September 2, 2014

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Article

Financial Fire Drill

Be Prepared for Unavoidable Financial Disasters

Lon Jefferies

September 2, 2014


History tells us that over a long enough time span, catastrophes are likely to occur. Fires, flooding, earthquakes—none can be 100 percent prevented and all can be potentially devastating. While these events can’t always be avoided, we can prepare for them. Running practice fire drills enables us to act appropriately during misfortune, while maintaining emergency food storage ensures we won’t starve when tragedy strikes.

Just as physical calamity can turn lives upside down, financial upheaval can lead to an unrecoverable loss. Fortunately, we have the ability to prepare for financial uncertainty in the same way we prepare for other exposures. As the current bull market is now both the fourth longest in history (64 months) and the fourth largest (+192 percent gain), now would be a perfect time to ensure you are prepared for the next market pullback.

Run a Portfolio Fire Drill

You can run a fire drill for your portfolio by understanding the loss potential of your holdings. It is critical to recognize the amount of volatility your portfolio will experience in declining market environments is dependent on your asset allocation—how much of your account is invested in stocks versus bonds. The larger the percentage of stocks in a portfolio, the more the portfolio’s value will increase during bull markets but decrease when the market declines. Let’s look at the historical performance and risk levels of a range of diversified stock-to-bond ratios.

Asset Allocation – Risk and Return (1970-2013)

Portfolio

Allocation

Average

Annual Return

Largest Loss in a

Calendar Year (2008)

100% Stocks

10.85%

-39%

80% Stocks / 20% Bonds

10.33%

-30%

60% Stocks / 40% Bonds

9.99%

-20%

50% Stocks / 50% Bonds

9.76%

-15%

40% Stocks / 60% Bonds

9.49%

-11%

20% Stocks / 80% Bonds

8.85%

-4%

After determining the asset allocation of your portfolio, ask yourself how you would respond to another market correction like we experienced in 2008. For this exercise, considering loss in dollar terms is particularly productive. For instance, if 80 percent of your portfolio is invested in stocks, you might be able to convince yourself that you could sustain a 30 percent loss. However, supposing you have $500,000 invested, a 30 percent loss would mean your portfolio is suddenly depleted to $350,000. To many, the thought of losing $150,000 is more uncomfortable than the thought of a 30 percent loss.

Next, picture every media outlet sending warnings day after day about how the market is only going to get worse. Imagine yourself checking what the markets are doing multiple times a day and constantly being disappointed that it is another day of losses. Last, visualize your friend, neighbor or family member bragging about how he got out of the market before the collapse and telling you how you are a fool for not doing so.

How would you respond in such an environment? Would you have a hard time sleeping or digesting your food? It’s critical to be honest with yourself. If you would stray from your long-term investment strategy by selling after a market drop and waiting for the market to recover, your current portfolio may be too aggressive. If so, scale back the assertiveness of your portfolio by reducing your stock exposure now because selling stocks during a market decline is the last thing you want to do.

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