What Are Your Rules?

Copyright: <a href='https://www.123rf.com/profile_pramot70007'>pramot70007 / 123RF Stock Photo</a>One of my old neighbors from Mansfield, I’ll call her Amanda, is a database programmer in her early 60s. She did the corporate life for a long time and struck out on her own about ten years back. The entrepreneur bug bit her and she built a successful business, taking on complicated programming tasks for her corporate clients. I hadn’t seen Amanda in quite some time so on my way home from my Mansfield office last week, I stopped by to see her. As I entered through the front door, I saw a great big red backpack in the corner of her living room. I couldn’t miss it because of the color and the bright reflective tape on it.

Curiously, I asked, “What’s that for?”

“Oh, that’s BOB,” she told me.

BOB, it turns out, is an acronym. It’s what Amanda calls her “Bug Out Bag.” BOB is her emergency preparedness kit, and it comprises everything that she, and her dog Gus, needs in the event of a natural disaster. She keeps a first aid kit in there, a Swiss Army knife, a change of clothes, flashlight, hand-crank radio, and enough non-perishable food items and water to last her and her dog for a few days.

At first, it seemed like she was overcautious to me. But she told me she used it just last winter during one of those lousy winter storms. She had lost power for 3 full days.

Amanda got into the habit years ago when she lived on the West Coast. Natural disasters like earthquakes, mudslides, and wildfires were part of her daily life. She began packing BOB after learning about emergency preparedness while taking American Red Cross training. She says that BOB is the least she can do to be prepared if she has to leave in a hurry.

Amanda has been responsible for directing her retirement funds over the years. Amanda was telling me how well she’s done this year alone – her investments are way up.

Interested, I inquired as to how her “golden years” nest egg was structured. Digging down it became crystal clear to me that her heavy reliance on equities, including some on a real rocket trajectory, has left her painfully exposed to a tremendous amount of downside risk, in the event of a significant market correction.

While Amanda is well-prepared to hit the road when the lights go out, her investment strategy is not.

The stock market moves in cycles, sometimes up, sometimes down. The S&P 500 recently hit an all-time high and is now the most extended bull market in history. Hopefully, that upward climb will continue. History proves that we can’t count on it, nor should we.

Veteran financial news publisher Alan Newman thinks the market is due for a correction. Newman points to signs including what he calls “insanely high” leverage. Newman says that the total market’s leverage – the technique of borrowing capital to make investments – is 55% higher now than it was at the peak of the 2007 market, before the Great Recession. In fact, Newman says that margin debt – a measurement of borrowed capital – is higher now than at any time since 1929, when analyzed as a percentage of Gross Domestic Product (GDP).

Newman’s not anticipating a repeat of the Great Depression by any measure. But he does point out that excessive leverage was a key contributor when the market unraveled in 1929.

Sitting with her at her kitchen table, I got thinking. Doesn’t it just make sense to always be prepared for the worst? Shouldn’t we have a financial BOB?

You betcha!

Folks, ask yourself how you reacted during the last bear market, in 2007-2009. Better yet, take a look at your investment strategy and back-test it against historical data. How well did it behave during the last significant downturn? What is your personal appetite for risk? How much risk are you exposed to with your current strategy?

When we analyzed Amanda’s portfolio and back-tested it against the 2007 downturn, she discovered she had a 42% drawdown – the potential decline from high to low. That’s 42% she’d have to make up if the same thing happened again.

Guggenheim chimed in on this with their white paper titled, “The Deeper the Stock Market Decline, the Longer the Recovery.” The paper focuses on the length of time it takes to get back to even during a market declines. It reads that a decline of over 40%, the time to get back to even is eighty months.

Hmmm . . . that is almost 7 years.

Let’s face it: Amanda’s “buy and hold” strategy has produced above average returns for the past few years. But at her stage within the financial lifecycle, Amanda also needs to think about capital preservation. In the next few years, Amanda will begin to wind down her business. She expects to retire within the next decade. Amanda doesn’t have the time to replace 40%-50% of her investment portfolio.

Can you?

I suggested to Amanda a more pro-active Rules-Based Investment Strategy (RBIS) rather than her current buy and hold. A RBIS is built upon the concept that a portfolio should be focused on risk management first. RBIS will incorporate both strategic and tactical risk management strategies that are designed to seek to protect capital as a priority giving her a higher probability of financial success.

This would be a good time for you, Cutter Family Finance readers, to understand the rules of your strategy – now, while the market is still moving up. Because once the market drops, and it will, it’s already too late.

Be vigilant and stay alert, because you deserve more.

Have a great week!

Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, a wealth management firm with offices in Falmouth, Duxbury, and Mansfield. Jeff can be reached at jeff@cutterfinancialgroup.com./em>

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