When times are good, it's tempting to throw caution to the wind. This is especially true during a strong economic environment. Over the 11-year bull market, which ended in March, stocks rose steadily, companies were able to easily obtain financing, and many professions offered secure paycheques. Many investors took consistent positive returns for granted, and, consequently, made questionable decisions when it came to their personal finances.
To quote legendary investor, Warren Buffett, "You only find out who is swimming naked when the tide goes out."
Over the past months, the tide went out fiercely, with the market plunging at a historic pace. In a matter of weeks, the S&P 500 dropped 34% and trillions of dollars in shareholder value vanished. This experience has been a wake-up call that the good times don't last forever. It's also a harsh reminder of the dangers of straying too far from a prudent investment plan.
A judicious strategy incorporates timeless investment principles, many of which have become clichés over the years. These investment truths not only help ensure that investors are on track to achieve their financial objectives, and they also keep them out of trouble by attempting to avoid financial missteps when times are good. Now is a wonderful opportunity to revisit these principles, as many investors are searching for guidance during these challenging times.
No. 1: Cash is king
The foundation of any prudent financial plan is to have at least three to six months' worth of expense money sitting in cash. As economists and market prognosticators debate the toll this global coronavirus pandemic will take on the economy, the folks with ample cash might be in the best position. If they lose their job or experience a significant decrease in income, their cash reserves should allow them to sail through these challenging times relatively unscathed.
Investors who are concerned about their future income are well-advised to continue building their emergency fund with extra reserves should the economy take longer than expected to rebound.
No. 2: Debt is bad
Many advisors will point out that borrowing money has both positives and negatives. They are right. In the right set of circumstances, leverage may be quite helpful. However, the people who are in the best shape financially are generally those folks who are not indebted to anybody. Even the most sophisticated investors and institutions can run into trouble if they don't carefully monitor their debt loads.
Over the course of the next few months, there will be no shortage of news stories of companies that went belly up because they succumbed to their insurmountable level of indebtedness. Eliminating debt is one of the most powerful financial positions one can find themselves in.
No. 3: A clear understanding of your time horizon is key
One's time horizon dictates how much risk can prudently be taken within their portfolio. It also keeps rough market conditions in perspective. If you're a long-term investor, then the current bear market should not scare you. In fact, it should excite you. It offers you the wonderful opportunity to buy equities at a meaningful discount compared to what they were trading at just a few months ago.
If you are a short-term investor who planned properly, you also should not be scared by the current bear market. Your portfolio should have been sitting in cash or allocated to high-quality bonds. In such a situation, the current environment should not impact you at all because your investments are not plummeting in value.
It's irresponsible to invest without having a clear understanding of when you need to use the money.
No. 4: Dollar-cost averaging keeps emotions in check
Dollar-cost averaging is the process of routinely adding money to investments at regular intervals. Every human is emotionally charged. Some people get emotional about politics, others about certain industries or a company's business practices. Emotional decisions have no place in the world of successful investing.
The benefit of setting up automated, routine contributions to your investment accounts is that it helps eliminate emotions from your process. It eliminates the desire to time the market, and it increases your ability to build wealth over time.
No. 5: Rebalancing allows you to make money without much effort
The act of rebalancing is when one adjusts the weightings of a portfolio as investment values go up and down to maintain their original asset allocation based on risk tolerance. Rebalancing allows one to sell the positions that went up in value, while simultaneously adding to the positions that went down.
The old adage in investing is to "sell high, buy low." This is a way to do just that.
No. 6: Diversification is the only free lunch in investing
There is a tendency for investors to find, and pile into, the hot investment du jour. This is great while things are going well, but all companies, sectors, industries and countries go through cycles. When things go south, having an overly concentrated position in any one area of the market can be devastating. This can be illustrated throughout history, with the most recent examples including technology stocks in the late '90s, financial stocks during the Great Recession and emerging market stocks over the past decade.
The best way to protect your portfolio from this risk of over-concentration in one market segment is to have a policy of diversifying across many asset classes. While such a strategy may lead to some investment laggards, it may also ensure that you should also have relatively high-performing investments within your portfolio as well. This slow-and-steady approach is a sensible way to ride out future market bubbles.
No. 7: Conservative bonds have a place in everyone's portfolio
When the market is soaring, many investors won't even look at high-quality fixed income. After all, why invest in anything other than highflying technology stocks?
The reality is that bonds serve a crucial purpose in all investors' portfolios. They provide the psychological benefit of minimizing volatility during turbulent markets. They serve as a cushion that allows investors to withdraw funds from assets that didn't plummet in value during a market correction. Lastly, there are rebalancing opportunities when stocks fall in price and the highest-rated bonds appreciate. To dismiss bonds as a core element of one's investment strategy is shortsighted.
No. 8: High returns mean a high level of risk
Investors tend to search for the magic bullet of high returns with no risk. When times are good, some folks may even think they found this panacea as their investments continue to rise. However, when the economic conditions turn, they soon realize that high expected returns could mean a higher level of risk.
The nature of the risk may come in many forms, including leverage, illiquidity or poor credit. The bottom line is if you want to potentially achieve high returns, you need to be willing to take a high level of risk. It's important for investors to go into every opportunity with their eyes wide open.
No. 9: Boring over exciting could be the right approach
Investors often confuse an exciting idea with a good investment opportunity. Excitement may be generated from the latest fad, an exclusive deal or a strategy that promises to trounce the performance of the S&P 500. These "opportunities" are, more often than not, being sold on the hype and not on their fundamentals.
If you want to avoid being lured into one of these situations, then pursue an approach of sticking with plain vanilla, boring investments. This may be a combination of blue-chip stocks, index funds or high-grade bonds. An investor may miss the next hot IPO, but they also won't get sucked into the next Ponzi scheme. The tradeoff seems worth it.
No. 10: Once you win the game, stop playing
The stock market can be an addicting place, especially if you've accumulated a substantial level of wealth over your investing career. It's important to understand that the main purpose of investing is for one to be able to achieve their financial goals.
Once the investor reaches that magic number, there is no reason to continue to put that money at risk. Granted, if there are multigenerational goals that are for decades in the future, then that capital should be invested accordingly. However, the monies that have already been accumulated to fund an investor's lifestyle could possibly be moved out of equities. Investors who have reached that point, are in the enviable situation of no longer needing to stress over the next bear market.
The silver lining of a severe market downturn is that it causes investors to reflect on the decisions they've made during the good times. As they introspect, they're forced to face the cold hard truth of whether they've stuck to these timeless investment principles. If they've strayed, it could be devastating and set them back many years financially. However, if they stay true to the principles, it should increase their chances of success in the long run.