Stocks take the stairs up and the elevator down. When they rise, it is slow and steady, but when they go down it feels like a free-fall. Given the recent market tumult, I wanted to share my top ten rules for defensive investing.
Defense doesn’t mean that you won’t have losses on days when the market goes down. It means that you avoid unnecessary risks that could really blow up your portfolio, so you can have the confidence to stay with the plan.
1. Diversification is the only free lunch in investing. You should be diversified by company, as well as by sector and country. If your employer issues you stock options or has an Employee Stock Purchase Plan, take every opportunity to sell and diversify elsewhere. Most disaster stories I hear are from people who failed to diversify.
2. Index Funds are the antidote to performance chasing. When you pick a concentrated fund, such as a sector fund or single country fund because of its recent track record, you risk buying at the top and experiencing a painful (and much larger than necessary) drop when the winds change direction. While it’s so easy to find actively managed funds that beat the index over the past year, there is a better than 80% chance that those funds will lag the index over the next five or more years. The Index fund is also likely a fraction of the cost and is also more tax-efficient than an actively managed fund.
Read More: Manager Risk: Avoidable and Unnecessary
3. Asset Allocation is the most important decision you make. Start with a carefully measured recipe so you don’t end up with a random collection of funds and stocks you’ve acquired over the years. If you’ve decided that a 60/40 portfolio is the right mix for your needs, that should be for all market environments, not just while stocks are going up.
4. You are going to be tempted to adjust your Asset Allocation. It is very tough to get this right, because humans are wired to make terrible investing decisions. We want to sell a down market and we want to buy when the market is at all-time highs. Obviously, in hindsight, we should buy when things are really ugly and sell at the peaks. Invest with your brain and not your gut-feeling.
5. Rebalance. When you have a target asset allocation, then the process of rebalancing back to your target levels creates a built-in process of selling assets which have shot up in value and buying assets which have temporarily gone out of favor. This works great with Funds, but don’t try this will individual stocks.
6. We buy stocks for growth and bonds for income and safety. When you try to switch those objectives, things seldom go as planned or hoped. Buying stocks for their yield and safety can easily lead to long-term under performance. Many times you will be better off in a plain vanilla index fund than a basket of super-high dividend stocks or supposedly safe stocks. Many high-yielding stocks are very low quality companies with no growth. When they do eventually cut their dividends, the shares plummet.
Similarly, you can find bonds that as quoted, should yield stock-like returns. Stay away. These could be future bankruptcies.
Read More: Bonds for Safety in 2019
7. Don’t use margin. Keep cash on hand. If you don’t thoroughly understand options, avoid them. Don’t buy penny stocks or stocks on the pink sheets.
8. Dollar Cost Average in every account you can. 401(k) accounts are ideal. You will often make most of your gains on the shares you purchased in a down market, you just won’t know it until later.
9. Take your losses. Don’t play the imaginary game of “I will sell it when it gets back to even”. If you are in a crummy fund, replace it with a more appropriate fund. We tax-loss harvest in taxable accounts annually and immediately replace each sale with a different fund in the same category (large cap value, emerging markets, etc.).
Read More: Why You Should Harvest Losses Annually
10. Stick to the Plan. Don’t make abrupt, knee-jerk changes. Investing adjustments should not be all in/all out decisions. Keep opening your statements, but recognize that a bad day, month, quarter, or year doesn’t mean that anything is wrong with your plan. Of course, if you didn’t start with a plan, that’s another story.
We genuinely believe that no one can repeatedly time the market and that the attempts to do create significant risk to your long-term returns. I try to convey this message consistently. Last week, a friend asked if all my clients were panicking about that day’s drop. And I said that I hadn’t gotten a single call that day, because they know we are in it for the long haul and have already positioned their portfolio with their goals in mind.
It will not surprise you that I think you are more likely to be a successful investor if you work with an advisor who can make sure you start with a plan, stick to an asset allocation, and implement your plan with sensible investments. Along the way, we will rebalance, make adjustments, and monitor your progress. We are looking to help more investors in 2019 and would welcome an opportunity to discuss how our approach could work for you.