This Is a Test, This Is Only a Test
The article below appeared in my Oct. 28 newsletter. But after the overnight global market volatility and today's expected steep drop in U.S. share prices, I figured it was worth reposting.
THE CURRENT GRUDGING ECONOMIC RECOVERY is in its seventh year and the stock market rally is in its eighth year. Here I earn nobody’s admiration by stating the obvious: These things don’t go on forever—but nobody knows when the music will stop.
That makes this a good time to hold a financial fire drill. Focus on three key questions. How would you react if the stock market dropped 30% next week? Would a market plunge derail your upcoming financial goals? How would you cope if an economic downturn put your job at risk?
This first question is about emotional fortitude, while the second and third questions are practical ones—but all three have profound implications for how you position your portfolio.
Let’s start with first principles: Most folks should own a portfolio that has healthy exposure not only to stocks, but also to bonds and other more conservative investments. That way, you should earn handsome long-run returns, but your overall wealth shouldn’t be too badly bloodied by a stock market crash and you shouldn’t find yourself selling stocks at fire-sale prices to buy shoes for the children.
Not sure you have the right balance between stocks and bonds? The tricky issue: What counts as a bond—and what counts as a stock?
Looks like a bond
Bonds typically deliver a steady stream of regular income. If that’s the defining characteristic, many parts of our financial life look like bonds. Think about all the income streams you collect: There might be Social Security retirement benefits, income from immediate annuities and any traditional employer pension you’re entitled to. If these provide a hefty portion of your retirement income, that can free you up to invest more heavily in stocks—and potentially earn higher long-run returns.
As you consider the bond-like income you receive, also give some thought to the regular drains on your finances—in the guise of mortgages, auto loans and other debts. You can think of these debts as negative bonds. Got $400,000 in bonds and a $300,000 mortgage? Arguably, your net bond exposure is just $100,000.
Between student loans, car loans and mortgages, many folks reach their 30s with what seems like an alarming amount of debt. But typically, their net position in bonds is still substantial—thanks to their paycheck, which can be viewed as another bond-like source of income.
Indeed, among academics, the four decades of income that we collect from our so-called human capital provides the intellectual justification not only for taking on debt early in our adult lives, but also for investing heavily in stocks. By taking on debt in our 20s and 30s, we can buy items—think college degrees, cars and homes—that we couldn’t afford if we had to pay cash. This has the added benefit of smoothing out our consumption over our lifetime. Meanwhile, the debt involved shouldn’t be of great concern, because we know we have plenty of paychecks ahead of us to service these debts and pay them off by retirement.
Those paychecks, with their steady bond-like income, also free us up to invest the bulk of our portfolio in stocks. We don’t need income from our portfolio while we’re in the workforce, so we can go light on bonds and instead shoot for higher returns with stocks. But as we approach retirement and the last of our paychecks, most of us will want to cut back somewhat on stocks and invest more in bonds.
Are you a stock?
Keep in mind that not everybody’s paycheck is bond-like. Let’s say you work on commission, you’re a Wall Street trader or you’re involved with a Silicon Valley startup. Your income isn’t bond-like. Instead, it looks more like a stock. Maybe you will have a huge payday—or maybe you won’t be so lucky, and you will find yourself with far less income than you had hoped and perhaps even out of work. To reflect this risk, you might want a healthy stake in bonds and other conservative investments, even if you’re in your 20s.
Whether it’s bonds, a regular paycheck, a pension, an immediate annuity or Social Security, you’ll likely discover that much—and maybe most—of your assets are in bonds and bond lookalikes. And, of course, you likely own other assets, notably a home and perhaps even a second home.
The implication: Even if the stock market tumbled 30% tomorrow, the hit to your overall net worth would probably be modest, so there’s scant reason to panic. But to avoid feeling unnerved, it’s important to stay focused on your overall net worth, or you won’t get the emotional benefit that comes with spreading your money across a broad array of assets.
Owning multiple assets doesn’t just make for a less unnerving financial life. It also has a practical benefit: If the stock market plunges, you can draw on these other financial resources to buy groceries and pay the mortgage.
For retirees, those resources might include their monthly Social Security check and their bond portfolio. For those in the workforce, they have a paycheck. What if that paycheck is at risk, because there’s a chance you’ll get laid off if the economy turns down? This may be the moment to accumulate cash and set up a home-equity line of credit—so, if the need arises, you can get your hands on enough money to make it through a long spell of unemployment.
