Are You Ready for Stock Market Limbo?
With the debate on the debt ceiling dragging into the eleventh hour and the prospect of a downgrade on the creditworthiness of the United States, I have been reading much speculation on the impact to the economy and stock market. It seems like another recession and crisis is almost guaranteed at this point. Speculation is that the stock market could take as much as a 50% tumble from current levels. So are you ready for stock market limbo (as in the dance when the point is to get as low as possible)?
As I read some of the speculation, I can’t help but think back to 2008 when the stock market lost 38% and some of the individuals I know lost that and more of their retirement accounts. I lost 18% in my retirement account because I held put options on every stock that I own. So I decided to check my retirement accounts and calculate my maximum exposure to a market drop of 50%.
Are You Diversified?
I admit that I occasionally watch Jim Cramer’s Mad Money show on CNBC although it has been a while. He has a segment on the show where callers can give him their 5 largest stock holdings with the question, “Am I diversified?” He will take a few seconds and then briefly outline his rationale explaining whether or not the caller is diversified. Usually this is based upon the business each company is in, and Cramer is making sure the investor doesn’t have 2 financial stocks or 2 retailers.
But did diversification really do anything in 2008? Even many of the big mutual funds lost a large chunk of change. The S&P 500 lost 38% despite being an index which is diversification by definition.
Why Diversify?
The whole point of diversification is to protect one’s portfolio from major losses. There are different methods of doing this not only within an asset class, but also between asset classes. One of the latest trends in personal finance is to get the right asset allocation. This is a topic for another post so I will save it for later. Suffice it to say, that if the point of diversification is to prevent losses, then you had better make sure that losses are prevented.
How Can I Sleep at Night?
Starting in 2007, I decided to purchase protective puts on every stock I owned. I had seen the bursting of the tech bubble and had experienced my share of losses on stocks over the years. I came to the conclusion that my number one priority should be to prevent major losses. After all, a 50% loss requires a 100% gain to get back to even.
Given all the recent talk about the different possibilities for loss in the market, I decided to check my retirement account exposure. Currently, I am 89.5% invested in stocks with the remainder in cash. I assumed that all of my stocks dropped to zero and wanted to figure out how much of my portfolio would be left. Essentially, I am calculating my “worst case scenario”.
The result: a 10.8% loss! I can live with that and even sleep well at night. Not to mention the fact that only about half of my retirement plan is based upon equities. I have about the same amount invested in real estate that when paid off will form the primary source of my retirement income until I am forced to take distributions.
So, are you prepared for a stock market swoon or crash? As Cramer might say, “Are you diversified?”
Yikes! Do you have any past posts on diversification? I’ve tried to diversify but could probably read a little and understand more about it.
I don’t have any but would be happy to write some more on the topic. Maybe that would be good for my next post or two. If you have any specific questions, feel free to ask.
I’m predicting a 600 point drop on August 2 if the ceiling isn’t raised. I can see a couple 200 point down days on Friday and Monday if it is not passed as well. 1000 points in a few days is nothing to scoff at.
I would not be a bit surprised if your prediction came true. I would worry about a return to a 4-digit DJIA and 6,000 as a potential crisis target. Couple that with gold at $2,000 per ounce or better, and you are looking at a Dow:gold ratio of 3 which could become a secular bottom.
I’m not particularly diversified, but am still young at 29. I hope to go long on bonds once interest rates rise. I’m about 90% stocks, invested in 17 different positions. If a major drop occurs, then I just continue to buy more equities at a lower price. As long as my dividends keep rolling in I’ll keep reinvesting. The lowered market value of my equities would only matter if I sold, which I certainly hope I won’t ever have to. I’m a net buyer.
Dollar cost averaging and reinvesting dividends is a good way to protect oneself in the face of a major decline. You have a good strategy and time on your side.
Limbo is fine with me, in fact I look forward to slow growth instead if we do not crash. This becomes a stock picker’s market and it would calm the extremist index investors for a while
Limbo in that sense would not be too bad at all. I was referring to the dance and “How low can you go?”. I would be OK with either situation because of the protective puts that I own. Sorry I didn’t make it any clearer.
Great post. I understand you have puts to lower losses, but how did you come up with a 10.8% loss if the worst case scenario happened? Also a Dow to gold ratio of 3 is a secular bottom? If an index fund got hammered for 38%, guess that’s not diversified enough! Look forward to your future posts on diversification. Will be an interesting week!
I have puts on every stock that I own so even if everything dropped by 50%, the puts would be exercised leaving me with a retirement account full of cash. The balance would be 10.8% less than my current balance. The key is the fact that I own enough puts to cover each and every stock. I don’t think the Dow:gold ratio will hit one like it has in the past. Just a gut feeling. It is a secular bottom for stocks in that case, but a top for gold. Once that ratio gets close to 3, I would start buying more stocks and taking profits in gold.