Surviving a Financial Panic

October 22, 2008

The last few months have been a real test of investor fortitude and preparation. While the market losses have not been particularly severe compared to past history, the media has declared a crisis.

The last few months have been a real test of investor fortitude and preparation. While the market losses have not been particularly severe compared to past history, the media has declared a crisis. The problem is certainly not trivial. The financial system is severely strained, but the end of the civilized world, as we know it, is not the only possible outcome.

How well you survive a financial panic most often depends on how well you have prepared for it. The market cycle has always been three steps forward, followed by one or two steps back. Over the long haul, it’s a great way to generate wealth, but in the short term it can be disconcerting.

Here’s what you need to do to ride out the inevitable storms.

Have a safety net. Don’t take more risk than you can financially afford. Your top-level decision for your asset allocation is to determine the right mix of stocks (equities) and bonds (fixed income). Make sure that you have enough cash and near cash so that any withdrawals you might need to make from the portfolio for the next several years are covered. We think 7 to 10 years is a good target for your very safe assets. The market will always have declines. We don’t know when they will come, how bad they will be, or how long they will last. Ample cash and near cash give you time for your risky assets to recover.

Diversify. Markets have always recovered, but individual companies’ stocks and bonds can disappear forever. Risks that you can diversify away are never rewarded by the market, but failure to diversify can result in painful punishment. Holding Enron, Global Crossing, or Lehman Brothers is almost a non-event to a well-diversified portfolio. That’s why we use index funds and ETFs to cover the world’s markets. Appropriate diversification means global diversification without any concentrated positions in industries, sectors, currencies, or geographical areas.

Diversification does not guarantee a profit, and you won’t always have the highest returns on your block, but it will prevent horrendous and unnecessary losses.

Have a plan and stick to it. Don’t take more risk than you can emotionally afford. No one enjoys a market decline, but a knee-jerk response will not serve you well. Selling into a financial panic is a proven way to lock in losses while failing to participate in the inevitable recovery. Know yourself and your risk tolerance. Ratchet down the risk in your portfolio until you are comfortable with the 95% worst possible short-term outcome.

Control your spending. If you are retired and generating income from your portfolio, living within your means is essential. A conservative withdrawal pattern with appropriate diversification and liquidity shouldn’t imperil your financial future. However, an unsustainable withdrawal rate can eat so far into your capital during down markets that you may never recover. Withdrawal rate is the greatest risk facing a portfolio and the one factor over which you have direct control. A 4% withdrawal rate is considered conservative, while anything over 6% may not be sustainable over the long haul.

The financial landscape has been rearranged in ways we could not have imagined just a few months ago. The governments of the world finally get it, and have taken bold action to contain the problem. It will take time to sort itself out. However, going forward we can expect increased regulation and a greatly reduced level of risk in our financial institutions. When the dust settles, we should anticipate a much-improved platform for the world’s economic growth.

Frank Armstrong, CFP, AIFA

Frank Armstrong III is founder and CEO of Investor Solutions, Inc. (www.investorsolutions.com), an independent, fee-only investment management firm in Coconut Grove, Florida. For the second year in a row, Barron’s has selected the firm as one of the top “100 Best” Independent Financial Advisors in the country. Frank has more than 35 years of experience in the securities and financial services industry. He contributes to major publications and appears regularly on television and radio. He is the author of the forthcoming book, THE RETIREMENT CHALLENGE — SINK OR SWIM: A Complete, Do-It-Yourself Toolkit to Navigate Your Financial Future and the bestseller, THE INFORMED INVESTOR: A Hype-Free Guide to Constructing a Sound Financial Portfolio.