon, but these expenses are unavoidable. Every investor should have 3 to 6 months of living expenses in a money market account ready to pay for unexpected or unwanted expenses.
4. Become a scaredy cat: All investors want high returns, but many are over-confident in their ability to handle market volatility. Markets go down when bad things happen and when long term perspectives are clouded by financially dark circumstances. It is not uncommon to see risk-seeking investors run for the hills when markets decline. Mixing various investments together such as stocks, bonds, international investments and real estate helps to mitigate unwanted volatility. Yes, owning bonds can be boring, but they usually go up when equity markets are falling. When the equity market experiences a significant decline, if you want to be more aggressive, you can sell your bonds at a profit and purchase equities at depressed prices. If you don’t own conservative investments during the good times, then you will be behind the proverbial eight ball when the markets become more challenging.
5. Don’t listen to Mom: After you have settled on an appropriate asset allocation, implement your plan by choosing securities. There are thousands of securities to choose from, both equities and fixed income. So how do you decide? Working with a professional advisor is certainly recommended, and understanding how that advisor works is just as critical. Although we can spend pages talking about this point, we are adamant that you understand one critical element of the markets that have developed in the last two decades.
Thirty years ago, Mom and Pop purchased a few hundred shares of stock, put it in their safety deposit box and forgot about it. At retirement, many were rewarded by securities that had appreciated handsomely. Today’s markets are different. Yes, being a long-term investor is a good thing, but owning individual securities has become a fool’s game. Today’s markets are controlled by mutual fund companies, pension funds, and hedge funds that manage billions or trillions of dollars. These “investors” can move quickly in and out of individual securities before you have the knowledge or opportunity to act. Looking at the dramatic declines experienced by many excellent Wisconsin companies in the last six months, it is evident that market volatility for any given stock can be dramatic. Don’t get caught holding the bag when major shareholders decide to sell.
The old adage, “If you can’t beat ‘em, then join ‘em,” holds true in this regard. Sell your individual securities and invest the proceeds into more diversified mutual funds or Exchange Traded Funds (ETFs).
6. Sell the fatted calf: This point is a continuation of our last point pertaining to individual securities. It is commonplace to meet investors whose single greatest asset is one individual security. Sometimes an individual inherits the security, and oftentimes they accumulate the security while working for an employer via stock options, grants, or an employee stock purchase plan.
In every instance, in the eye of the (be)holder, the stock is wonderful, and immune from the terrible declines that affect other securities. The investor wants to hold long term, to be loyal to a stock that has appreciated so nicely over the years, to be loyal to a company that has meant so much to them over the years, and to avoid the tax man by selling it.
As an acknowledgement, the majority of wealth in America is still made by owning a single individual company (public or private), as can be documented by Bill Gates, Steve Jobs, the wonder boys at Google, or other privately held business owners. What is never told is the vast wealth that is lost when securities decline. Imagine the decline in wealth that occurred at Motorola, Nortel, WorldCom, Enron, K-Mart, United Airlines, Washington Mutual, Citigroup, Bear Sterns, AIG, etc., as those companies experienced dramatic declines or even bankruptcy. Maybe Forbes can put together a list of those who have lost the most wealth, and the lessons they wish they had learned sooner.
Paying a 15-percent capital gains tax and diversifying the proceeds is much less expensive than losing 40, 60 or 80 percent of your worth when the majority shareholders of your company (mutual funds) decide to get out of Dodge before a stock hits bottom.
If you could choose between putting a majority of your money in one security or having 15 percent less money in a diversified portfolio, most rational investors would choose the latter. Sell the fatted calf that has grown into a prized steer before it goes to slaughter.
In the final analysis, there is a difference between losing money and suffering financial hardship. If you follow the above steps, you will be in a better position to achieve your goals and weather a financial storm. Markets can and do go down in value. Although every market decline in U.S. history has been followed by an up market, there are many families that were financially ruined before markets recovered. If you don’t have time to follow our six step guide, then follow Warren Buffet’s two golden rules for investing. Rule #1 is to not lose money. Rule #2 is to not forget Rule #1.
