Six Defensive Moves in a Down Market

Six Defensive Moves in a Down Market
A Great Time for Regular Investing

by CraneAmyButtell
24.12.2008



Market volatility is enough to give any investor heartburn these days. Although there have been some notable gains — the Dow Jones industrial average’s 889.4 point gain on Oct. 28 being one of the most impressive ever — most of the volatility has been on the downside.


With the media delivering one grim story after another about the economy, most observers aren’t expecting to see the market stabilize soon. Unemployment is up, banks aren’t lending, big corporations are teetering on the brink of bankruptcy and banks are failing at a rapid clip, news that doesn’t exactly inspire confidence.

Still, with so much riding on your investments, including your retirement and your kids’ college savings, you might feel it’s time to position yourself somewhat defensively given how long this downturn might last. You don’t want to stop investing, because there’s no way to know when the market will rebound; you have too much to lose by being out of the market at the wrong time. But here are some steps you can take to lessen the pain and position yourself as best you can.

Dollar-Cost-Average Your Contributions

You’re most likely already doing a lot of dollar-cost averaging — investing a set amount regularly — if you’re contributing to a 401(k) or college savings plan. This is a good strategy no matter what the market is doing because when you dollar-cost average, you buy more shares when prices are lower and fewer shares when prices are higher, keeping your overall cost basis down.

If you can employ this technique with your other investment accounts, do so. By dollar-cost averaging in a volatile market, you keep your cost basis down. If prices fall farther, you’ll benefit more by spreading your purchases out over a longer period than if you just invested a lump sum all at once.

For example, if you have an individual retirement account and plan to invest the maximum allowable of $5,000 annually, you could arrange to have $416.66 transferred from your bank account to your IRA every month and have that invested in the stock, mutual fund or bond of your choice. Or you could invest the money all at once in your IRA at the beginning of the year, then dollar-cost average it out yourself over a year.



Consider Stop-Losses?

Stop-losses aren’t a good idea for most investors in most long-term investing situations. But if you absolutely cannot afford to lose more than a certain amount of money in your investment accounts, this strategy is worth considering.

You might fall into this category if you’re a retiree on a fixed income with only a certain amount of assets in your retirement account besides your Social Security. To implement this strategy, you either call your broker or go into your online investment account and set a floor on some of your investments. When the prices of the securities you select reach those floors, your brokerage will automatically sell them.

Keep in mind, however, that in falling markets the price can blow right by your stop-loss order and you may be sold out at a much lower price. This is why you should employ this strategy cautiously. (Editor’s note: Many investors don’t like stop-loss orders because of their automated nature and because they might cause you to sell high-quality stocks that drop for reasons unrelated to their fundamentals.)

Save More

In a difficult economy, it makes sense to hunker down and cut your expenses where you can. Unemployment is rising, and you never know when you or your spouse might be out of a job. If you do hang on to your job, later on you can invest some of your excess cash for your retirement, your children’s college education or any other long-term goals you have.

Below are the extra savings you can expect to generate for differing saving rates. The following assumes you’ll reap 8 percent annual compound interest, pay 25 percent in federal taxes and 6.5 percent in state taxes, and see an average inflation rate of 3 percent:

• by saving $50 a month for 30 years, you increase your savings by $25,970
• by saving $100 a month for 30 years, you increase your savings by $51,940
• by saving $200 a month for 30 years, you increase your savings by $103,880

Stretch Out the Long Term

Change your attitude on what constitutes the long term and remember that stocks historically have averaged an annual return of 10 percent or more. Think of the long term as 20 or 30 years, or even more, rather than five or 10 years.

Because stocks increased so much in the 1990s and in the 2000s after the end of the dot-com bust, the law of averages dictates that the market will then have a number of average or subpar return years at some point.

Large returns are nice, but there’s no guarantee they’ll continue in the short run. History shows that the stock market has produced many years of ugly returns, even consecutively, or returns that have gone essentially nowhere over a number of years. Think about the late 1920s and 1930s as well as the mid-to-late 1970s and early 1980s.

Surviving a negative or sideways market that lasts for years takes a lot of patience. In those circumstances, continue dollar-cost averaging, work on bolstering your cash cushion and save every dime you can get your hands on.

If you’re getting close to retirement age, consider staying on the job a few years longer to shore up your nest egg. If that isn’t a possible, consult or take on a part-time job.

Just about the worst thing you can do is start drawing your assets down when the market is tanking, as it will be difficult for your investments to recover sufficiently to fund the rest of your retirement, given lengthening life spans.

Check Your Asset Allocation

With stocks and below-investment-grade bonds taking substantial hits in the last few months, it’s likely that your target asset allocation is out of whack. Take a look at your investment accounts and determine what you need to do to get back to your target allocations.

Financial planners generally recommend that you reallocate assets periodically, with once a year being a good benchmark. At this annual reallocation, you should move investment funds from asset classes that have done well, or at least have not done as badly as others, and move them into those that have declined, such as stocks.

Given the uncertainty of the markets, it might make sense to reallocate gradually rather than all at once. For example, if your investment accounts total $100,000 and your target allocation is 60 percent stock, 20 percent bonds and 10 percent cash, you could move funds out of bonds and cash gradually to bolster your stock allocation up to the preferred target.

Such a gradual shift could work in several ways. For example, you could move money out of bonds into cash all at once, then gradually dollar-cost average into stocks over the next six months or year or so. (Editor’s note: Be careful with asset allocation so that you’re not trying to time the market, an often disappointing venture. Many investors believe that for a long-term portfolio, there’s little reason to own anything except stocks.)

Expand Your Cash Cushion

Cash is an important bulwark in a falling market and during what’s shaping up to be a potentially long recession. When you have enough cash to last out the ups and downs of the markets without having to sell any of your investments, you can respond to market developments rather than react to them.

Financial planners recommend that employed workers have six months of living expenses squirreled away. Retirees should have at least two years of cash, preferably more, so that they can ride out a bear market of several years without having to sell investments at fire-sale prices for living expenses.

If you’re still working, see where you can trim your expenses and direct those savings into a bank savings or money market account. Interest rates on these savings vehicles aren’t great, but the ease of access to these funds is the most important factor.

With an expanded cash cushion, there’s less danger that you’ll need to tap your investment accounts for funds, whether by liquidating taxable mutual funds, stocks or bonds or by arranging to borrow from your 401(k) account.

No Time to Cash Out

When positioning your portfolio, it makes sense to play both defense and offense. Just remember not to give in to your emotions and get out of the market altogether, no matter how dire the markets and the economy may seem today. The next upturn is impossible to predict.


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