How To Crash-Proof Your Portfolio Now
The bull market is reaching excessive heights. Protect your wealth by following these six simple steps. The upshot? Stick to value.
Headline risk is mounting and yet this decade-long bull market keeps hitting new records. Investors face a day of reckoning; below I show you how to prepare ahead of time.
But first, let’s review three impressive feats achieved last week in the markets:
1) The S&P 500 climbed 2.3% to hit a new all-time high, as investors shrugged off trade war fears. Federal Reserve dovishness and resilient U.S. economic growth added to Wall Street’s ebullience.
2) Gold prices surged 4% and broke above $1,400 per ounce for the first time since 2013, fueled by increasing hostilities between the U.S. and Iran. Military action was averted at the 11th hour last week, which relieved the stock market. However, geopolitical tensions continue to buoy the yellow metal.
3) The price of crude oil soared more than 9% for the week, racking up its largest weekly gain since December 2016. Oil had been slumping, as signs point to a supply glut combined with slowing global economic growth. However, the flare up of tensions in the Middle East stoked concerns about supply disruptions.
Meanwhile, according to the widely followed Cyclically Adjusted Price to Earnings (CAPE) Ratio, stocks in the S&P 500 have only been this expensive during the crash of 1929 and the great financial crisis (see chart, which depicts the latest data as of market close June 21).
The CAPE ratio is defined as price divided by the average of 10 years of earnings (moving average), adjusted for inflation. The CAPE ratio now stands at 30, compared to the historical median of 15.7.
Your Six-Point Checklist
We’re overdue for a bear market, but by following these steps, you can shield your nest egg and stay invested:
1) Use Stop Losses When Buying Stocks
One of the most widely used devices for limiting the level of loss from a dropping stock is to place a stop-loss order with your broker. Using this order, the trader will pre-set the value based on the maximum loss the investor is willing to tolerate.
If the last price drops below this fixed value, the stop loss automatically becomes a market order and gets triggered. As soon as the price falls below the stop level, the position is closed at the current market price, which prevents any additional losses.
A trailing stop and a regular stop loss appear similar as they equally provide protection of your capital should a stock’s price begin to move against you, but that is where their similarities end.
The “trailing stop” provides an advantage over a conventional stop loss because it’s more flexible. It allows the trader to continue protecting his capital if the price drops, but when the price increases, the trailing feature becomes active, enabling an eventual protection of profit while still reducing the risk to capital.
Over time, the trailing stop will self-adjust, shifting from minimizing losses to protecting profits as the price reaches new highs.
2) Diversify Among Stocks and Sectors
Don’t put all of your eggs in one basket. Also be sure to diversify across sectors.
Investors often punish themselves as much as the market does. Despite the compelling case to diversify, many investors hold portfolios with assets concentrated in relatively few holdings. This common failure has its roots in lack of knowledge and just plain laziness.
3) Spread Your Money Among Several Asset Classes
Don’t just stick to components of the S&P 500 or the Dow Jones Industrial Average. Spread your portfolio among value, small-cap, large-cap, growth and dividend stocks.
4) Spread Your Investments Geographically
Don’t simply focus on specific country or regional funds, or on emerging markets. The best course of action is to diversify throughout the world through international index funds.
5) Set A Specific Retirement Date
It’s important to have a specific date in mind for when you plan to retire. This should be based on multiple factors, not just your investment portfolio.
If you enjoy your job, would you prefer to keep working (and saving) a little longer? It’s tough to get back into the working world once you’ve left it behind.
Are you slated to get a defined-benefit pension from your job? Are you fully vested already? If so, you may not need to make significant changes in your investments.
When are you eligible for full Social Security benefits? This varies depending on when you were born. If it was in 1960 or later, you will have to wait until age 67. If you start to collect your benefits earlier, your monthly payments will always be lower than if you had waited.
Then make an honest assessment of your future spending needs. Will you sell your current home and move to a lower-cost area? What are the tax consequences of this? After you have a specific target in mind, you can start formulating your strategy for getting there.
6) Create a Plan for Drawing Living Expenses in Retirement
When you draw on your investment portfolio for living expenses in retirement, keeping your tax bill down will give you more to spend. A tax dollar saved is as good, maybe better, than an investment dollar earned.
It’s usually best to let your wealth compound tax-free for as long as possible. The greater variety of accounts you have, the more opportunities you’ll enjoy to diversify your tax savings. This can help you keep your tax bracket down in retirement.
As a general rule, you should withdraw cash from taxable accounts first. Later on, focus on tax-deferred accounts such as traditional Individual Retirement Accounts (IRAs) and annuities.
Leave accounts with tax-free withdrawals for last. An example of such an account is the Roth IRA, which allows taxpayers, subject to certain income limits, to save for retirement while allowing the savings to grow tax-free. Taxes are paid on contributions, but withdrawals, subject to certain rules, are not taxed at all.
Early in your retirement, converting currently taxable assets to spending money makes sense because little or no additional tax likely will be due.
First, take dividend income and any mutual-fund distributions in cash instead of reinvesting them. You pay tax on these payouts even if you reinvest them, so this step won’t cost you anything.
Next, sell investments with no cost basis or the highest basis and therefore no or low taxable gain.
Assets with no cost basis include money funds and bank CDs as well as Treasury bills and various types of bonds held to maturity. Bond funds likely carry a high basis compared with your sale price, and therefore low tax liability.
Ideally, you’ll be more passive in taking long-term gains and more active in “harvesting” your tax losses.
Continuing to hold profitable, long-term investments in a regular account is, in effect, a form of tax deferral. If you sell losing investments, you offset your tax liability on any gains you’ve taken with other investments.
By following the above steps, you can protect your portfolio but still tap growth.
Note: This article originally appeared at ValueWalk.com on July 25, 2019. The author is John Persinos. John is the managing editor of Investing Daily.
Category: Stocks
