What's Your "Recession Reserve"?

Industry Insight

 

Even with 2008 ever more distant in the rearview mirror, investors still get reminded during most years—and already this year for sure—that stock markets can be a roller coaster.

Now that we’re between major downturns, let’s look at your investment “risk tolerance” in a different way, potentially drive some of the jitters out of investing, and maybe allow you to seek more growth potential.

“Risk tolerance” as typically measured by investment advisors is the degree to which you are willing or able to accept fluctuations in the value of your investments. If your risk tolerance is low, you want conservative, stable investments. High risk tolerance means you’re fine with bigger short-term swings in exchange for more long-term growth potential.

Although the word “risk” itself implies danger of true loss, the U.S. stock market has been positive for 73% of years from 1927-2015, and all 15-year periods have been positive during that time.¹ Sharing in potential market growth is as easy as owning a broadly diversified basket of stocks, as long as you see it as a long term proposition.

But there are two ways you can actually lose money in the stock market:

1. Own stock in a single company which defaults; the stock value may drop to zero. That’s true loss. But it’s easy to avoid disaster—don’t hold more than 5% (preferably much less) of your investments in any single company stock. Winners offset losers in a diversified portfolio, so owning a broad pooled fund investment may do the trick by including dozens or thousands of stocks.

2. Sell securities for less than you paid…for example, buy a broad U.S. index fund when markets are doing well, then sell during a recession for a lower price per share. Again, true loss.

So why do people “sell low”? Sometimes it’s an emotional reaction to a market drop—“I’m losing money, so I’m getting out now.” Understandable, but again, true loss.  The cure is to recognize that markets always perform in cycles, and a lower account balance is not really a loss unless you sell. Hang on, weather the downturn, and don’t sell low out of an emotional overreaction.

But here’s the other reason people sell their investments low and lose real money: they simply need to raise cash. Retirees often fall into this camp—regularly liquidating part of their portfolio to pay the bills and have their fun. That was the plan, right?

But this version of selling low can also be avoided, with a simple math exercise to create your “recession reserve”:

First, market downturns are unpredictable, so assume the next recession starts tomorrow.

Next, understand that recessions tend to last about six months to a year-and-a-half; afterward, stock values start climbing back up, sometimes slowly, sometimes dramatically, in fits and starts.

Through twenty-eight market downturns from the Great Depression through the 2008 recession, it took an average of 3.3 years for the purchasing value of stocks to return to full value (adjusting for inflation, and reinvesting stock dividends); the 2008 recession took about 5.3 years to play out, and in only four of those twenty-eight downturns did it take more than six years for stock values to recover.²

So assume a five-year dip for a recession starting tomorrow, until stocks to return to full value.

Now, how much cash will you need from your investments over the next five years? (Or seven years if you want to be extra-cautious?) Stop right now and figure that out. Got it?

Okay, that’s how much you should consider taking out of the stock market now and putting into a potentially more stable holding (like intermediate-term bonds) that should not get hammered if the next recession starts tomorrow. This is your “recession reserve.”

When a market downturn comes along, simply draw needed cash from your recession reserve, instead of selling stocks to raise cash.

If your “emotional” risk tolerance is very aggressive, this simple math approach can help you prevent being overweight to stocks and putting your financial plan in potential danger. If you’re a conservative investor, but know you need more long-term growth to meet your goals, this can help shelter a correct amount of assets, but not more than necessary.

So the “recession reserve” strategy may help you worry less about market dips, and allow you to participate more in the growth potential of the capital markets if you wish…instead of allocating your portfolio based merely on your age, or on a negative emotional reaction to inevitable market swings.

This can really work, but always work closely with your financial advisor to choose efficient investments—and to find the right balance between what the math says you can do, and what your gut says you should do to sleep well at night. And be sure to reevaluate each year to make sure your recession reserve is adequate.

The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning past performance are not intended to be forward looking and should not be viewed as an indication of future results.

Please note that all investments are subject to market and other risk factors, which could result in loss of principal. Fixed income securities carry interest rate risk. As interest rates rise, bond prices usually fall, and vice versa.

1. “Reasonable Return Expectations,” DST Systems, Inc., 2016.
2. “Don’t Fear The Bear,” Mark Hulbert, Wall Street Journal, 2014.

CERTIFIED FINANCIAL PLANNER^TM consultant Kenny Gott is President at Piatchek & Associates and author of the book "Bottom Line Financial Planning". He can be reached at kgott@pfinancial.com.

 

Click here to visit our dedicated Recession Reserve^TM page.