“Winter is coming! Winter is coming! Winter is coming!” Is this a cry to get all of your money out of the stock market because the end is near?
No, no, no, it absolutely is not!
If you watch the hit series Game of Thrones you know winter has been highly anticipated throughout the six seasons it’s been running. You may also know that you want to be on the right side of the wall for fear of the deathly “White Walkers”, and you may want to begin acquiring some serious protection if you haven’t already done so. Just like winter is coming here and on Game of Thrones, winter may also be coming for your portfolio. So here are some tips to ensure you’re on the right side of the wall and that you’ve got some serious protection for your portfolio during those dark times.
Do I have your attention? Let’s begin.
Some people ask me, “Steve, with interest rates so low, why should I have any bonds or CDs or savings accounts in my long term investing plan?” This is when I tell them the story of the Farmer.
A farmer must plant his crop at a specific time. He knows that as spring approaches, it’s time to get the soil ready for planting, fully aware of the growing and harvesting season ahead.
If all goes according to plan, (maybe based on the Farmer’s Almanac or hopefully the Department of Agriculture), he will be tending to his crop throughout the summer.
What does he do as he tends to this crop? Of course, he wants to keep his crop healthy until he’s ready to harvest in the fall, so does he pluck his healthy plants and keep the weeds sprouting around and trying to take over? Of course not, he weeds out the underperforming plants and keeps only the healthy ones.
Notice I used the word underperforming plants. I do this purposefully because there is a direct analogy from the farmer’s experience to the successful investor.
Most investors will look at their portfolio and sell their winners and keep their losers in the hope that the losers will rebound and become winners in the future. In reality, however, after taking their profits “off the table”, they end up with a portfolio of losers. This would be like tending your garden and pulling out only the healthy plants. You are left with weeds and other unwanted junk. Same thing for investors.
Following this strategy of selling your winners and keeping your losers will end with an unhappy result.
Farmer’s lesson #1:
Cull out your weakest plants, get rid of the weeds and tend to your healthy plants, fertilize them, keep the bugs away, and watch them faithfully.
Cull out your weakest holdings, tend to the heathy companies in your portfolio, maybe add some money to them, and watch them faithfully. Look for their ability to compound their earnings at high rates of return and watch their business very carefully. If you can find a group of companies that will do this, hold on to them as long as you possibly can. This is where real wealth creation comes from.
Farmer Lesson #2:
The farmer knows, as we all do, that winter will eventually come. Some winters are mild, some are nasty, but as spring turns to fall and fall to winter, the farmer knows when it’s time to harvest and to prepare for the upcoming cold weather.
What does the farmer do? He will take a portion of his harvest and cans or bottles it. He will put his tomatoes, his corn, his cucumbers, and make sure they are preserved for the winter ahead. And, most importantly, he will store these goods in his pantry to use when needed.
The bonds in your portfolio represent the farmer’s pantry.
As stock investors, we know that markets and economies are cyclical and bear markets are always going to come. Bear markets are a necessary part of the economic cycle because of the basic fact that good economies that last a long time tend to make people do silly things. Maybe the expanding economy caused too many people to take on too much debt. Maybe people spent too much and didn’t save enough for rainy days. Maybe companies over-expanded when times were good and were too optimistic about future prospects.
It takes a bear market to wring out these excesses and get things back in balance. For instance, in Florida where I live, brush fires are a natural process of getting rid of the unwanted growth which damages the health of the overall forest. Nature has its way of clearing this out, and a free market does the same. So bear markets will always come. Some will be mild and some will be nasty, but, assuredly, just like the inevitability of winter, an economic downturn will occur.
As I said, the Farmer knows this and takes precautions by canning and bottling and putting his food away in the pantry.
As an investor, by taking money out of your portfolio to live on, your bonds will act as your pantry.
Let me explain:
When the stock market declines, we don’t want to take your portfolio income out of stocks because it would mean selling stocks when they are low. You will want to take the money out of your bonds for a while until the stocks rebound. I successfully did this during the nasty market decline in 2008, and it gave the stocks in the portfolio time to rebound and catch the rise that followed the decline. I also added money to stocks during the downturn, which gave an added boost when things rebounded.
It doesn’t matter how old you are. If you are taking money out of your portfolio to live on, you will need enough bonds in the portfolio to get you through the bear markets. How long is a typical bear market? Over the past 66 years, there have been 13 bear markets, lasting an average of 14 months. The longest bear market since 1929 was 21 months and the shortest about 2 months*.
Interestingly, bear markets don’t really last that long. Bull markets last a lot longer, but…bull markets, bear markets… nothing lasts as long as a Game of Thrones winter, said to last for years. So be grateful we don’t have to prepare for that.
Depending on the amount you’re taking from your portfolio, at least have enough to get you through, let’s say, 14 to 21 months of a nasty stock market.
Therefore, Farmer’s Lesson #2: Always prepare for the winter because—we always know—winter is coming!
As for investments, if you get it wrong, you do not want to get side-swiped by a White Walker, Dragon, Army, Khaleesi, She Who Has No Name, The Seven Gods, or whatever else is in store for the Game of Thrones’ fanatics in April.
Be smart—and always remember the Farmer and his pantry.
*BOFA Merrill Lynch Global Research, Bloomberg