Do You Have a Disaster Plan?

Do You Have a Disaster Plan?

Market Downturn Protection Plan

One of the unfortunate results of the 2008-2009 financial downturn among the general investing public (401K holders, IRA contributors, etc) has been a fear to continue contributing, or how to protect their nest egg against another downturn. While the probability of such a repeat event is statistically very low, the presence of a plan will help you sleep better just knowing a plan is in place should such an event occur.

You can worry and do nothing (like most investors in 2008-2009), or watch the market with three simple targets in place, and a specific plan of action should those targets be hit, and you can keep your investments safe from the damage they experienced a few years ago. Anyone with a computer and internet connection can perform easy periodic checks to see if any action is needed. Here are the basic things you will be watching for.

Let's define those targets and how you can know they have been met. First is a 20% reduction in a major Stock Market index such as the Dow Jones Industrial Average or the S&P 500 Index. Here we will use the S&P 500 for the example, but you are free to choose the index of your choice. Develop the habit of checking the index every month, say when you pay your mortgage, electric bill, or other monthly activity. When you pay this bill, check the index to see if there has been a decline of 20% from the highest point it has made in the past year to eighteen months. You can find this information on Yahoo Finance by going there from your web browser and several indices will be shown on that page. Select the one of your choice and click on it. On the right there will be a chart showing the movement of the index, below it you can select the 1y, which stands for One Year. A chart will appear and you will see the history of that index over the past twelve months. If you see the index has declined from the highest point by 20%, the first target has been reached and you are ready to take action.

Use a hand held calculator or the calculator on your computer to determine if a decline of 20% has been reached. Why 20%, you may ask? That is the standard level of a decline which confirms a bear market is in place. When that is reached it will be a news event, which will get the attention of those who may never open their brokerage statements because they don't understand them and are afraid to ask their advisors for an explanation. They will be scared and probably react, particularly if they experienced the 2008-2009 downturn and don't want to go through that misery again.

Your first action step would be to protect one third of your total investment dollar amount by moving it to an investment that will not lose more money. The most common investment vehicle in America is the mutual fund, and most fund families will have as an option a money market fund. If you are working with your 401K there will be a money market or cash option; talk with your HR representative at work for directions if needed. Should you be working from a brokerage account, say for your IRA, if you choose the money market fund in the same mutual fund family, all you have to do is transact a mutual fund exchange from say a growth fund to the money market fund, and you will not have to pay any commissions to your broker. For your employer's 401K plan there should be no commissions, but in both you will probably have to leave this one-third of your investment in the money market fund for a period of time, usually 30 days, before you can move it back into an investment that will probably grow.

Now that the first trigger has been reached, you will be more aware of market conditions simply by your knowledge of current events and you will begin to look for the second target. Should the market continue to decline, the second target is a 25% decline from the high, or an additional 5% downward move. Follow the same procedure you previously used to calculate the decline from the high. Should that target be reached, you repeat the transfer of investment dollars to a money market fund or cash equivalent using the approximate dollar amount previously moved.

At this point you have two thirds of your investment in a vehicle which, for all intents and purposes, will not go down in value, leaving one third invested in the market. Now you have the pattern, the first target was a 20% decline, second was 25%, the third will be 30%. When that point is reached, if it should happen, move the remainder of your investments into cash equivalent funds and you will be 100% in a cash position.

Now for the part of the plan that involves reentering the market with your cash which has been protected. We know what goes down does eventually go up. We saw that beginning on March 10, 2009 and the market has not stopped improving since that time (as of this writing). But when do you get back in? You use a similar reentry plan which allows you to buy low after you have sold high. You are still actively watching the market now and have probably been checking Yahoo Finance on at least a weekly basis rather than a monthly basis, so you look for an increase in the index of your choice. The reentry percentage is now a new number. Your entry percentage is 7.5%. When your index has grown from a low by 7.5% you scale your investment dollars back into the market, the dollar amount remains at one third of your total with each 7.5% increase in the index. You can use the same reentry procedure of mutual fund exchanging (no commission charges) right back into the same funds you exited, or you can choose others that suit your specific needs, if you are not comfortable choosing which funds, it will be worth the cost to pay a financial advisor to direct you. If you do not have a financial advisor, check with a CPA who may be able to help you, or will be able to direct you to someone who can assist you

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If the average investor had taken this action in the 2008-2009 downturn, the results would have looked like this. Assuming a 401K with $100,000 at the highest point of the S&P 500 in May of 2008 of around 1425, in September of 2008 the first target would have been achieved and about $26,000 would have been moved to a cash equivalent instrument. {NOTE: These numbers are close estimates and will hopefully serve as an example, but don't take them as exact}. Remember, the original $100K is now $80K because of the 20% decline, and one third of that is a little over $26K. The S&P Index would have been around 1140. The second target would have been reached in the first week of October of 2008 and another $26K would have been moved to a cash equivalent instrument when the S&P would have been around 1083. The third target of 25% would have been reached in the second week of October of 2008, and you would have moved the remaining investment dollars to a cash equivalent with the S&P at approximately 1,029 where it would have remained until the market stopped falling at around 730 (based on daily closing numbers) on the S&P.

Our average investor in this example would now have about $73K in cash or cash equivalent investments by the middle of October 2008 when the public was wondering what was happening to the stock market and not knowing what to do. Now we wait for the bottom and you can't know that until there has been a time of recovery after the bottom is reached. Remember our recovery number is 7.5% increase from a low. We know the low was made on March 9, 2009.

TRIVIA QUESTION: On the S&P Index Intraday, what was the lowest number reached during this downturn? Answer, on March 8 intraday the S&P bottomed at 666. Zombie apocalypse narrowly averted!

As the market began to rise, we see the increase of 7.5% later in March and redeploy 1/3 of our 401K, which has been safely in cash since October 2008. Soon after in March we see an additional increase in the markets of 7.5% and deploy the second layer. And in mid April an additional increase of 7.5% is made in the market and we invest the remaining dollars in suitable investments (maybe the same investments we had late last year when we went to cash), and we are 100% invested with the S&P Index at around 840. You can calculate what your return would have been, but it is safe to say you exited at a high point (S&P 1029-1140) and reentered at a lower point (S&P around 840).

Most investors (probably yourself included) did nothing because such an event had not occurred for 70 years, and even the most experienced financial professionals were stunned and shocked, so don't feel bad if you did nothing. In fact, if you did nothing your account value has probably more than recovered and is showing an attractive return since the decline. However, there were many who panicked, sold out at the bottom and may not have returned even now, missing one of the most amazing recoveries in history.

Having a plan of action for an emergency is far better than an emotional reaction in the midst of the emergency. This is why our schools have emergency plans and drills for dangerous weather events. The probability is it will never occur, but just in case it does the plan is in place.

Evaluate this plan to see if it may be helpful in your longer term retirement accounts. For reference, we almost saw these conditions come to reality in August 2015 in the late month downturn, but the markets began recovering and did not exceed the 20% decline, avoiding bear market conditions.

This material is for information purposes only and should not be construed as an offer or solicitation of an offer to buy or sell any securities or investment instruments. Brad Gholson is not a licensed broker, broker-dealer, market maker, investment banker, investment advisor, analyst or underwriter.

Copyrighted 2016