On 8/14/2015, in his “Intelligent Investor” column for the Wall Street Journal, Jason Zweig wrote about the need to “Reassess Your Investments Before the Next Panic.” There is wisdom in his approach: most investors only take action when it is too late. They sell their investments after the damage has been done, and then are reluctant to return to the market until after prices have moved up and it is again too late to recover that which was lost on the way down. The article references studies that demonstrate that this typical behavior may cost investors an average of 1.5% per year in return.
The article recommends taking inventory of your investments when times are good, and trying to imagine what might go wrong in the markets and how you’d be effected. “If you think stocks can’t fall by at least 50% again,” as they did during October 2007 and March 2009, “you are wrong. If you think you… can know exactly when that will happen, you are crazy.” He describes performing what one advisor he interviewed termed a “pre-mortem” on your portfolio, trying to imagine, with the help of your advisor, all the things that could negatively impact your holdings and what you might do about it.
I would add to Mr. Zweig’s article that the key to this pre-mortem analysis is also noting whether your investments are likely to all be effected by the same events in the same manner, or whether your portfolio is diversified enough that different portions of the portfolio will be effected differently. The most basic example is simply looking at stocks and bonds: what is bad for stocks (a severe recession, for example) can actually be a positive for bonds (particular high – quality bonds). While during good economic times, bonds can be a drag on your portfolio’s performance, you’ll be glad you have them when times are not so good.
Since we can’t predict WHEN bad things might happen, or enumerate all the possibilities, the key is making sure your portfolio is diversified enough and contains enough safe assets to allow you to hold on to your risky assets during down markets. I’ve told many clients over the last few years that there were really only two types of investors who were hurt during the financial crisis: Those who panicked and sold near the bottom, and those who needed income from their portfolios and hadn’t set aside enough in quality bonds or cash investments. They were forced to sell their risky assets to pay the bills, and then didn’t own enough shares to make up for the damage when the market finally turned around.
The moral of the story is to perform Mr. Zweig’s “pre-mortem” exercise not to scare yourself but to make sure you are in a position to a) sleep at night and b) pay your bills when a bear market comes around. And, as the article points out, you need to do that exercise while the sun is shining, not after the clouds have gathered and the storm has started. Investing takes discipline, and discipline requires having the right portfolio for your situation in place before trouble starts.